Dismal Markets Demand Patience

The stock market has gotten off to a dismal start in 2008, as investors have marked down their expectations for the economy and corporate earnings. In just a few weeks time, the prevailing view on Wall Street has shifted from an attitude that the credit and real estate problems would be "contained" to the view that a U.S. recession is more likely than not.

A number of sectors (e.g. banks, homebuilders, retailers) have already suffered bear-market declines, suggesting that a great deal of economic weakness has already been discounted, but stocks are likely to struggle over at least the balance of the first quarter, as earnings expectations are ratcheted down and investors get a better handle on how severe the economic downturn could be.

The stock market has been extremely oversold, having fallen nearly 7% (using the S&P 500) since December 26^th. Moreover, the S&P 500 has been testing major support in the 1375-1400 region - a level that marked the lows in each of 2007's corrections in March, August and November.

Certain indicators of investor sentiment have reached extremes normally found at inflection points in the market; the latest survey from the American Association of Individual Investors [AAII] shows nearly a three-to-one ratio of bears (59%) to bulls (20%). Ordinarily, the combination of an oversold condition, a test of major support, and extreme bearishness would point to a sharp relief rally, if not a good intermediate-term buy point.

The difference in the current set of circumstances is that it is possible we have moved from a bull market into a bear market, and the economy has moved into recession. If that is the case, sentiment should be expected to be bearish, especially in a "retail" survey such as AAII, and should not used in isolation to gauge low risk longer term buying opportunities.

From a technical standpoint, the 1375 - 1400 level is indeed an important support level, and may hold the market, even on a longer term basis, but a great deal of technical damage has been done. The multi-year uptrend has been violated in the S&P 500; longer-term moving averages have either rolled over or are in the process of rolling over; major sectors have plunged to new lows; and since the mid-October high, the market has been tracing a clear pattern of lower highs and lower lows, which is the definition of a down-trending market.

The fact of the matter is that we simply don't know if the economy has in fact tipped into recession, how bad it will be, whether a bear market is in progress, and how low stock prices will go. There is a self-reinforcing tendency in economies and markets that can push things farther than one might view as reasonable in both directions - the downside as well as the upside.

The weight of the evidence suggests that patience is a far more prudent strategy than trying to pick a bottom this early in the game. If this is a bear market, and it was to end now, it would be one of the shortest in history. Only two of the last 15 bear markets have ended in less than six months. This one, having begun in October, is only four months old.

A safer strategy than trying to anticipate a bottom is to wait for one of two things to happen: either (1) wait to see if the market is able to break its current pattern of lower highs and lower lows, or (2) wait for the type of percentage decline normally associated with bear markets and at price levels that can be legitimately described as attractive. At this point, we think that 1300 on the S&P 500 would meet these criteria.

It is certainly possible that the economic downturn is going to be mild and we are seeing the lows in stock prices right now, but given the elevated risks of recession and a bear market, and given that we already have a reasonable percentage of our portfolios allocated to stocks, we are not going to be in any hurry to increase exposure at this time.