When looking at charts, patterns are in the eye of the beholder. While a group of analysts will look at the same picture and derive different opinions, there are general rules we can apply. The most important is that any trend line must have three points on contact with the data series.

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As the credit crisis evolves, many steadfast rules have been discarded.  Companies once thought too big to fail are gone and a free market administration has expanded the government’s role in the economy to a level last seen during FDR’s New Deal.  With constant shifts, investors must assess how the landscape has changed and what a prudent investor must do to profit.  During this chaos, one constant has remained.  In the banking sector, JPMorgan Chase (JPM) stands alone as the trendsetting institution capable of profiting from other’s misfortune.

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With three trading days remaining, I will be happy to see the month of October pass.  During this month, what had been a bad bear market turned viscous.  At the beginning of October the Dow Jones Industrial Average (Dow) was 18.2% lower for the calendar year and 23.4% below the peak of 14,164 achieved in October 2007.  With VIX trading near 40, investors were on alert.  However, little could have prepared for the carnage.  Over the past 3 weeks, we have seen the Dow drop an additional 24.7%.  This brings the year to date loss to 38.4% and the drop from last October’s peak to 42.2%.

While these drops have been devastating, the internals of the stock market are enough to shake the core of most investors.  During October, the Dow has closed higher on 4 trading days.  On those positive days, the average gain has been 5.2%.  On down days, the markets has fallen an average of 3.4%.  The average spread between the high point and low point in a given days has been 722 points.

I have often said that confusion presents opportunity.  At current price levels, all major indices are now trading well below my fair value targets.  Value Line reports the average Price/Earnings ratio (PE) of 12.1.  The prior bear market low was 14.1.  Many leading companies are selling at prices that are 60-80% below where the traded a year ago.  From a technical perspective, stocks are as oversold as they have ever been.  My timing model needs an average rebound of 55% in order to revert to a more balanced position.  With markets wound this tight in one direction and values appearing across the board, the likelihood of a sharp rally increases.  However, we must remember a few key lessons.  When living through paradigm shifts, cheap stocks can become cheaper and oversold markets can remain oversold.  Expecting the selling to cease does not translate into markets immediately moving higher.

For this reason, the next two months will be among the most important periods in stock market history.  In one week, the Presidential election will end.  This will remove a layer of uncertainty.  Further, Treasury will be implementing additional pieces of the TARP plan and Congress has indicated they may pass an additional stimulus bill.  By late November, massive amounts of liquidity will be in the system, some pieces of uncertainty will be resolved and consumers will begin focusing on the holiday season.  Within this environment, stocks should behave well, unwind the oversold nature and recoup losses.  To me, a rally into Dow 10,000 seems plausible and achievable.  After that, bigger questions remain.

Having suffered through such a harrowing drop, investors are frightened and angry.  The Dow trades near the same level as August 1997.  Twice in a 10 year span investors have seen stocks rally sharply to crater just as quickly.  With a 42% drop from the October 2007 peak of 14,164, many investors have seen a lifetime’s savings cut in half.  Those who used modest leverage have seen their wealth drop greater percentages.  As the Dow has made no money in a decade, people begin questioning the wisdom of a long term allocation to equities.  Add in the extreme volatility and investors quickly decide that fleeing the market is a wise choice.

I easily understand the motivation and actions of investors who are scared of what lies ahead.  People approaching retirement now face a situation where they must either continue working or alter their lifestyle.  Investors will begin reevaluating their willingness to accept equity risk and money that is needed for expenses in short time periods will be shifted to safer havens.  Combined with the deleveraging of banks and hedge funds, fewer buyers exist for the stocks traded in the market.  The clear result is prices must drop to lower levels to reflect this new supply/demand balance.

The clear implication of this trend is that all rallies will stall, stocks should no longer be held as long term investment and the only people to prosper for years will be nimble traders who quickly realize gains, avoid missteps and do not allow losses to grow.  This trend is logical, yet may be oversimplifying the situation.  A small subset of people who can survive with low single digit returns will look toward alternative investments and bonds.  However, most people need return in order to achieve their long term goals.  For years, people have been assuming high rates of return in their savings calculations.  Most private companies have applied returns of 8-10% in their pension calculations.  In order to meet these goals, people will continue to seek higher return alternatives.  While this bear market has devastated investors and shaken their confidence, a sustained move high will serve as the remedy to all their ills.

With the emotional tug between reducing risk and seeking return, we must watch the market’s action over the coming weeks.  To work off an oversold nature, markets will either stabilize or rally.  Assuming a rally, we need to see how far the market can travel.  Most expect any rally to be met with selling as investors move to a lower risk profile.  If this occurs, the fears over future stock market returns will be justified.  However, markets rarely behave in set, preconceived manners.  A sustained rally that pushes us over Dow 10,000 could make people forget the recent past and embrace the long term potential.  While the paths the markets will take are unclear, one thing is certain.  Over the next two months we should begin to see a trend develop that will persist for years into the future.  Successful investors need to watch this underlying trend, position accordingly and look for opportunities as they develop.

