Weekly Market Commentary, February 12th 2008
For the past six months, Mr. Market has been forgiving. Considering the path from Dow 14,000 to the depths of the credit crisis, this may seem like an odd comment. However, I believe it is accurate. When I first witnessed the beginning of the credit crisis during July, I was surprised. I had been bearish on housing for some time and felt that poor underwriting standards, excessive debt levels and the desire to write the final piece of business would cripple lenders. As months passed, the markets ignored these risks, pushed higher and left the housing bears frustrated. Having left for vacation a few weeks before the credit markets began melting down, I had my views in place, but no portfolio positions to profit from them.
As the markets sank to lows I kicked myself for being right, but not profiting. Fortunately, I anticipated the Federal Reserve’s (Fed) interest rate reductions, positioned my portfolio and reaped large gains. Then Mr. Market gave us a do over. As lower interest rates alone did little to change the housing market, the credit crisis was bound to redevelop. After a few months and a brief market rally, crisis returned. Those who had missed the initial market drop during July and August were given a second chance to profit.
This same forgiving pattern played out many times over. Looking to short high momentum stocks such as Apple? If you missed the pullback during August, Apple rallied to over $200 during December to crash to $125 during January. Wished you had added an emerging market position to your portfolio? The iShares emerging market trust traded below $110 during the summer, rallied above $160 and now trades near $136. When you consider that markets often confuse people at each turn, the ability to initially miss a trade and then be given a second chance is remarkable.
Last week it appeared the market was giving us another chance. During the first five trading days of 2008, the Dow Jones Industrial Average (DJIA) sank 5%. This drop was quick, abrupt and painful. From that point in early January, stocks would continue declining and would not stop until the DJIA hit a closing low of 11,971 on January 22nd. Last week the DJIA declined 4.50% and pulled within 210 points of the closing low. Was this another example of Mr. Market attempting to give investors a second chance to sell stocks from their portfolio before the DJIA headed lower? I think not.
While it is always dangerous to argue that this time is different, I believe it is. When we were pulling toward the January 22nd lows, the internals of the market were a disaster. New lows were spiking and the technical underpinnings of the market were breaking down. By the time we hit bottom, less than 15% of New York Stock Exchange (NYSE) listed stocks were trading above their 50 day moving averages versus 33% today. 16% of NYSE stocks were showing bullish patterns versus 32% today. Within my timing model, 8% of stocks were bullish versus 42% today. Therefore, while last week’s drop was painful, it was not devastating. Instead of seeing a market breaking to new lows we witnessed a market consolidating gains. Individual stocks did not experience broad based pain, but pulled back within bullish patterns.
The investment implications of this difference are crucial. As the market remained strong and consolidated we exited a period where excessive news flow could have destroyed the market. Generally, 4th quarter earnings and 1st quarter guidance were weak. Also, the barrage of economic reports is showing a weakening economy. However, many stocks absorbed this information without breaking down. We now enter a period where company specific information will be sparse. With nearly 6 weeks until companies are forced to pre-announce poor results, the bulls have a chance to push this market higher. Without hard data to counter their claims, bulls do not need to worry about battling poor technicals. Instead, they can push this market higher as people begin to believe the worst is behind us. Over the coming weeks, expect to hear people speak about how lower interest rates, fiscal stimulus and recovering equity markets point to a strengthening economy. Within this subtext, people will return to the market, begin buying stocks and push prices higher.
Having developed my bullish thesis, I do not plan on waiting for Mr. Market to provide me with a second opportunity to profit. Instead, I will take action now with the expectation of profiting in the coming months. Last week I was 55% net long. This week I am 70% long. Over the past three weeks, I have doubled my exposure to the market. In the next three weeks, I expect to increase that exposure further. By focusing my purchase on the securities that pass my valuation criteria, I continue to build a portfolio with high expected return, above average dividend yield and below market risk exposure. Doing so will provide safety during volatile markets, stability during flat markets and positive performance during strong markets.
Great commentary. You really put it in ways people (at least myself) can follow.
Awesome read as usual Sean, thanks for sharing
Very interesting read. I like that you’re looking at market reaction, instead of trying to predict the news. At first, I thought we were going to be in a straight bear market. But I’ve been having many of the same thoughts lately. What matters, is the cheerleading, and what people are talking about.
I learned a long time ago, not to trade the facts. Trade the perception.
Good article.
Thank you for the comments. Many years ago I realized that financial journalism is reactionary and does not offer great insight to why markets behave in certain ways. My job is to make money for my clients. Instead of over-intellectualizing the markets by predicting news flow I would rather see how they behave and develop strategies to profit.
well said.