Weekly Market Commentary – September 16th, 2008
The Great Gatsby, considered among the 20th century’s best works of fiction, is approximately 40,000 words. Herman Melville’s epic Moby Dick is nearly 215,000 words. Each week I write this commentary I spend between 1,200 and 1,800 words describing either the current state of the market or a relative issue affecting the capital markets. Over the past year I have needed to write 75,000 words, the length of two novels, to describe my thoughts. Doing so in a manner that is interesting to read and avoids constant repetition is sometimes difficult. For this reason, I search for metaphors and analogies that are unique an interesting. This writing style allows me to convey my message and keep readers interested as well.
This week there is no need to develop a clever analogy. Simply, this market is brutal and I fear that more pain lies ahead. On September 2nd, the Dow Jones Industrial Average (DJIA) closed at 11,516. The markets had been rallying from their July 15th low and many commentators were debating whether the bottom had occurred and we were ready to resume a move higher. At that time, I expressed my view that more pain should be expected and a cataclysmic event would occur to push prices to new lows (http://www.epicadvisorsllc.com/images/Weekly_2008-09-02.pdf). In the two weeks since writing this, we have seen the Dow and S&P 500 close at new yearly lows with the NASDAQ just 10 points away from its annual low.
The events that took us to this level are well advertised. What started with the nationalization of Fannie Mae and Freddie Mac has led to the bankruptcy of Lehman Brothers, forced merger of Merrill Lynch and serious liquidity problems at both AIG and Washington Mutual. Yesterday, the Dow dropped an incredible 504 points (4.4%) as equity markets had their worst day since after the 9/11 terrorist attacks. During the carnage I commented to a client that in a 6 month span we are going to witness the disappearance of the largest mortgage company (Countrywide), the largest brokerage firm (Merrill Lynch), two of the four major independent investment banks (Bear Sterns and Lehman Brothers), the nationalization of the housing industry (Fannie Mae and Freddie MAC) and most likely the demise of the largest insurance company (AIG) and the largest savings and loan association (Washington Mutual). Surely these events must be considered cataclysmic. Is it reasonable to assume that the bottom is in and now is the time to buy stocks at bargain prices?
While I think we are now closer to a bottom than 2 weeks ago, we are not there yet. Too many people are spending time calling a bottom than fleeing from the markets. Until we see widespread pessimism with everyone running for the exit, a bottom will not occur.
With all the chaos in the market, how do I decide that pessimism and fear has not reached extreme levels? To do so I use many different models to measure investment sentiment. As with most things in this market, arguments can be made in favor of either a bearish or bullish viewpoint. I will look at a few factors that support each perspective with hopes of developing a definitive answer.
First we will examine the bullish factors. The VIX (a measure of fear based on option prices) spiked 6 points higher yesterday and now trades above 31. Importantly, the current reading is seven points above the 10 day moving average. This type of spread between the current price and moving average often represents extreme investor fear and an approaching bottom. The NYSE New Highs-New Lows reached -611 yesterday. This means that new lows on the New York Stock Exchange (NYSE) outnumbered new highs by 611. This reading is similar to what was seen when the market reached temporary bottoms in March, but well below what was seen in July. I would call this slightly bullish. The final bullish factor is that many companies are now very cheap from a pure valuation perspective. However, as we have seen cheap stocks disappear (i.e. – Fannie, Freddie, Lehman, AIG, etc.) one is wise to question these value metrics during such turbulent times.
The bearish viewpoints are more numerous yet share key factors. There are many different ways to examine how most stocks are behaving, A few I use are the NYSE bullish percentage, percentage of NYSE stocks above the 50 day moving average, percentage of NYSE stocks above their 200 day moving average and most importantly my timing model. Looking at these metrics we see the same results. While stocks are weak and pointing lower, we are nowhere near the extreme readings that are needed for a true market bottom. For example, my timing model is 31% long. While leaning bearish, I do not consider it oversold until it reaches 20% long and we bottomed at 6% long in July. To get to these extreme readings, the DJIA needs to consolidate at these levels before heading slightly lower or experience an 8-10% drop in the coming weeks.
