Pierced Hopes for Stock Bottoms

Wednesday was a rotten market day, in a rotten market month, in a rotten market year, in a troubled economy.  Otherwise, things are OK.

The Good News:

Aggregate bonds (AGG or BND), Treasuries (SHV, SHY, IEI, IEF, TLH and TLT) and investment grade bonds (LQD) were up.

The Bad News:

Municipal bonds (MUB), below investment grade bonds (HYG), international sovereign bonds (BWX), and emerging market bonds (PCY) were down.

Key equities asset categories were all down significantly.

The Bond Picture Wednesday:

Bellwether Asset Categories:

We watch these ten key asset classes as macro level representations of the larger world of investment assets (asset type / proxy fund):

• US Stocks (VTI)
• Non-US Developed Market Stocks (EFA)
• Emerging Market Stocks (EEM)
• US Real Assets (VNQ)
• Global Commodities (DJP)
• US Aggregate Bonds (AGG)
• US Treasuries 7-10 Years (IEF)
• US Dollar Index (UUP)
• Crude Oil (USO)
• Gold Bullion (GLD)

Bellwether Asset Category Performance Since September-End:

Here is how the bellwether funds performed over the last 36 days (essentially October and November to-date).

Key bonds and the Dollar are up.  The rest are down — mostly down hard.

The chart for each bellwether fund shows price change in percentage terms, and is contrasted with price change for SPY (proxy for S&P 500 index), as well as the fund’s 20-day, 50-day and 200-day simple moving averages.

The returns in the labels are the price change over the 36 days.  The subject asset category is plotted with candlesticks, and SPY is plotted in gray as a line chart of closing prices.

click images to enlarge

US Stocks (VTI, down 31.4%)

Non-US Developed Market Stocks (EFA, down 32.1%)

Emerging Market Stocks (EEM, down42.7%)

US Real Assets (VNQ, down 56.5%)

Global Commodities (DJP, down 28.1%)

US Aggregate Bonds (AGG, up 0.2%)

US Treasuries 7-10 Years (IEF, up 3.0%)

US Dollar Index (UUP, up 9.5%)

Crude Oil (USO, down 45.3%)

 

Gold Bullion (GLD, down 16.8%)

Longer Historical View of Key Asset Category Performance:

Our November 17 post provided longer historical data for the ten key asset categories — from 200 days to a year — in several different formats, including calculations of the price change necessary for each asset category to reach its highs, lows, and moving averages.  It also provides volatility risk ratings from the Risk Grades data service for each key asset category.

What To Do With Cash?

We have major portions of our portfolios in cash, and have had since July. While we don’t believe in market timing, this situation, which began to show itself in the summer, is an historic storm that we chose to let pass. The sky became dark, the air changed, and the wind began to blow.  We went into the storm cellar.

It was not timing.  It was self-preservation.  There’s a difference.

Our problem now is when and how to re-enter profitably with limited risk of loss, while not missing too much of the upside.  Since we haven’t lost much on the way down, we can miss the early beginning of the up cycle and still be ahead.

We don’t think the right conditions exist today to commit cash to equities.

Whether we are near a bottom or not, we will let braver souls probe and test before we commit more risk capital.  In the meantime, one of our key investment activities is observation, study and thinking about re-entry.

Critical Dimensions for an All Clear:

Here are the things we are thinking about as we seek a prudent re-entry point — information we will use to become comfortable that the storm we avoided has passed by:

1. Technical Market Factors
2. Valuation Fundamentals
3. Risk Levels
4. Government Intervention Policies
5. Economic Conditions

This very difficult period will eventually end, and those with cash will probably generate substantial returns after re-entry.  While waiting for that new day, this is what we would like to see for each of the five critical dimensions.

1) Basic traditional price and volume charts need to stop flashing danger signals and show a period of sustained flattening or rising prices — we’ll sacrifice the very early gains to reduce risk of loss.

2) Valuation fundamentals based on reported historical growth and profitability, not estimates of future growth and profitability, need to stabilize and be at attractive levels.

