Weekly Market Commentary, March 4th 2008
                The efficient market hypothesis (EMH) states that the prices of publicly traded assets (i.e. – stocks) reflect all the known information about that asset. Therefore, the market has taken different opinions from millions of investors and created a market price that reflects the collective wisdom.  For those who believe in the EMH, market prices reflect everything that is known about the future and therefore the market price is correct.
               Personally, I do not adhere to a strict view of the EMH. While I will concede that technical trends in various stocks often foresee the future, there have been many instances where crowd mentality pushed prices to extremes. As the housing bubble inflated and grew, did people truly believe that house prices would rise forever? Did the investor buying Google at $741 in early November honestly think the price of this stock would continue its parabolic move?
               EMH advocates will make the argument that housing and Google’s price at the time reflected all available information. Only when new data became available did the market react and adjust prices accordingly. As interesting as this debate could become, I do not want to focus this entire article on an academic theory that has been debated many times in the past. Instead, I would like to focus upon what the markets are currently saying, what the message may mean and the implications for the future.
               Since the Dow Jones Industrial Average (DJIA) peaked in October 2007 at a price of 14,164, the market has sold off at an uneasy pace. An initial drop below 13,000 in November led to brief rally. From there, prices continued downward in sporadic fits and eventually hit a panic low of 11,971 on January 22nd. We then saw a quick rally to 12,743 on February 1st, multiple reversals and a market that is groping for direction.
               Last week I wrote about the dramatic reversal that occurred on February 22nd. A market within 2% of its January low reversed and ignited a rally. Within 3 days, the DJIA was 50 points from its February 1st high and was poised to rally. Looking at the chart, you witnessed a wedge pattern that appeared ready to break to the upside. Doing so would have implied that the lows were behind us and prices were to rebound. This breakout never occurred.
               As I write this article, the DJIA is down 220 points on the day and has lost 650 points (5%) over the past four days. My proprietary timing model had been 48% long and is now 32% long. The NYSE bullish percentage has declined from 44% to 39%. Most ominously, major indices which had been poised to break higher have now resumed their long standing downtrends and are quickly approaching the bear market lows.
               Reviewing where we have been is helpful, but the key questions remains where do we go from here? As a value investor, I always attempt to define the key piece of information that ignites any market move. While many will point to the credit crisis, weak economic reports and corporate specific news, I have seen little in the last few days that was unknown. The prior week the markets went higher in the face of this news and now they head lower. When we were setting lows in January, the housing and credit problems were well known. If we are to believe in the EMH, the lack of original data implies that prices should be relatively unchanged versus where they were a month ago. Perhaps that is what this market is attempting to say.
               If we take a broad view, a trading range presents itself. Since early January, the DJIA has moved in a 600 point range between 12,000 – 12,600. As we headed higher last week, clarity was approaching. Instead, we reverse, remain in the trading range and see no discernable direction. All we can say for certain is that current prices have now traveled to the lower end of the trading range. From here there are few alternatives. The most likely result is either a continuation of the trading range with the markets heading higher over the next few weeks or a bearish break lower with no end to the pain already inflicted.
               While the trade seems like a reasonable risk – we either go up or down – the outcomes are not symmetrical. An unsustained bounce from these levels would offer the opportunity for a quick trade and nothing else. However, a break lower would be ominous with no end to the carnage. Therefore, caution is key as the risks from a bearish move far outweigh the benefits of a bounce.
               From a portfolio management perspective, we must be very careful. Last week, I was 80% long. As my timing model has turned, my net exposure has been reduced to 70% long. In a normal environment, I would add index exposure and raise my portfolio position. Today I am not doing so. Recognizing that a bearish breakdown would have extreme ramifications, I will hold my current position. With the majority of my long exposure in commodities and undervalued companies with great operating businesses and above average dividend yields, I am confident that I can exit a bear market stronger and wealthier. Only when the market picture becomes clearer will I alter my portfolio position.
Hey Sean,
What do you make of this last hour rally? 2nd day with key support levels holding up. I feel cautiously optimistic that the bulls are atleast temporarily taking back the reigns.
O btw, outstanding article as usual, loved the comments on EMH.
The late rally was reminiscent of what we saw 10 days ago. The real question is whether this time the rallies sustains or if we are simply bouncing within a trading range. At the moment, I don’t have the answer. For now, I will watch the market and determine what the next move may be.
It does not look like the bottom will fall off anytime soon. Although today’s rebound in the last hour is a result of short covering, it nevertheless shows us the bears are not as strong as we have given them credit for. I think we will trade between 12000 and 13000 for a couple of weeks.
That’s a really good look at the efficient market theory. I really don’t buy into that hype too much, like you, but it is always good to keep things in mind when you invest. Thanks for the words of wisdom, keep up the great writing