Is the Worst Behind Us?

Includes: DIA, QQQ, SPY
by: Zachary Scheidt

After a debilitating third quarter 2007, and a devastating beginning to 2008, some investors are finally beginning to ask if the coast is clear. Peak to trough, we have experienced a 19.4% loss in the S&P 500 index, and the low has held for over three weeks now. Interest rate cuts have supported prices while financial institutions have slowed the pace of multi-billion dollar write downs. Most recently, a frightening scenario calling credit worthiness of bond insurers into question has given traders another reason to sell. Yet the damage appears to have been contained with relatively little bloodshed and most of the major indices closed last week with gains. Even Investors Business Daily gave a cautious green light last week when the NASDAQ composite completed a follow through day on stronger volume signaling a potential new bull market.

So what is one to do? Many are still nursing wounds sustained from discouraging losses, while others on the sidelines are itching to get back in the game with the capital they have skillfully preserved. However, peering beneath the surface, there are still rip tides in place that go dangerously undetected. For example, there have been very few fundamentally strong growth stocks that have formed healthy bases and are now breaking out on strong volume. Instead, we are seeing growth names simply trading off their lows in an ominous pattern of lower lows and lower highs. The cumulative advance decline line has not made an impressive turn. This statistic alludes to fewer names participating in the market rallies we have seen the last few weeks. The result is a few defensive names propping up the index levels while most investors portfolios are not keeping up with the averages. Finally, the VIX index (which measures expected volatility or expected risk) has fallen back to a relatively low level showing investor complacency compared to readings seen earlier in the month.

While I am not a pessimist by nature, I believe we are currently operating in a bear market that will take more than a quarter or two to work itself out. The economy did not create this difficulty over the last few quarters, but rather has increased its risk level over years of easy credit and abundant liquidity. It seems foolish to believe that such excesses could be wrung out by a few short months of relative volatility. The market as a discounting mechanism will most definitely turn higher before the economic difficulty ends, but it seems very pre-mature to think that a four month decline will compensate for four and a half years of steadily rising equity prices. Bulls will state that valuation levels have fallen to “normal” levels, but they often forget to consider the fact that in a bear market these valuations fall below “normal.” Simply put, if an average price multiple on equities is around 15, then one would expect the market to spend just as much time below that average, and for valuations to be as far below the average as bull markets show valuations above that average.

Despite my conservative viewpoint, I am not willing to suggest that every investor pull his or her long exposure off the table and wait for a better environment. Instead, I would urge caution and disciple in order to stick with the pre-determined plan. For me, this means holding adequate short exposure to offset my risk in names I feel comfortable holding for the long-term gains. For others it may actually mean pulling most of their capital out of the money. For very long-term investors, it may mean adding to dollar-cost-averaging programs in order to take advantage of lower equity prices for the next several months. But despite these varying ways to approach the current situation, there are some primary rules that should be carefully followed.

  1. Do not use leverage - With volatility in the upper end of the last decade’s range, even the most aggressive traders should exercise caution. There are plenty of opportunities to trade long or short in vehicles that move enough to create strong profits. But a leveraged portfolio adds a risk dynamic that brutally punishes any mis-step. Knowing how to tighten risk controls during challenging environments is the hallmark of any successful trader.
  2. Stay involved - on the conservative end of the fulcrum, some traders view this market as too difficult to trade in and wisely choose to sideline their capital. However, sitting on the beach waiting for the market to firm up is not a productive endeavor. Instead, successful investors should be using the time to develop watch lists, research fundamental trends, and prepare to aggressively pursue opportunities when the time is right.
  3. Learn from all experiences - History is littered with successful traders who have experienced failures. Reading any of the Market Wizard books by Jack Schwager will open ones eyes to see just how pivotal giant losses have been in shaping some all-star trader’s mentalities. If you are hurting from losses sustained in this market, don’t throw in the towel and give up. Instead, create a journal to document the difficulties and then learn what could have been done differently to exercise better caution.

The current market is just as full of opportunity as it is full of risk. So roll up your sleeves, commit to a disciplined plan, and execute with more skill and less emotion.