Why It Is Important to Start Reinvesting Now

Back in October 2007, the markets started unwinding. With the benefit of hindsight we now know that it was the beginning of a bear market. The stock market is perhaps the most efficient forward looking indicator, and in October 2007, it told us that a recession could be expected to start during the next six months. It did not lie, and here we are.

Now a typical recession lasts ten months. And the market as a forward looking mechanism bottoms approximately six months before the recession ends. So we should expect the recession started about April 2008, it should end about January 2009 and the market should have bottomed right about July 2008, but they did not!

At this point in time the market is looking at historic information and reacting to news that we are relatively deep in a recession. So is it pricing in bad news that is potentially already priced in?

The market is no fool; what it tells us we must hear. It is telling us that the chances of a longer recession compared with historic norms is more likely than not. A lot of indicators suggestive of a bottom are now in place. We have seen very high volume selling on down days which is indicative of capitulation. We have seen VIX levels well above historic norms associated with market bottoms. This is a time when de-leveraging and redemption are pressing smart money to behave dumb. Yet the market continues to defy all odds and continue its slide.

What we have not seen is the markets' response to the third quarter's earnings. Its early in earnings season, but to date the market response has not been positive. So far, results have been in-line to ahead of expectations with outlook indicative of weakness, though perhaps less than expected. IBM, INTC, JNJ, C, MER and more were all ahead of estimates, and while cautious on outlook, where indicated, they were better than expectations. The initial instinctive response has been to sell the news. We are not yet ready to climb the wall of worry. But we need to wait a while longer; far more information will flow through the markets over the coming weeks and it is not the information that is important, it is the markets' response to the information which is critical.

As of now, the earliest exit from a recession would be six months from now - April, 2009. I expect an exit later during Q2 2009, mainly because what is needed to initiate a recovery has started (the rescue package of financial services), but more is needed. No, I do not expect a hugely enhanced rescue package; I would like to see energy capitulate. This is important, because it is good for the consumer, and perhaps more importantly, it is critical to get industrials fired up for growth.

Oil prices have finally fallen below $70. I think oil will retreat to $60, which is my view of an equilibrium price level (marginal cost of production). Since energy stocks have not yet stabilized, I expect oil prices to continue to fall and perhaps even undershoot to the downside. This based on my views that stock prices tend to fall ahead of price declines in the underlying commodity. Absent leadership from financials and technology which typically outperform towards the end of a recession we could see the market grind further down as energy meets its date with equilibrium and capitulates.

Analysts have now started deep cuts to earnings estimates for energy and basic materials. My view is that once these cuts are reflected in 2009 expectations, the SP500 forward earnings will be realistic. I believe we are largely there for all sectors except for energy. This is occurring now and I do not believe it is long until the market can move on.

How vigorous can the recovery be? Will it be a meek recovery because the consumer has been deeply wounded and financials have been decapitated? Industrials are the one sector which can lead growth; and grow it will particularly with basic material and energy prices at economically rational levels. The vigor of growth in industrials is very dependent on capital availability. So yes, it could be meek. Yet, I expect a fairly vigorous recovery. Corporate balance sheets are surprisingly strong and they are well able to invest with lower levels of leverage. In addition, all the risk averse cash which is sitting on the sidelines will rapidly return once the perceived risks reduce. Finally, emerging markets remain a strong catalyst to long term global growth.

Coming back to why now is important; today markets are well valued and probably close to a bottom. If they fall further, that is fine, the recession might continue a quarter or two beyond expectations - all it means is that you have book losses which will be replaced by profits once the next expansion starts. Does a few months to a year matter in the context of a lifetime of investing? Preserving capital to capture 100% of the up move is something most believe they can do and what almost no-one can do.

I have been told a low is always re-tested. This is true, if we are at a bottom now, it is virtually certain that we will have a rally, followed by a re-test of the lows over the coming six months. Why then am I keen to commit now?

When a rally occurs, the market will move up with vigor; the advance is broad based. When profit taking occurs and drives the market back down, the quality small caps, mid caps and large caps stay at higher relative values; it is the lower quality issues which get beaten up disproportionately. By buying at the re-test, you compromise quality for price. For example if you own BHI, you might want to switch to SLB to improve portfolio quality and lower portfolio risk; if you own neither, you might want to buy SLB now instead of being forced into buying BHI on valuation at a re-test.

