Rocky Mountain Humane Investing Outlook: April 2009 (Posted July 2009)
“Markets do have a lovely tradition of overshooting themselves both in the upside and downside”: from the RMHI 1st quarter client letter.
Is there a more droll way to describe the emotions of early March? It would have been uncommonly rare to have seen the selloff in late February and early March evolve into a lasting period of price erosion without some sort of quick rebound, only the 1929-31 period showed a lower low after such a devastating waterfall selloff. The selloff in March created a sense of investor despondency and incoming phone calls only seen at major market bottoms. This depression stood in contrast to a string of data points suggesting emerging stability that I wrote of in January:
- “Declining New Lows: On October 11th when the SP500 first reached 850, the number of stocks making new lows exceeded 3000. On January 20th the SP 500 touched 804 and the number of new lows was 186. Despite the SP500 being actually lower than 10/11, the number of stocks making new lows is only a tiny fraction of previous sell-offs. This trend has been apparent since November when the index made what might be the ultimate low for this Bear Market of 740 yet the number of new lows was just 600.” At the March low there was only 855 stocks making new lows, despite the market being 22% below the October low. In addition, volume at the October low was 2.85 billion whereas the March low volume was just 1.56 billion, clearly a marked drop in selling intensity. All major market bottoms showed this behavior.
- “Crude oil prices: Stability in oil prices may mean we’re reaching stability.” Crude oil and other commodities are frequently a barometer of worldwide economic activity. The May futures contract for crude broke out of a downtrend in the third week of February and have rebounded from $40 to $54 a barrel. In addition, industrial use metal Copper broke its downtrend at $1.40 and has rallied to $1.80.
- “Baltic Dry Index: The Baltic Dry Index of shipping rates for container ships has leveled off after a precipitous decline. The Baltic Index is a very good forward indicator of worldwide economic activity. It reflects the prices paid to hire an oceangoing freighter to haul goods or raw materials. In recent years, China has been a driver in pricing with their economic expansion.” While the Baltic Dry index is not an ideal barometer of economic activity in this cycle (a probable glut in oversupply of available ships, causing cheap pricing), the lack of continued price erosion is clear.
- “A roadmap of composite (1929-2002) post-crash DJIA performance. Ned Davis Research has done a fascinating study of post crash declines in excess of 20%. Although the “crash” phase was not the actual end of the Bear Market, the declines were not exceeded either. Retests of the market lows were very common and generally occurred within 90 days of the waterfall selloff. In our case, October 11 would be the 0 date while November 20, 2008 remains the ultimate low of this Bear decline, which perfectly parallels the composite roadmap of this chart. Other points of merit: The waterfall selloff occurred on average of 130 days before the end of the recession, but the markets started to make progress approximately 70 days before the end of the Recession. Based on analyst estimates for the Standard and Poors 500, the approximate end of the recession could be in the 2nd or 3rd quarter of 2009, which coincidently matches Davis’s chart.” While the markets did go to new lows in March, they did not break and with blazing speed erased the March decline in two weeks. Furthermore, my reference to the parallels of 1974 and 1938 continue to look accurate, especially 1938.
Mark Twain said: “History doesn’t repeat itself; at best, it sometimes rhymes.”
Economies and equities have gone through boom and bust cycles many times over the past hundred odd
years. While the reasons for the boom or bust change with each cycle, the reaction of the market place
post-collapse, which is based largely on human psychology and economics reveals a pattern that continues
to rhyme with surprising frequency and accuracy. These patterns of market behavior are most accurate in
the transitional period between Bear and Bull cycles but lose their accuracy once the transition cycle is
over, whereby the markets are on their own and trade according to new incoming data.
In January, I brought this chart to your attention:
“We are in a moment “in-between” of gray twilight between dark and dawn”
In early March we found ourselves in a period of agonizing investor angst yet improving market internals and even more astonishing…….. early signs of economic stability and yes……….improvement. The U.S. Equity market staged a rally with breathtaking swiftness and rebounded from 650 to 830 on the SP500.