3) Risk in terms of actual and feared corporate bankruptcies and frozen credit market situations need to decline, and price volatility needs to moderate substantially.

4) Government policy in the US needs to become clear — installing the new President and new Congress, and seeing what they say they are going to do.  Governments here and abroad need to stop announcing new budget busting rescue programs and abandoning or converting old programs to solve financial market and general economy programs.

5) General news about the major domestic and international economies needs to become less threatening.

Next Steps

We and our clients each have our own individualized long-term asset allocation plan, based on our own facts and circumstances — some conservative, some aggressive, etc.  However, we all have more cash than the long-term plan contemplates.

We will be legging into our long-term allocation plans over multiple periods, and will use persistent trailing stops to partially protect against being too early or wrong in our decisions.

If strong rallies materialize in certain asset classes before our general criteria are satisfied, we may choose to participate with some of our capital at a faster pace than our basic legging-in plan, but with fairly tight trailing stops to potentially capture rally benefits while avoiding riding the rally back down if it fails to continue.

On to tomorrow …

Comments

[bosun.j:]

All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.

2008 Nov 20 01:42 AM

[liack:]

bosun your poetry is as beautiful as the authors...

2008 Nov 20 01:58 AM

[You're Kidding:]

Good luck with this.

Remember, though, that it took almost 3 yrs for the 1929 crash to get to the bottom, and there were 5 or so false rallies back up along the way. The first one was especially mean because the market went back up almost 50% over the course of a few months, before turning south from there. I'm sure just before that point most everyone was convinced the bottom was behind them. Unfortunately, they were very wrong.

People buy and sell stocks every day the market is open. The person buying thinks they are getting the best deal. And likewise, the person selling thinks they are getting the best deal. They both can't be right. This behavior cannot be accurately modeled with mathematics because unpredictable emotions are what cause people to do what they do.

When you believe that the market is headed up or headed down, what you are really saying is the sum total of all human behavior as represented by the sale of billions of shares of stock, will either be up or down for a given time period. Anyone who thinks they can predict this kind of thing is obviously dreaming, but in the long run they will actually be correct about 50% of the time, just by chance alone! And then when certain people have streaks of winning guesses, we call them *Market Gurus.* That's like saying a coin toss that gives 5 or 6 heads in a row, actually means something, when in fact it means nothing, and simply happens by mere chance.

There is, unfortunately, no method to this madness. We like to think there is, because we want so much to understand things and be able to predict them. But we delude ourselves. All *analysis* ends when we *feel* it is time to move. Then we make our bet, either up or down. We are right half the time.

Right now, my analysis says we are some time from a bottom. I'll be going in long when I *feel* that *it is time.* I've got a 50-50 shot of being correct. In the meantime, I am short the market with 7% of my money. It *feels* like the right thing to do from my *analysis.*

LOL

2008 Nov 20 07:23 AM

[dshort:]

"Wednesday was a rotten market day, in a rotten market month, in a rotten market year, in a troubled economy."

I couldn't agree more, and Thursday was even worse. The S&P has now snatched the gold medal from the 2000-2002 bear market as the worst decline in the history of the S&P 500 (which took its present form on March 4, 1957). The question now is whether it will emulate the grueling decline in the Dow in 1929-32:

dshort.com/charts/bear...

Frankly, my favorite position now is cash. When the S&P 500 rises above its 10-month moving average, then I'm ready to wade back into equities:

dshort.com/charts/SP50...

Meanwhile, capital preservation has trumped my quest for alpha.

2008 Nov 20 11:11 PM

[AlexR:]

On Nov 20 07:23 AM You're Kidding wrote:
> in the long run they will actually be correct about 50% of the time, just by chance alone!

Actually the 50% long-run average would only be accurate if the stock market were a zero-sum game. It's not. In the long run, profitable companies take in more money from customers than they pay out to employees, suppliers, and governments. This "free money" ultimately flows to shareholders in some form. That makes the odds somewhat better than 50/50.

2008 Nov 22 05:31 PM