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Weekly Market Commentary - July 15, 2008
Posted by Sean Hannon
July 15, 2008 at 5:00 pm
Last week I described how the equity markets are severely oversold and that history has taught us that buying stocks in this environment ultimately yields substantial rewards. Since then, the Dow Jones Industrial Average (DJIA) has declined 360 points (3.2%). This represents a significant move that pulls us deeper into oversold territory as investors react to an array of negative news and throw stocks out the door. Given this move lower, is not the desire to buy more compelling? Aren’t we being given an additional 3.2% upside gain when the market eventually turns? Normally, I would say yes. However as someone who is very long of equities at the moment and has seen great value stocks become even cheaper, I find it more prudent to reexamine not only my views of the markets, but the views of other investors as well.
An analogy I have often used is that the markets behave like rubber bands. Normally, we fluctuate within a range where minimal stress pulls the rubber band in either direction. At times, normality ceases and the rubber band becomes tightly stretched in one direction. Eventually the tension is released and the rubber band violently snaps back in the opposite direction. With the market severely oversold, we are clearly stretched to the downside. Knowing that markets never go in one direction indefinitely, we will eventually see a sharp rally in stock prices. The only question is when the rally occurs and for how long and how far it takes us.
Over the past week, no action has occurred to alter my view. In fact, as the market has deteriorated many conventional sentiment indicators show that fear is beginning to dominate. The VIX has moved sharply higher and is approaching 30. New lows on the New York Stock Exchange (NYSE) are expanding and equity mutual funds are beginning to see increasingly large outflows. All said, when hope is finally abandoned the market will bottom and begin the sharp rally I expect.
Given these conformations of my oversold thesis, why not become longer? I have two large concerns. The first is that everyone is expecting a sharp rally that takes us 5-7% higher, stalls and then resumes the primary bear market decline. While the thesis makes sense, the fact that everyone expects it is unnerving. Experience has taught me that the consensus view is rarely correct. Therefore, we need to see some deviation from this view before a short-term rally can occur. Hopefully the signs of retail investors pulling money from equity mutual funds indicate the capitulation needed to form a bottom. Only when I see the majority of investors abandon the idea of a quick, tradable rally will I expect that rally to occur.
My second main concern is the calendar. This week we have a series of key economic reports, many important earnings reports and options expiration this Friday. Next week we will see another slew of earnings reports with most of the S&P 500 disclosing how they did in the prior quarter and what they expect to see in coming quarters. With such key fundamental information becoming available, the market has the ability to react strongly. Decent earnings with reasonable forecasts should push us higher. Confirmation of the perceived economic and credit market tightness would drive us lower.
So should we view the next two weeks as decisive for the market direction? Clearly I think so. After the next two weeks pass, company specific news will be sparse and stock prices will react to non-specific news. The absence of a strong catalyst will eliminate the ability for prices to push higher based on business fundamentals. Without that catalyst, investor psychology will dominate fundamentals. While this could produce a rally, psychology based moves are not sustainable over long periods of time.
Considering these competing factors, how do you position yourself in this environment? For me, the answer had been to maintain core positions I find attractively valued, realize gains on short-term trading opportunities and attempt to capture some of the excess volatility that is priced into the market. Following this strategy, I have closed a number of short positions, applied option strategies to capture the high level of implied volatility and maintained my core holdings. With 30% of my portfolio invested in financials, the bank sell-off and constant battering of the brokerage sector has taken a toll. However, I firmly believe that the stocks I hold are sound institutions selling at hugely discounted prices. A few weeks of volatility and market-to-market losses can be hard on the psyche, but if the intent is to grow wealth over long periods of time, occasional adverse outcomes must be expected. The key is to hold positions you believe in and position yourself for when the market turns. If history teaches us anything, it is that a disciplined investment approach which focuses upon value and long-term prospects will yield results far in excess of what the general market indices can deliver.
Excellent read Sean as always, thanks for the insight!