Weekly Market Commentary July 23rd, 2008
For anyone willing to take a contrarian view, this past week was a lot of fun. With the market showing extreme stress, it felt as if the pain would never end. All stocks were sold and fundamentals were disregarded. Having positioned myself very long and exposed to the companies I felt were too cheap and too under loved, the selling was painful. Then things changed. A better than expected earnings report from Wells Fargo acted as a catalyst to drive the entire market and the financial sector higher. Seven trading days later, the Dow Jones Industrial Average (DJIA) is 700 points higher and many major banks have rallied 50% or more. Capturing such a large rise in such a short period of time has an amazing ability to turn pain into pleasure.
Having called a market turn and being positioned for it is very gratifying. However, we must always look forward. Prior gains have been reflected in our accounts and now we must focus on where the markets go from here and where the opportunities exist. Only by developing a view of the future can we arrange our portfolios for future gains.
People use a variety of tools to make investment decisions. Technical traders and value investors look at a myriad of data to determine what they think is the most likely outcome for the market. Having developed a view, actions are taken, positions are monitored and various steps implemented to make sure that the investor is comfortable with the risks they have taken and the opportunities that exist. At a high level, this approach is sound and logical. However, I would also apply my own twist.
As a value investor, I am extremely concerned with the long-term business prospects of the companies I own. Believing that a superior business will ultimately yield long-term benefits, I allocate capital based on which companies I think have a high margin of safety accompanied with outstanding return potential. While a long-term focus allows me to look past volatility and noise, I realize that we all live in a world of short-term goals. Within this short term world, business prospects take a backseat to market psychology.
The severely oversold market we faced over the past few weeks had pushed the market to an extreme where a quick decisive rally was needed. Having seen that rally, we must assess where prices go from here. Two weeks ago, every market expert called for a 500-700 point rally on the DJIA that would work off the oversold level. We have received that move and now many are taking the view that gains will be consolidated with a retest of the prior lows. Intuitively, this argument has merit. My timing model was 4% long at the extreme and now sits at 34% long. VIX has spiked toward 30 and now trades below 22. The S&P 500 moved sharply and now hovers just above the January and March lows. All this data argues for people to monetize their gains, move to the safety of cash and await the market’s direction. As I said, it makes perfect sense.
There is just one problem I have with this scenario – it makes perfect sense. If I have learned anything over the years it is that the consensus view is often incorrect. Further, following the consensus view will never allow one to achieve superior long term results. Instead, I must develop a view, compare it to the consensus and determine if opportunities exist for a contrarian to profit.
Using this approach, I believe the current rally has more room to the upside. There are a handful of factors to support my thesis. Key among them are that sentiment indicators have come down from the extreme fear readings we saw a week ago, yet have not approached levels showing complacency, too many investors are looking for reasons to sell any rally and the market’s reaction to news has shifted dramatically.
The reaction of the market to information is of particular note as it describes how investors are processing information and making decisions. In environments where the markets are heading lower, all news is viewed bearishly. When prices trend higher, all news is seen as support for stock prices. Currently, the market has put a bullish spin on each piece of data and has allowed for prices to head higher. Key examples of this dynamic are the reaction to bank stocks and Apple’s earnings release.
Virtually every bank has reported sharp declines in earnings and credit quality. Dividends have been cut, assets have been sold yet prices move higher. The market has treated each earnings report as a reason to take the sector higher. When Apple reported a strong quarter with tepid guidance, the stock sold off dramatically. Having closed Monday above $166, Apple traded as low as $147 before the market opened Tuesday. By the close of trading Tuesday, Apple was above $162 and is now trading at a price that is higher than Monday’s close. In 48 hours, Apple saw 10% of their market value erased and then recovered. In bearish markets where prices are heading lower, stocks do not react to news in this fashion.
Having profited from the initial move, I am faced with a market where I am long of stocks that are trading at higher prices than a week ago. How do we approach this situation? My policy has always been to maximize gains while controlling risk. With that mandate, I have been selling stocks I have held for a quick rebound yet do not planning on keeping for long periods of time. Further, as my core holdings have grown in value, I have systemically sold shares to maintain a proper risk balance. Over the coming weeks I will continue this policy. By harvesting gains and managing risk, I can profit from the long term potential of my core holdings as well as benefit from a short term rally.
Great read once again Sean! Always love to hear what you are up to as well as your insight! Thanks!