Weekly Market Commentary - August 19th, 2008
Last week I commented that the current rally had run its course and the time had arrived to eliminate index exposure and focus on specific stock ideas. Beginning August 8th, I sold exposures to the Dow Jones Industrial Average (Dow), large cap growth, small cap and mid cap indices at prices that range between 1.5-5% higher than where those same instruments trade now. While gratifying to have made the proper call, the prices I paid for some core holdings have suffered along with the general market. The end result is a portfolio that has been battered over the past week yet is better positioned for the months ahead.
When making investment decisions, I consider two distinct time periods. The first is a long-term view of where I think our economy is headed, what the implications are for the financial markets and what actions can be taken to profit from the events that will unfold. As mentioned last week, over the next 3-5 years, I expect the general market to show little to no return. With the economy weak and credit limited, dominant firms with positive cash flow will have the ability to fund innovation and increase their dominance. Weak companies with limited access to credit will see growth drop, innovation stall and market share lost. For me, the implication is clear. Focus on large cap stocks with dominant market share. Avoid small cap stocks, companies carrying heavy debt loads and those who are struggling in weak industries.
By constructing a portfolio using these criteria, I search for undervalued companies with large dividend yields and sustainable business models. When I buy these stocks, I am not sure of where prices are headed over the next 3-6 months. Instead, I focus upon where the value will be 2-3 years from now. Having completed my due diligence, I am comfortable knowing that short term volatility may occur yet long term gains will soon follow. Going forward, I focus upon how the business evolves, what changes have occurred and how that affects the company’s intrinsic value.
While this long term view makes sense to most, the implementation of it is very difficult. Firstly, exhaustive research is needed to understand both the company and its fair value. The second challenge is to buy the stocks when they meet your valuation threshold. Since I like to buy at a large discount to fair value, I am often the one picking up shares of stocks that everyone else has discarded. Consider two of my recent purchases - XTO Energy (XTO) and General Electric (GE). XTO is down 38% over the past 8 weeks. GE is 33% off the high reached last October and now trades at the same price it fetched in 1998. With drops these large most investors begin questioning the logic of buying a stock that has fallen so far. Instead, I attempt to ignore the market movement, focus on value and act when the price is attractive. This process is never easy yet yields gains over various business cycles.
Having implemented a long term investment strategy, we must also focus on what the markets are doing now. After all, short term volatility can cause one to make long term decisions at the worst possible time.
With the Dow nearly 3.50% lower over the past 7 trading days, we find ourselves in a dangerous position. My timing model is currently overbought with 80% of the stocks rated buy. VIX is trading below 22 and few other sentiment indicators are bearish. Instead, many pundits are saying the bottom occurred in July and that we will move higher from here. Personally, I do not buy it.
As I predicted, the Dow rallied from an oversold condition and bounced nearly 7% over a four week period. At that time, we quickly approached a long-term downtrend that had been in place since the market’s peak in October. Facing resistance, the market broke down, has violated all support and now trades below all key moving averages. Looking at my timing model, a further 6-8% down move is needed to restore an oversold condition that could serve as the prelude to a rally. Such a move would violate the prior lows and add considerable questions about the future path of the market.
While the rally from mid-July was welcome, it also appears over. I never believed July represented the low of this bear market. Instead it was a tradable bottom that allowed for one to rebalance their portfolio and position for the more difficult markets that lie ahead. While I remain fairly long of stocks, my positions are concentrated in names that I think will prosper over the coming years. I am using market volatility to generate trading gains and hedge my long positions with selective short exposure. By doing so, I look to control some of the short term pain while I await the market’s recognition of my core portfolio’s embedded value.
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Very nice post. Keep it up!
fantastic post Sean, great insight into market behavior and trading long.
Amazing read, I live for your articles each week!