Defend & Advance

March 10, 2008


2007 Market Views And Portfolio Adjustments Went Against The Odds
We braved the odds when we claimed in "Defense Pays" that the market’s rally to new all-time highs in the fall of 2007 was running on weak legs. Below are some quotes from this November 2007 issue.

  • There is additional evidence that the rally since the Federal Reserve’s discount rate cut on August 16, 2007, might have been a bear trap.
  • Stock indexes are not on firm footing when less than (<) 40% of New York Stock Exchange issues are trading below their 200-day moving price average ($NYA200R).
  • A test near 1370.60 (the prior low) for the S&P 500 is expected.
  • The next shoes to drop will be consumer credit vehicles, municipal bonds, and high-yield credit.
  • August 2007 was only a prelude to the liquidation phases that lie ahead.
  • One of the central tenets of trend following is that fundamentals must sustain primary trends. Figure 3 causes us to pause and question the underpinnings of stock advances that came off the August 15, 2007 corrective low prices for the major indices.
  • Recent fundamental weakness in earnings growth and stock leadership makes it less likely that stocks will advance to new all-time highs. A shift to HQ leadership indicates that the market is near a turning point in the prior trend. The rotation from LQ to HQ was 14 months old when the correction began on July 19, 2007. The duration of the 2006-2007 rotation is within the range associated with the onset of prior bear markets.
  • "LQ to HQ rotations are harbingers of broad market corrections." Historically, the pain does not end until the S&P 500 declines 15% to 30% or more (restated from Offense-Defense Part II, July 2007).

These were very bold pronouncements given that the market’s performance from November 1 to April 30 usually bests its performance from May 1 to October 31. According to Jeffrey A. Hirsch’s Stock Trader’s Almanac, since 1950, over 80% of the market’s cumulative yearly advances have accrued during the late fall to early spring season. Many traders have warned if you sell in November, you stay and pray! I usually adhere to their axiom of to sell in May and go away! It usually does not pay to go against the Almanac, but I had a lot of evidence that stocks were likely to resume their declines during what typically is a strong seasonal price pattern for market indices.

Efficient market players are forever ready to declare aspiring market beaters dead! They take a shoot-to-kill stance on managers if the market moves against them. I am a Bear who sought shelter in defense. Survival comes from preserving enough capital to profit from the next Bull market, whether it is bred from another asset bubble or cultivated from undervalued assets—or both. Survivors know when they are investing and when they are speculating. They weigh risk and reward. Victor Sperandeo taught me to invest in Bull markets and to preserve capital while speculating with a limited amount of capital in Bear markets.3 It pays to listen.

This Is Not Science. We Are Simply Estimating Risk And Reward

The market cycle since 1994 has been an induced business cycle feed from excessive debt creation that inflated an emerging market bubble that burst (1997-1998), and then a domestic technology-telecom bubble that burst (2000-2002). We have just witnessed the end of a generalized credit bubble built around a housing bubble bred on financial securitization (risk intermediation). The turmoil seen in the credit markets since July 2007 might end up being the Grandfather of all post-World War II credit contractions that ushers in the second Bear cycle in the Mother of all Bears for the 21st century. Crisis begets opportunity, and there currently are stocks and bonds to buy at great values and there will soon be many.

Markets Move In Technical Price Patterns Supported By Economic Fundamentals

Double top formations are very bearish technical patterns. A double top is more likely if other indicators confirm it. The first top in the S&P 500 (and other domestic stock indices) was in March 2000, with the first bottom in October 2002. The second top might have been in October 2007, with the second bottom evident soon or many months away—and at prices that drive stock indices much lower than recent lows.

Market technicians (chart readers) label these price patterns as double tops and double bottoms. Figure 3 depicts what might be developing as a secular double top for the S&P 500, with the first top formed in 2000 and the second in 2007 near 1550. The first decline bottomed near 780 (-44% off the first top) with the second bottom projected to lie between 960 and 1152 (-27% to -39% below the second top, 1576.09). Why? A stock index’s 4-month moving price average (MA 4) usually declines below its 12-month moving price average only when stocks are in the midst of a 20% or more decline off their prior top. Consequently, we expect the S&P to decline to at least 1230, which is 7.6% below the S&P’s Feb-08 month-end price and -22% off the high.

It is highly likely that the economy either is in or headed into a recession, which implies at least a 28% decline from the prior top–a decline to 1135 on the S&P. Twenty-eight percent is the typical decline associated with all recessions since 1960. Since then, stocks have declined prior to the onset of recessions and bottomed before their end. S&P 960 equals in inflation-adjusted terms, the price near-bottoms made between July 2002 and March 2003. Since nearly five years have passed since the first bottom, a successful test of this bottom (support) will most likely be higher than the prior bottom, near a price of 960 or 1152.

Fundamentals Usually Align With Technical Price Patterns (Especially When Measuring A Full Business Cycle)

Figure 4 shows the S&P reported earnings for 2008 at $67.90, which represents a 20% decline from a June 2007 earnings peak. Reported earnings are graphed (green line) in relation to the S&P’s 6% historic trend line growth (red line). Standard & Poor's posts various earnings estimates on their Web site. The 2008 estimate is 5.3% below 2008 Q4 results. Notice how the oscillation of reported earnings above and below the S&P sustainable trend line is nearly symmetrical. Extreme earnings above the trend line precede plunges below it.

A long gaze at Figure 4 caused me to adjust earnings so they more closely track corrections that have followed prior earnings peaks. Our objective is to depict the median of all corrections after prior peaks. The median correction ended with reported earnings 31% below the S&P’s sustainable earnings trend line, which corrects current earnings to about $48. Figure 5 employs 10 years of normalized earnings at $49.69.4 Since this is not science, any estimate within $2 of highly volatile earnings works for estimating the downside. Our estimates are more reliable because these two methods produced nearly identical results.


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