Weekly Market Commentary, April 8th 2008

                 In prior letters, I have described how financial markets are driven by participants with different time horizons.  Over long periods, business and economic factors combine and allow stock prices to track those companies whose prospects appear brightest.  Over shorter timeframes, market psychology and investor emotion dictate the direction of prices.  As earnings’ season takes shape over the coming weeks, short term psychology will collide with business fundamentals.  The outcome?  We will gain more clarity about the future path of prices and be able to render a verdict about if the past three weeks represented a reversal from the bear market bottom or a bounce in a market that will continue lower.

                When the Dow Jones Industrial Average (DJIA) reached a low point of 11,740 on March 10^th, all the key elements existed for a bounce.  VIX, a volatility index measuring investor fear, was trading near 30 (the one year average is 20), the markets were oversold by a number of different measures and investor polls showed the more people were bearish than bullish.   With overwhelmingly negative sentiment readings, most people had prepared for the markets to head lower.  This created a situation where either good news or the appearance of good news would allow for a quick rally as bearish bets were covered.  Since the economy has continued weakening, it would be difficult to find pockets of good news.  Luckily for the bulls, appearances can often be more powerful than reality.

                As the DJIA rallied nearly 1,000 points over the past month, we found ourselves in a quiet period.  With the fiscal quarter ending, most companies refrain from commenting on their business performance until earnings season.  This created a vacuum where company specific news was sparse.   With limited company specific news to distract them, the bulls have been able to sustain a rally.  Looking for excuses to buy, we were pointed in many directions.  Federal Reserve (Fed) policy was considered loose enough to encourage growth, yet strong enough to contain inflation.  The rescue of Bear Stearns was seen as a proactive approach to quelling market turmoil at the expense of free market principles.  As various banks and brokerage firms have raised new equity (i.e. - Washington Mutual and Lehman Brothers), we have been directed to the willingness of large investors to back these firms.  Lost on most is that these investments are made at great expense to the institutions and their shareholders while greatly benefiting the new investors.

                When an oversold bounce began accelerating, fear and greed combined to push the markets higher.  Fearful of missing a rally, investors began buying every stock they could find.  This in turn pushed the market even higher.  With this positive cycle in force, where do we find ourselves?  From a sentiment perspective, a market which was once oversold is quickly becoming overbought.  My timing model had been 20% long a month ago.  Today it is 73% long.  Newsletters that had been correctly bearish for many months are now becoming bullish.  A month ago, the markets were looking for any reason to go down.  Now they are looking for every reason to go up.  Short sellers who were confident a month ago now find themselves increasingly nervous at the rediscover that markets can remain irrational longer than they remain solvent.

                Given the improving market backdrop, it is reasonable to assess my current stance.  After all, I have doubted this rally from the beginning and have questioned whether policymakers have done enough to alter the path of the economy and the effect it will have on the markets.  While my long term thesis remains intact, I must also take account of where we stand. 

                So, what do I see?  I consider my current portfolio positioning ideal for this market.  Having stayed conservative over the past month, I have maintained a net long position of nearly 65%.  Since many of the core companies I own have performed well over the past few weeks, I have generated positive return while keeping my risk level low.  At the same time, I have maintained enough flexibility to allow for a quick reaction to whichever direction the market takes over the next few weeks.  This layer of flexibility will be essential to performing well in what should continue to be uncertain times.

                While the market is never easy to understand, the continual interference by the Fed and Treasury has further muddied the view.  By not allowing the economy to work off its excess capacity, lenders to return to rational pricing and financial markets to rediscover equilibrium, we are faced with increased uncertainty.  With that, there are a few key data points to observe.  The DJIA closed April 1^st with a 391 point rally that brought the index within reach of a price point that has stopped many previous rallies.  Since then the DJIA has attempted to break higher on many occasions, but has yet to close above the top of the trading range.  During this rally, sentiment has improved and the general pessimism that provided fuel for this rally has been extinguished.  Finally, the quiet period has ended as companies begin reporting 1^st quarter results and provide guidance for future quarters.  At the moment the bulls are in charge, but we have all seen this market take quick, unexpected turns.  As reality and perception meet, positive news will allow for the market to push through the top of trading range and head higher.  Overly negative news will expose the past month as a bear market rally with stock prices dropping to new lows.  While those brave enough to make wagers about the next 200 points from DJIA can step up, I will not.  With a portfolio full of attractively valued companies and ample cash reserves, I am positioned to react to the markets decision and profit accordingly. 

The beauty of investing is that we have the option to wait for the ideal entry point.  There is no need to chase every pitch with the hopes of hitting a home run.  Instead, wait for the situation you prefer and act accordingly.  For me, I will wait for the market to either break above its trading range or sink toward new lows.  Once the primary trend has been confirmed, taking advantage of the market becomes easier.  Until then, I hold my portfolio content in knowing that solid companies purchased at attractive valuations will compound wealth over time.

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Related Posts From the Past:

• STTG Weekly Highlights, July 13th 2008
• STTG Weekly Highlights, July 21th 2008
• Blain’s Nightly Stock Picks, April 23 2008
• Hard Market Sell Off in Afternoon Trade
• Weekly Recap, Chicks and Corporate Destruction

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