As the market sold off in the first half of 2008, investors have been looking for the point of capitulation where stock prices surrender to the bearish sentiment of the day until finally the last seller succumbs to his willingness to take any price, even a rock bottom price, for the value of his shares. Optimism is surrendered. Hopes for a higher price disappear. The financially defeated investors yield, allowing for the market to bottom. When the last seller throws in the towel and there are no more sellers left to dump shares, then there is no place for the market to go except up.
In bank stocks, July 15 was a classic point of capitulation. Worry spread that two of the biggest banks around, Fannie Mae and Freddie Mac, were going belly up because their stock prices were falling swiftly toward single digit levels. The combined enterprises, once valued at over $100 billion, fell some $80 billion in market value and took a great deal of investor confidence down the drain as well. Worries about the creditworthiness of some $5 trillion in outstanding debt obligations spread throughout the banking sector. It would be hard to find a bank somewhere that doesn’t have these agency bonds on their books. If agency paper was to be the next victim of the sub-prime lending debacle, then no bank or savings & loan would be safe. Acknowledging that these stocks were in fact too big to fail, without saying so explicitly, the Fed stepped in with legislation to effect the quick nationalization of these companies, if necessary, so that the debt issues of these institutions wouldn’t lose value, even if their stock prices did fall to $0. This dramatic move, along with some technical requirements that made it harder for short sellers to dump shares in bank stocks, resulted in the mother of all short-covering rallies.
Eight days later, the bank sector was up 50%. Wachovia shares doubled. Capitulation, it seemed, had finally arrived.
The odd thing about capitulation is that there have been times throughout history when defeated armies have surrendered to lower ranking soldiers who lack the authority to sign off on the deal. A sponsion is an agreement by an agent not authorized to cut the deal. The sponsion must later be ratified by those in power for it to be binding.
I worry that the financials, as important as they are, lack the requisite authority to mark the beginning of a new bull market. Financials will spend the next several months trying to rebuild their credibility, retool their business models, and strengthen their balance sheets. The last seller may have decided that he’d take $7.80 for his Wachovia shares, but after the stock bounced to $17 new investors in the name remain scarce. For a true capitulation, one that signals a great buying opportunity for investors, we need some other sectors to attract new investors and start moving the market higher.
The main driver of 2008, financials, is a long way from having the authority to assert leadership. Energy stocks, the other prime mover during the past 6 months, have moved so high that each move up only made the subsequent tumble more painful. No, for this really to be a profitable point of entry, I believe that export-driven sectors like technology and health care need to start moving up. So far we’ve only experienced a short-covering rally in the financial sector. The result has been a sponsion. We eagerly await ratification by stronger areas of the market.
One area of the market that is looking better is the small cap growth stocks style (represented by the IJT iShare). Morningstar notes that this ETF has large concentrations in energy and industrial materials areas which have helped performance, but so has a 12% weighting in software and hardware stocks, and a more than 15% weighting in healthcare. In contrast, the utility iShare has started losing money recently, losing money when oil prices rise on interest rate fears, and losing money when oil prices decline because many utility sector stocks trade like the energy manufacturing company that they are. In any case, the heads “you win” and the tails “I lose” characteristics which the utility stocks have recently displayed have cost them a place in the asset allocation mix.
For clients invested in our ETF model, this gives us another chance to continue with our move out of ETFs and into the mutual fund model. Clients have sold their XLU shares and will be using the proceeds to purchase holdings in the software sector where we believe shares are attractively valued and industry fundamentals remain healthy.
For clients already invested in the fund strategy, we have reviewed current portfolio holdings and see no reason to change them at the moment. Companies in the healthcare sector are looking strong, and short-term bonds are struggling to maintain their place in the portfolio, but having just added biotech holdings to the fund strategy, we’re not anxious to double-up on healthcare quite yet. Nor are we willing to let go of bonds given our concerns that a true point of capitulation may not have been reached. Capital, once lost, is hard to recover. We’ll wait for a few more signs that the July 15 low point has been ratified by the capital goods, technology and healthcare sectors before we let go of any more of our defensive positions.
The individual stock strategies have stepped up, proactively, to begin adding to holdings of semiconductor, healthcare equipment, and insurance names. Even the individual stock portfolios retain some dry powder, though, in the form of cash equivalents and holdings in a closed-end bond fund. We are hoping that what we saw in July was a bottom. Heck, we even think that it’ll prove to be a bottom. But having invested much of our cash from the sidelines during the first two weeks of July, we are now in the unenviable position of “hoping” that we reached the low point on July 15. The market feeds off the dashed hopes of investors, so we’re a little bit uncomfortable hoping for signs that an economic rebound is coming. There are many reasons to expect a rebound, but not a lot of signs that it has arrived yet.
The individual stock portfolios are “buying low” in anticipation of the rebound. Both the ETF and the mutual fund strategies are waiting a bit longer for confirmation that the capitulation was for real.
Douglas B. May, CFA, is President of
May-Investments, LLC and author of
Investment Heresies.
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