The other thing to keep in mind is that during the rally, dividend payers will outperform. When the lows are re-tested, these stocks rarely re-test their lows. Take for example BP; the company has capacity and a long displayed ability to generate large free cash flows. It can deliver 4m bpd through 2010 from existing reserves, it has pretty exciting E&P prospects, it is a leader in alternative energy, it has a re-structure in place to improve HSE and cut costs, it has a good share buy-back program, it increased or maintained its dividend every year as far back as I have looked (Feb 1999) and today it delivers a yield of 8%. When it re-tests its low, you will not get this yield. Today, you can lock in a return equaling the long term market return and look upon any capital gain as a bonus and as the dividends rise in future years, your yield relative to the price you paid continues to go upwards. I am not yet constructive on energy, but BP is certainly a stock I have my eye on.

To conclude, at this point in time companies with superior intellectual capital are going at fire sale prices. So are companies with an ability to consistently generate large free cash flows. So are companies with excellent management teams. These qualities provide a wide safety net and an entry barrier against competition. Buy them; go back to or above your normal asset allocation to equity, re-balance your sector allocations and buy the industry leaders.

Disclosure: Of the stocks mentioned in this post, I am long INTC (Price $14.50, Yield 3.8%).

Comments

[whidbey:]

"At this point in time the market is looking at historic information and reacting to news that we are relatively deep in a recession. So is it pricing in bad news that is potentially already priced in?"

I suspect the market does not look at anything, but opportunity over a fairly short time period. Long range investing takes faith that the market is sustainable over ones investment horizon. Of the two the short run is current the decision horizon.

Until we are reasonably sure that the dance of treasury qua anking is ended (over?) your advise is early. You are correct the prices are very tempting, but they can still go either way.

2008 Oct 17 11:05 AM

[peterthepai...:]

the bear market started in jan 2000

2008 Oct 17 12:33 PM

[sieraromero:]

An investor who is a long term investor in these times, is like a monkey put in a closed cage with a lion or tiger. You are going to be eaten alive. You must always have stops put on your positions. You must learn and use some sort of options, and finally you must stay imformed in educated more so than any other time in history on the world's economic and political conditions. This is not your fathers stock market anymore and no it will never return to your fathers stock market anytime soon if ever.

2008 Oct 18 09:12 AM

[Timothy Stolz:]

Good, well thought-out and logical article. One thing that remains an unknown is the effect on the price of oil the OPEC meeting later next week might have.
Based on their past history, we may assume that they will "say one thing and do another" either way their actions may in fact establish a base of around $75-$90 for a barrel of crude oil.
Shiv....if the market does not get the capitulation of the energy stocks like you wrote, is it possible that this sector is at the bottom now?

2008 Oct 18 09:48 AM

[Shiv Kapoor:]

Timothy - I do not think energy has bottomed just yet. I think OPEC will cut. And I think the cut will cause oil prices to fall further because it will confirm an expectation of falling demand. The falling demand also means that as production grows in the future, there is existing supply which can satisfy it (because an OPEC cut will be of production not production capacity). Initial gut reaction will possibly be a hike in oil prices, but once things are thought through, it should fall. My guess is energy will bottom with oil very near $60; from here oil prices might well fall a bit further, but energy stocks will likely bottom before oil prices do (see magical pairs on maxkapital.blogspot.co... As far as the broader SP500 index is concerned, it may have bottomed at 840. But there is a chance that it will reach for 740 (740 is the level where SP500 will trade at a 20 year dividend multiple low which is indicative of an economy in outright panic; and even in such an environment I have a fair value of 1247 on the SP500, so for an investor it is a good time to be accumalating). Also did a post on the oil bull which sort of explains why I am not constructive on energy right now but am very positive on the sector longer term; its on maxkapital.blogspot.co...).

2008 Oct 18 03:48 PM

[Did U Think...:]

You go first. I will watch you lose another 50% and then buy stocks when they really bottom.

2008 Oct 19 12:00 AM

[MSmailbox:]

I learned quite a bit, here. I may take a position, in Intel... Not because you have a position, but because I agree with your argument. As I read your concluding paragraph, I was already thinking INTEL. When I saw your position, it provided a confirmation. Normally, I hesitate to follow anyone's position, and I almost made the mistake of excluding Intel, but that would be just as foolish, as blindly following. So, I wil put Intel on my mental "watch-list." I am currently paying for a gross misjudgement, on POT. I tried to "catch a falling knife," then repeated my mistake, as I tried to average down. Now, I must hold a huge position in POT, as I redirect what's left into other areas. What have I learned, over the past 14 months? Never capitulate, but continue to invest, using the benefits of my mistakes, to direct my future investments.

2008 Oct 19 02:32 AM