Looking at the two competing viewpoints, I find the bearish arguments more persuasive. A conclusion that can be drawn from the bearish arguments is that investors are not willing to admit defeat and move out of equities. Instead they are trying to catch bottoms, sector rotate and fight for each point of return. When the DJIA dropped over 500 points yesterday, Google and Amazon performed relatively well. Investors seem to think the chaos can be contained within the financials and that by rotating to higher growth areas their portfolios can be spared.
While I understand their rationale, I fear these investors are incorrect. Yesterday after the close, Hewlett Packard announced they were eliminating 24,600 jobs and taking a $1.7 billion restructuring charge. This morning Dell announced they are seeing a softening in global technology demand. The problems in the financials are now spreading to key clients (i.e. – technology firms). When we look at the highly compensated employees who will be unemployed and in a soft job market, the service industries in both northern Virginia (home of Fannie and Freddie) and the New York Metropolitan area (AIG, Lehman, Bear and Merrill Lynch) are set to suffer. With lower business dinners and offsite events, waiters will earn less. This then impedes their ability to spend on discretionary items. The ripple effect reaches bars, restaurants, entertainment providers and retailers. These industries then reduce headcount and the problem spirals further. Together it is a bleak view of soft economies, weakening housing markets and limited economic growth. Investors who think they can sector rotate out of this problem are destined to be disappointed.
As I have outlined, the picture is bleak. Knowing that stock prices do not move in one direction indefinitely, a bottom must eventually occur. The question is when and at what price. What we know is a bottom will occur when most investors have abandoned hope. At that point, all sellers will have been forced from the market, valuations will be cheap and apathy high. While prices must go lower to reach that point, each drop brings us closer to the end of the bear market and the resumption of the path to higher stock prices.
Having read this commentary, the big question that remains is what should an investor do? If we are convinced prices are heading lower, why not go to cash or outright short the stock market? Would that not help preserve capital, register decent returns and have us well positioned for the up move?
I admit these arguments have merit yet I am disinclined to go in this direction. While a handful of short sellers have been able to generate positive returns in any market environment, being short a stock is more difficult than being long. The average investor is wise to use short positions for general risk management purposes, but an inexperienced short seller getting aggressive in a down market is a recipe for disaster. Similarly, being in cash offers safety, but little return. With cash paying negative real interest rates (the rate of inflation is greater than the income received), cash may give you comfort today, but will insure you have less wealth in the future. Since our goal in the markets is to grow wealth over time, owning stocks offers the best opportunity to compound wealth. Nearly all investors agree with this premise, yet the desire to be in cash or short still lures them. While tempting, just remember that an investor who moves to cash today will eventually reenter the equity markets. By moving to cash now, that investor is betting that they will know the perfect moment when stocks have bottomed and it is time to buy. Market timing in this manner can be attractive for the few who make the proper calls, but many studies have shown that timing is extremely difficult and often lead to subpar returns.
So we return our initial question. What should an investor do now? My approach has been to eliminate index exposure and focus on the stocks I find cheapest. As the market has dropped, I have been closing short positions at profits. This has caused my equity exposure to increase dramatically and has increased my risk position. With a heavy weighting in financials, the past two weeks have been brutal as stocks I find cheap have crashed in value. As the market has dropped I have been selling calls and buying index puts to profit from the decline. The hope is that such defensive measures can partially insulate the portfolio from massive losses and leave me in position to add stocks as the markets head higher. For me, they key is to exit the bear market with a group of stocks that offer limited risk, high upside potential and dominant industry position. When markets bottom and stabilize, which they always do, one wants to be prepared for better times. During these times, focusing on the long term business value, as opposed to what the stock price may be tomorrow, will help in preventing your emotions from making decisions that will hamper your future financial performance.
While the daily news flow is overwhelmingly pessimistic, short term reactions lead to poor decisions. Investors build portfolios to achieve future goals. We must always keep that timeframe insight when making investment decisions. As F. Scott Fitzgerald reminds us at the end of The Great Gatsby, “tomorrow we will run faster, stretch out our arms farther… So we beat on, boats against the current” looking toward our goals.
Fantastic read Sean, thank you for all of your 75k words so far here at STTG, the content & your valuaations are outstanding