Contracting credit should be an aspect of the business cycle.  As the economy grows, credit booms, investments are made and price levels rise.  Eventually, we reach a point where prudent lending standards prevent further credit expansion, borrowing stagnates and economic growth either moderates or declines.

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During September, the Dow Jones Industrial Average (Dow) has dropped nearly 10%.  This compares with drops in the NASDAQ of 16%, the S&P Small cap index of 9% and the Wilshire 5000 of 14%.  While prices were dropping, the government became linked with the capital markets.  Over the past year, we have seen Treasury and Federal Reserve (Fed) attempt to influence behavior.  All of these actions were done at the edge of acceptable policy and were meant to unclog the capital markets while allowing free enterprise to reign supreme.  Over the past month, government intervention increased and free market ideology was swept aside.

To gain perspective, during September we have seen key linchpins of the housing market placed into conservatorship (Fannie Mae and Freddie Mac), the failure of two large banks (Washington Mutual and Wachovia), the nationalization of the largest insurance company (American International Group), the elimination of the stand alone investment bank (Lehman’s bankruptcy and Morgan Stanley and Goldman Sachs becoming commercial banks) and the disappearance of the largest brokerage firm (Merrill Lynch merging with Bank America).  With the government failing to approve a rescue bill, we have entered a period of heightened uncertainty, lower tolerance for risk, lower levels of financial leverage and lower innovation.

These expected changes have a dramatic implication over how we will invest.  To consider the effects, I have developed the “Five Lessons of the Crisis”.  They are as follows:

1. Solvency, not liquidity, is king.  After the collapse of Bear Stearns in March, many investors believed that a lack of liquidity had lead to Bear’s demise.  Following this script, the Fed began allowing broker-dealers to access the Fed window and broadened their list of acceptable collateral with the intent of allowing firms to conquer short term funding issues.  As we learned from Lehman, Wamu and others, this is not the case.  Bad loans and poor trades eroded the capital base and left these companies insolvent.  Rather than allow an insolvent company to grow out of its problems, we have seen bankruptcy, nationalization and asset seizures.
2. Valuation is in the eye of the beholder.  As a value investor, I have watched stock prices drop to levels I never thought possible as companies I thought would never be attractively priced are now outright cheap.  However, these same stocks have become even cheaper.  At a certain point we will look back at this period and discuss how shrewd investors snapped up shares at bargain prices.  For now, those same investors are experiencing escalating losses.
3. Public policy cannot cure private market woes.  As of now, every piece of government policy has failed.  With each proposed measure, markets have rallied.  Inevitably the measure fails and markets swoon.  Only through time and pain will excesses in the private markets be purged, bottom and lead to rebound.
4. Deleveraging markets kill innovation.  What started as a credit crisis has morphed into a Main Street crisis.  The major negative to deleveraging is that new loans are not being made.  Without new loans, companies do not expand, employment does not grow, the incentive to create and market new products declines and economic growth declines.  Together, we have a weaker economy and a lower standard of living.
5. No company is too big to fail.  For years, the presence of the Greenspan Put and Helicopter Ben has led many to believe that certain companies are too big to fail.  This thought no longer holds.   Going forward we should expect investors’ required return hurdle to increase as old rules no longer apply.  The result will be lower future gains as the days of P/E multiple expansion are now past.

Knowing the rules of the market have changed, we need to decide how to progress.  The answer is cautiously.  Right now, buying stocks remains far from anyone’s mind.  However, within fear opportunities exist.  Capitulation is needed for a market bottom and that has finally arrived.   An investor looking for an excellent business at a cheap price should look toward XTO Energy.  XTO possesses oil and gas reserves in geopolitically safe areas.   Market value of their natural reserves exceeds $60 per share and a high amount of 2009 production has been hedged at energy prices that are higher than prevails today.  Therefore, XTO offers excellent value with limited exposure to volatile commodity prices.

Disclosure: At the time of this post Sean is long XTO.

As a value investor who takes in-depth bottoms up views of companies, I love looking at reams of data with the hopes of discovering a hidden gem.  At times you find information buried in a company’s financial statements.  Other times you see how the general market misprices risk and look to profit from the opposite view.  No matter where the data originates, you need to look, examine and determine a profitable course.

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The Great Gatsby, considered among the 20^th 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.

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Confirmation bias is a tendency to interpret new information in such a way that it confirms our beliefs and to avoid or ignore information that contradicts our beliefs.  A clear example of this tendency is how nearly every investor reacts to their portfolio value.  Most people when asked will say that market timing is impossible and that they have adopted a long term view.  However, these same people will look at their account value each day and attempt to discern some insight from the change in value.  If the portfolio increases in value, investors consider themselves smart and savvy.  Sustained declines in value are treated with an explanation that daily fluctuations don’t matter to a long term investor.  Subconsciously, these investors are practicing confirmation bias when positive moves are attributed to smarts and negative moves reinforce an extended timeframe.

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