As I write this, the market has fallen -24% thus far in 2009, following the -37% plunge in 2008. Investors worldwide are enraged, demoralized, and fearful. It feels as though investor sentiment couldn’t be any worse, and a turnaround in sentiment is one of those "potential positives" that investors need to consider. A reduction in the level of fear could fuel a tremendous rally.
- But from what level will it come?
- How long will it take?
- And what will transpire between now and then?
In a bear market, however, the largest moves down usually occur in a panic at the end of the sell-off. Taking money out of the market, prior to the bottom, may preserve capital on the downside that more than make up for the missed opportunity cost when the market finally turns up.
Missing the worst 10 days of the year typically makes a bigger impact on portfolio returns than does missing out on the 10 best days. An investor offered the chance to miss the worst 10 days, even if it also means forfeiting the best 10 days’ gains, should probably take that deal in a heart beat.
We began raising cash last week and early this week. Both in the fund accounts and in the individual stock portfolios, we have sold off positions to reduce our vulnerability to a continued sell-off in the market. The key question, of course, is "where’s the bottom?"
It’s hard to set a level at which the market is so cheap that value investors will be forced to come in, which is how most bottoms are formed. In our January economic forecast, I said that the market was headed lower, and gave the 7,000 figure for the Dow Jones Industrial Average. That level was based on earnings for the S&P 500 Index companies falling to $60 (from over $100), and the Price/Earnings multiple falling to 11-times those earnings.
We’ve fallen to that level, but is it enough?
We don’t know if it’s low enough or not. The 7,000 level on the Dow (and 660 level on the S&P 500) was only intended to indicate that at some point during the course of the year, we believed the market would trade much lower than where it traded in January. At the moment, earnings are a very poor indicator of value because things are so unstable. If we only experience a severe recession, which is what we’ve experienced thus far, then today’s levels could hold. We continue to be plagued by legitimate worries that we’re headed for a full scale Depression. If we are, then the earnings collapse has just begun and the market can still go lower.
I wish I didn’t have to be so negative, but signs of a turnaround are not as strong as I would wish. Unfortunately, our government leaders are aligning the vast resources of the government against the millions of business owners, without whom an economic recovery will not be possible. I don’t know if these de-stabilizing moves are preventing a recovery, or the monetary stimulus associated with bloating the nation’s money supply is just requiring more patience than I can muster.
Typically it takes about a year for increases in the money supply to accelerate the rate of economic growth. The money supply began expanding late in 2007, so some signs of recovery ought to be visible by now, but the traditional stimulus of 2008 was more than offset by the implosion of our banking system. Perhaps the huge explosion in money growth, beginning in September of 2008, just hasn’t had time to work its way through the system. A global surge in monetary stimulus also didn’t begin until late in 2008. The impact of these moves, as well as that of the fiscal stimulus package recently passed, are still ahead of us. It would be reasonable to see early signs of recovery, any day now.
What transpires between now, and then, will determine whether our latest moves to raise cash come to be something we regret. With the market in a free fall, and signs of distress certain to outnumber potential early indications of recovery, it became too risky to be anything but minimally weighted in the market.
To generalize about the portfolio, we currently have about 20% in cash equivalents, 30% in high yield fixed income securities, 20% in inflation-oriented investments, and 30% in more traditional stocks, tilted toward technology but also including stocks in the biotech sector. We typically have at least 60% in equities, so some would consider us underweighted, to the point of being below our minimum required commitment as outlined in our client profiles. The main reason for being so conservative is that it is working. Owning just about any equity has led to further losses, so by having money in non-equity asset classes we have been able to significantly reduce losses for clients thus far in 2009.
The other reason for reducing stocks below our stated minimum is that our fixed income (high yield bond and preferred stock) investments are experiencing volatility, up and down, more like what stocks traditionally deliver. On days when the market is selling off, the portfolio is not performing like one that has 40% in "safe" assets, so we decided to scale back even more on the amount invested in traditional stocks.
At this point, I believe the market could move 1,000 points in either direction. The current trend is down. If a Treasury auctions fails due to the bloated amount of treasury issuance which current deficits require, the dollar could plunge and rates could soar, sending investors reeling even more. If the recent stimulus fails to gain traction and the economy keeps heading down into a Depression, then I think the pundits calling for a 4,000 or 5,000 Dow could get their way. Stock market volatility is still very high, though below the peak levels experienced in November and December. In a typical bottom, prices plunge to new lows and volatility spikes at the same time. Is that sort of washout still in our future?
On the other hand, the accounting geeks could revise mark-to-market accounting rules as early as next week, which might send financial stocks soaring in a relief rally. Oil and natural gas stocks could add to recent gains as falling production and lean inventories work to change the supply/demand fundamentals. A restructured auto industry and an aging auto fleet could prompt buyers to return to automotive showrooms, which could help restore consumer confidence. Overseas stimulus could start having an impact, which would probably be reflected in higher commodity prices. New tax breaks for homebuyers might prompt more home sales, which would help bring housing inventories into balance. There is no shortage of things that could be better, tomorrow, than they are today.
The odds-on bet is still that things improve from where they are today. A friend of mine who has been managing money in Denver for 35 years firmly believes that values are as cheap today as they were in 1982, at the last fantastic buying opportunity presented to investors. He has been telling his clients that even if Obama’s economic model for this country IS France, which might give most of my readers pause for thought (or worse), even French companies have profits, and stocks on the Bourse de Paris that go up and down to reflect their future prospects. This, too, shall pass.
But from what level? I wish I knew.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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