In January, Ned Davis Research published a chart that has been uncanny both in terms of market seasonality and behavior and is likely a good road map for 2009. This “road map” is meaningless unless the underlying economic data support the price movement. The March rally has been unique in that it was supported not by government acts but improving economic data, a contrast to the failed rally of November and December.
Ever since the market bottom in October there have been a series of false starts where rallies petered out in a matter of a few short weeks. These rallies were only technical in nature; there was no underlying fundamental reason to support them as the economy remained in freefall. Since the bottom in early March, there have been six 90% upside volume days, a clear difference than the tepid rally in November and most importantly the rally coincided with news from Citigroup, JP Morgan and Bank of America that January and February were profitable.
A cyclical Bull Market to last till late summer, in five steps:
Step One: The composite chart above details a brief “blast off” rally in the range of 18% starting in late
February. These rallies catch everyone by surprise, as they appear to come out of nowhere but do coincide
with bottoms in the economy and investor sentiment. Our rally appears to have peaked at 23% and started
in early March rather than late February.
Step Two: A period of consolidation for the market to digest the move. The market pulls back a bit but
doesn’t break lasting for 4-6 weeks. I believe we’re in this phase now.
Step Three: A 30% rally as investors see further evidence of the economic bottom with the prospects for
the recession ending and stability in housing. This move like Step One is a virtual race to get invested by
an underexposed hedge fund industry and others. In the past 10 recessions, the stock market has staged a
lasting and major bottom on average 4 months before the end of the recession, or mid Summer 2009.
Further argument for the end of the recession by summer will be the effects of the Presidents stimulus
package, which will start to resonate within the economy in the second quarter of 2009. Earnings estimates
by Standard and Poors validate this thesis as well with a quarterly earnings jump from the 1st Q to the 2nd
of $13.00 to $14.96.
Step Four: The pause that refreshes. The months of June-July bring a second gentle period of
consolidation as the gains are digested by trending sideways. Stock market rallies coming out of
recessions are generally always exceptional but they don’t move in a straight line.
Step Five: A midsummer and final rally in the range of another 25% to the normal stock market valuation
of (100 year average) 16 times 2010 earnings of $66 or approximately 1100 on the SP500 by August. A
good chance this will be the high of the year.
I fully realize these figures sound astonishing but we can hardly forget how far we’ve fallen. A rally of this
magnitude actually falls in line with (here’s the rhyme again) 1938 and 1974, which rallied 60% and 51%
respectively. The last emergence from a recession for the stock market was (another rhyme) March 2003
where it staged an unending rally till the end of the year with a trough to peak move exceeding 50%.
The mean cyclical return for the stock market in a secular bear market is 65% over 508 days. In addition,
volatility in the markets today is much greater than in previous periods. Ned Davis’s own estimates are that
the SP 500 could reach 1200-1300 by summer, which would be wonderful. But any rally that extends into
late summer will likely be running out of steam and showing signs of exhaustion and excessive enthusiasm,
this is the stage of the rally where we must be selling. The very same panic-stricken investors who are in
cash now will be rabid to gain exposure as performance envy kicks in. There is substantial career risk for
a portfolio manager to be in cash and show nil or negative returns when market indices are substantially net
positive for the year, the NASDAQ has already returned to positive for the year.
Post Rally: The present rally will be based on the presumption that the economy has bottomed but
investors will not have had the chance to factor in unintended consequences, especially inflation. Its my
guess that inflation will return as an issue but its clearly too early to profit from that at this point in time,
the prospects for deflation need to be cured first along with housing before inflation is a substantial issue.
If inflation remains in check and Treasury bonds remain relatively stable with low yields along with an
economy that shows improvement then the stock market should merely correct itself with the normal
seasonal weakness and not commence a new Bear market. Either way, I plan on sticking to discipline and
having minimal long stock exposure by late summer.
All the best,
March 29, 2009