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Stocks Will Bottom Well Before Economy

Investing is really about risk management. When the odds are favorable, you expose some of your capital to the risk of loss in search of possible gains. The best time to invest is when both the technicals (charts) and fundamentals (valuations, future earning potential, etc.) are favorably aligned. There has never been and there never will be a time where the techncials and fundamentals are perfectly aligned, which is another way of saying there is always some form of risk in any financial market. It is simply the degree of risk which fluctuates.

Fundamentals: The Market Looks Forward

It would not surprise anyone if we saw negative GDP (economic) numbers for the next three quarters (Q3 2008, Q4 2008, and Q1 2009). Things look and are bad:

  • Housing is still a mess.
  • Banks still have problems to deal with.
  • Americans have seen their wealth decline via housing and stocks.
  • Credit default swaps (CDS) market remains a threat.
  • The deleveraging process is not over.
  • Etc.

The last time the U.S. posted three consecutive quarters of negative GDP growth was during the 1973-1974 bear market. GDP numbers are released over time, but basically have a one quarter lag. For example, the final 3rd quarter GDP numbers for 2008 will not be released until December 23, 2008. Here are the numbers from 1974-1975:

  • Q3 1974 -3.8% (known in late Q4 1974)
  • Q4 1974 -1.6% (known in late Q1 1975)
  • Q1 1975 -4.7% (known in late Q2 1975)
  • Q2 1975 +3.0% (known in late Q3 1975)

You might think stock investors did poorly between the start of Q3 1974 and the end of Q1 1975 since the economy and social mood were less than stellar. Since the markets had already fallen significantly (sound familiar) in anticipation of the coming economic weakness, an investment made in stocks in Q3 of 1974 was quite profitable. From the bottom made on October 2, 1974, the S&P 500 gained 30.84% during the next year. The point is the markets bottomed well before the economy. It goes without saying 2008 is quite different from 1974, but the concept of markets looking forward will apply at some point during this bear market.

The Headlines Will Continue To Be Worrisome

Investors need not wait for the headlines to become more positive before allocating some of their capital to stocks. The headlines below were on the front page of major U.S. newspapers between late September 1974 and late March 1975. Stocks bottomed on October 2, 1974, which means while the headlines were still very negative, stocks were looking forward to better times.

  • Nixon's Chief Aids Go On Trial
  • Ford's Ban on Wage and Price Controls Draws Criticism
  • Nixon Tapes Open Pardon Question
  • Arab Oil Nations Warned
  • Inflation Spurts 1.3%
  • Fed Pledges End to High Interest Rates
  • Senate Joins Efforts to Get Nixon Tapes
  • Spending Cuts Urged
  • Ford Defends Action, Made No Pardon Deal
  • Police Stop School March
  • Terrorists Hold French Embassy
  • Police Escort School Buses
  • Nixon Likely to Resign From Bar
  • Ford May Pardon Others
  • Big Energy Taxes Next?
  • West Must Change Ways, Iran Warns
  • Terrorists Cut Demands
  • President Opposes Gas Tax, Rationing
  • U.S.-Soviet Talks Fall Apart
  • Tax Hike Heads New Ford Plan
  • Energy Crisis to Change Americans
  • President Hopes to Cut Inflation by Next Year
  • Tapes Reveal Nixon Knew Facts Early
  • $3 Billion OK'd For Housing Aid
  • Ford Says He Will Prove Polls Wrong
  • Mileage Boosted in '75 Cars
  • Anger at Watergate Trial
  • Ted's Night of Anguish for Mary Joe
  • Economic Index Takes Plunge
  • U.S. Investigates Food Price Fixing
  • Jobless Rate HitsThree-Year High
  • Ford Pleads for Inflation Fight
  • Financial Crisis Faces Sympathy
  • Coal Strike Seems Inevitable
  • Stores Ask Voluntary Rationing of Sugar
  • Kent State Shooting Guardsman Acquitted
  • Skyjacker Dies in Shootout
  • 15,625 More Autoworkers Jobless
  • Hijackers Hold off Executions
  • Recession Hits Auto Plants
  • Chrysler May Halt December Production
  • Watergate and Hush Money
  • Threat of Gas Lines - We're Using Too Much
  • U.S. Economy Flashes New Distress Signals
  • Real Wages Nosedive
  • HUD Accused of Mortgage Bias
  • Watergate Case Goes to Jury
  • Gloomy Jobless Rate
  • Big Economic Plan Pledged
  • A $16 Billion Tax Cut
  • Oil Price Batter Balance of Trade
  • Ford's Jobless Forecast Grim
  • Highway Funds Low, Projects Cut
  • 9.3% Unemployment Hits California
  • U.S. Rolls of Unemployment Climbs to 8 Million
  • FBI Works On Hearst Case

