Pebbles in the Pond
I've found it easier to be a top-down investor than a bottom-up stock picker. This is not to say that the choice of individual stock within its industry is an insignificant one, rather that my personal preference is to start with a vision and try to see who would benefit the most if that vision becomes a reality. I then choose the best candidates for that vision. Of course, one cannot have an educated vision for the future before studying the past and assessing the present. To that end I run various computer programs to give me "market pulse". Here are some perspectives on the current market state [note I wrote this article last Tuesday but waited till Thursday for my number crunching to have more up to date numbers. The market action since then has made some of these numbers obsolete.] If you've been losing a lot of money in the market since April, you are not alone. The market indecies do not accurately reveal the carnage that has taken place in the stock market lately. In fact the damage is already greater than the Crash of '87 (if there ever was a stealth crash, this is it).
Two thirds of the stocks are more than 20% off their highs and one third have lost more than 36% from their highs. The median 26 weeks and 13 weeks return is -10.2% and -12% respectively. In fact, if your stock has not lost any money in the past six months, it is in the top 10% of all stocks. The "hot" sectors at the moment are Electrical Utilities, Drugs, Telecom, and Tobacco. All are defensive sectors. RB is at a 21 year low and Gold is at a 19 year low, and the Morgan Stanley Cyclical index is at 18 month lows, off some 27% from its high. These are classic signs of a dramatic economic slow down. Another sign of the slow down is the huge divergence between the Treasury bills performance, and the "high yield" (read junk) bonds' performance. Whereas one has been soaring high on "fright to quality" the other has been dropping like a rock out of fear of default.
So what is causing all this? No it is not Asia or Russia, though to be sure they've had some effect; it is the public's over exuberance. The concept of "risk" has been completely lost with many market participants. The belief has been that in the "long run" you are always better off with stocks than bonds, or anything else for that matter. With such mentality, no price was too high to pay. After all, you could always hold on to your shares for as long as it took and then sell them higher to someone else in the future (i've heard such comments from many people who never believe in taking a loss). This mentality more accurately represents pyramid schemes than investments. Stock can and do lose money for very very long periods of time (more on that in later articles).
There is also another aspect to the current investment mentality. One that states the stock analysts, fund managers, and market strategists are essentially useless and one can achieve superior results just by investing in an index fund. As has always been the case, whenever the vast majority of investor believe the same thing, the market dynamics will make sure for that "thing" to be wrong. Since 1994, the most influential element of success in stock market has been huge market cap (and by extension, membership in SP100, NASD100, and liquidity). Earnings growth, cash flow, return on investment, and return on assets have mostly been ignored. You can see evidence of this by looking at the performance of NDX versus any other sample of stocks that shares all NDX characteristics except size. Reflecting on High-Low Logic indicator and Bolton-Tremblay numbers will point you to the same direction.
Since 1908, there have been 3 secular bull markets in this century: 1923~1929 @25% per anum, 1942~1966 @10% per anum, and 1982~1998? @15% per anum. The average growth rates are the geometric means for the over all returns. 69% of the times the market grows above trend and in the remainder it either marks time or falls to touch the trend line. It hardly ever stays below the trend line for an extended period of time. If it does that this time (which I do not expect) then get ready to run for the hills as it can be very nasty. But for now, this means that Dow could hit 7450 (or even 6200 depending on how you calculate the trend) and the secular bull market will still be in tact. As bad as these numbers sound, they only mean that Dow can come in line with the broader market before the resumption of the up trend [when I first said this some time ago in a different forum, it was prediction. Now it is a reality]. These trends have been calculated using regression analysis on Dow Jones Industrial Average. If we do the same regression analysis for the 5 years prior to '87 crash, we get 25% a year. Hence the crash (which by the way only brought things in line with the trend). Similarly, do the regression analysis on Dow between May '95 and May '98, and you have a rate of return of 40%! Hence the current down turn.
Here is a slightly different perspective which is more short term oriented. The percentage of stocks that are 2 standard deviations above their 200 day moving average should be ~4% (almost by definition). The market can withstand the overbought situation until this number reaches ~18%. Prior to October '87 this number was ~27%, in the mini-crash of '90 it was ~22% and in the April of '98 it hit the all time high of 35%. Read your stat books and try to calculate how unlikely it is for 35% of your samples to be 2 standard deviations apart from the mean.
So where do we stand now? Unfortunately the madness still continues. This is a by product of the fact that it takes a long time for people to have a change of mind. The percentage of stocks that are two standard deviations *below* their 200 day moving average was at 51% as of last Friday. To put this in perspective, this number is on average ~8%. In the bear market of 1990 it was only 36.5% and right after the Crash of '87 it hit 56.8%. In other words, it's been already as bad as Oct. '87. So why do I think that there is still more to come? Because there is still little panic in the market. And because I still see no difference in the investor perspective. The number of stocks that are two standard deviations *above* their 200 day moving average is still too high for an end of a correction; it is at 2.6%, whereas in the past, before the upturn has begun this number has reached 0.06~0.8. Another oscillator that I use and has never failed me in the past (it is devised in part by using the relative strength of the 4 weeks cumulitative new highs) tells me that it will most likely be Feb. '99 before the upturn begins.
What is my strategy now? First and foremost, I am going to get rid of the margin on my accounts. The down turn is bad enough and I don't need to stack the odds against me by being leveraged and paying interest at the same time. Secondly, I'm going to see if the companies I hold can survive a major slow down and will want to be holding them during such slow down. Third, I am going to keep a close tap on the market pulse. I am looking for signs of rationality and raising cash for the next set of purchases.
Where to after this? In the short run, there will be rallies in the same big stocks that have led the market so far. This is because people will consider them great bargains. The smaller stocks will not rally much in the face of falling indecies and the "big bargains" that will be abound. They will not however fall much further from where they are either. Given that VIX is at an 11 year high (that would be Oct 87 :D) Shorting the volatility of the smaller stocks may be a good option (no pun intended). Eventually the big growth companies will have a much worse faith than their smaller cousins. Sentiment will turn away from the big companies towards the smaller companies with no international exposure and from growth to value. Once things stabilize, those will be the companies that I'll be buying and holding.
Best of luck to all
Sun Tzu |
