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2nd Quarter Commentary
Market Update
Stock Market Bottom: Now or Later?
April 4, 2008
The stock market started the second quarter with a strong gain of over 3% on April 1. In contrast, the first quarter opened decisively on the downside. Is the market now projecting a more positive message than it did at the outset of 2008 or is it just an April fool’s joke? The stock market has been in a cyclical bear phase since October. Is a sustainable upturn likely now or later? To address these questions, we will assess the status of a number of factors that historically have signaled a market bottom.
- The market no longer falls on bad news and responds well to good news. This rule applies to both markets and individual stocks. April 1st was the first occasion since the credit crisis began when several banks announced significant write-offs and subsequently their stocks and the market went up. Moreover, financials and consumer discretionary stocks led the markets advance. Their leadership is typical at the early stages of a cyclical market bottom. Nonetheless, there are likely to be further tests of the impact of bad news on the market before one can say categorically that bad news is now good news.
- A general disbelief exists about whether the market can sustain any rally. Market participants have become acclimated to sharp and short rallies followed by renewed weakness. In technical terms, they wait for upside breakouts with confirming tests of any advance. These investors are useful because they provide the buying power as the market climbs higher. Currently, investors lack confidence about a durable rally.
- As the market comes off its bottom, volume of transactions increases significantly. In this respect, volume is the weapon of the bull. So far, volume has been unimpressive in total despite advancing volume outpacing declining volume in recent sharp rallies, including April 1st. Market professionals tell me that they are waiting for bigger volume days before buying stocks aggressively. The broader market usually stabilizes for some time while the market averages continue to decline. Usually, the bluest of the blue chips fall at the end of a bear market. By then, most stocks are already sold out. Despite the markets’ volatility, the broader market is showing signs of stabilization, but it is too early to be conclusive. The imminent test of the broad market is the response to first quarter earnings reports and management guidance for the quarters ahead. If the broad market holds up well to any disappointing profits news, it would be bullish.
- Sentiment should be extremely bearish about stocks. Sentiment has been bearish with short lived extremes which have shifted quickly to less bearish. Overall, sentiment is bearish given the desire by many professionals to hold relatively high cash positions. A recent visit to some hedge funds in New York found them to be very risk averse with relatively high liquidity.
- An extremely negative event occurs that caps underlying negative economic trends. The demise of Bear Stearns is illustrative in the continuing setting of concern about credit and capital sufficiency.
- Spreads between high and low quality credits stabilize and begin to narrow. One year ago these spreads were relatively tight suggesting little concern about risk. Currently, they are relatively wide reflecting ongoing credit concerns, especially in a recessionary environment. A definitive narrowing of spreads would be quite bullish because it would suggest less concern about credit and the economy. In the current cycle this is a very key indicator. Recently, spreads have shown a small improvement and this improvement has been a factor in the market’s better tone. Nonetheless, spreads will remain relatively wide as long as there is concern about underlying economic growth. Bernanke’s recent testimony to Congress reflecting concern about near term growth serves as a reminder to the markets that risk remains elevated.
- A market break in competing asset classes with equities would be bullish with stocks. Commodities have gained increasing interest in recent years due to strong foreign demand. More recently, an index of commodities rose 40% over the 12 months ending mid-March with half that gain since the outset of 2008. Thanks to a recent break in the commodities futures, the same commodity index is now up only one-half of what it had been in mid-March. If the commodities market quiets down, U.S. stocks may benefit. A stronger dollar reflecting improving U.S. growth would also dampen some of the enthusiasm for commodities. This may come later in the year and in 2009.
- In a cyclical bear market, a recession should eventually become evident and accepted by most pundits. At that point, speculation arises about the depth and duration of the recession. We believe that we have reached the point where there is general acceptance of a contraction in the economy and guessing is increasing about its degree of depth and duration. A short and mild recession would be relatively bullish for stocks initially, but could be problematic for inflation later on.
- Forecasters, analysts and money managers no longer look beyond “the valley” or the recession. They become more short term in their thinking. Until recently, most pundits have been looking positively toward the second half of 2008. Now they are looking at developments a day at a time.
- Securities analysts significantly revise downward their profit estimates. So far, they have cut back on their first and second quarter estimates, but remain optimistic about the second half. In our opinion, the consensus view of a 15% profit gain for the year remains optimistic. The sooner expectations are diminished for earnings growth, the sooner stocks can find a solid bottom.
- The bottom line is that issues with credit and with the economy remain with us. We know the stock market discounts the future so we can not wait until the obvious is
perfectly obvious. A number of the bottoming factors are directionally improving, but important ones, such as narrowing spreads and increased stock market volume are absent. Consequently, the market may be in the early stages of bottoming, but until spreads narrow and volume increases, we can not confidently say that the market has bottomed. Moreover, risks do still exist whether they be earnings growth expectations, credit and capital sufficiency, etc.
Nonetheless, at the outset of January, we recommended raising cash because of our concerns at that time about growth and the markets. While continuing to have some concerns, we recognize that the variables affecting markets are dynamic. Consequently, reflecting the belief that reflationary monetary and fiscal policies will successfully deal with the economy and credit issues, we recommend lowering cash in aggressive portfolios to 10% from 25%, in growth portfolios to 5% from 10%, in balanced portfolios to 10% from 15% and in capital preservation portfolios to 15% from 30%. Our priorities for purchase would be long/short and distress hedge funds, emerging market equities and large cap U.S. growth stocks. Where appropriate for tax reasons, municipal bonds remain interesting. For the contrarian with an opportunistic bent, we suggest housing and related, perhaps through the appropriate ETF.
A. Marshall Acuff
Managing Director
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory LLC
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