We can expect the headlines to look quite bleak in the coming quarters, but we must keep in mind that it is not unusual for stocks to bottom well before the economy and social mood. An investor who held stocks while the headlines above appeared in his daily paper was rewarded with a nice profit.

Positive Signs - Maybe Something To Build On

  • The stock market already knows GDP numbers are going to be weak in the coming quarters, which is a big reason stocks are down roughly 40% from their all time highs.
  • While valuations could get more attractive, they are currently near 18 to 25 year lows.
  • Investor and public sentiment is extremely pessimistic (a contrary indicator).
  • The VIX ("fear index") is near all time highs (a contrary indicator).
  • The number of new highs vs. new lows made on the NYSE last Friday was off the charts bearish, showing a very strong desire to sell stocks at any price (which can be bullish for the future).
  • The October 10, 2008 lows held up during last week's retest.
  • Thursday's close was impressive and came on strong volume.
  • Stocks made money last week.
  • LIBOR has come down indicating some improvement in the credit markets.

Buffet and Hussman Say Now Is The Time

While we must understand even the best of the best cannot pick market bottoms, both Warren Buffet and money manager John Hussman say now is a good time for investors to begin moving slowly off the sidelines (assuming you currently have a large cash position). In today's New York Times, quoting Mr. Buffett:

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now. Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month -- or a year -- from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."

Entire Buffet opinion column is here (NYT).

Money manager John Hussman posted this comment on his website on October 15, 2008:

"Sellers at these levels may find themselves scrambling to repurchase stock as that occurs, particularly in view of current valuations (even adjusted for the impact of an ongoing recession). On nearly every measure - sentiment, valuation, volatility, oversold conditions, and others, we are observing extremes associated with strong expected return/risk profiles, on average. Again, we retain put option coverage, now in-the-money, in the event that the market continues lower. However, my impression is that investors underestimate the potential for a very rapid 20-25% market advance as risk aversion collapses."

No One Knows What The Future Holds

Markets have proven time and time again that those who are willing to buy when valuations are low and the outlook is bleak have been rewarded with profits. All we can do is assess probabilities based on what we know today. Even with favorable odds, we can get negative outcomes, which is where risk management comes into play.

Could Stocks Go Lower? Absolutely, Yes

Today, valuations look better than they did a year ago since stock prices have come down. Do valuations alone mean it is time to abandon risk management and/or invest all your cash? No. It is still prudent to maintain a very large cash position. It is also prudent to use some type of downside protection or hedging, which we have mainly in the form of put contracts. If we dip our toe into the water and are unsuccessful, we will remain patient while still holding a large cash position. If the market starts to become profitable from here, we will consider our options based on the information available at that time. A measured, gradual approach will enable us to manage risk. If it seems totally unbelievable that now may be a good time to invest, then it probably is a good time to invest for the longer-term. The best opportunities will come when people are most fearful and pessimistic.

Are You Saying The Bear Market Is Over? Only Time Will Tell

Within the context of a secular (long-term) bear market, cyclical (shorter in duration) bull markets will occur. The duration of the cyclical bull market can be months or years, which is another reason to keep an open mind about the possibility of stocks performing better than most would believe in the coming weeks and months.

The market never makes it easy. This time will be no different. It will never feel comfortable to invest after a 40% decline. However, it is prudent to have a plan in place should the markets surprise on the upside in the coming months. We have such a plan, which manages risk. You should never come to the markets with a blind bullish or bearish bias. I understand and respect the risk that remains in this market, especially related to the process of deleveraging. However, I also understand what is happening now in the context of past bull and bear cycles.


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