A month ago the Final Thought of our letter was “The stock market takes the stairs up and the elevator down.” We should have saved that for this missive as the sell off in stocks the past few weeks acted like the express elevator the fall of 2008 was. The easy analysis is that the drop was related to the events in Europe, the fear of contagion in the region, and that our financial system may experience a similar fissure soon. Add the concern that the operations of our markets have possible issues and trigger fingers, even if they are fat, appear to be hitting the sell button quicker than usual. We have been skeptics regarding the stock market and Wall Street for over a decade. Initially some labeled it paranoid, but the recent headlines of corruption, especially regarding the blurred headlines between Wall Street and Washington, have brought some at least to the fence to sit on.
One of the first issues we challenged was the purity of the dominant investment philosophy Wall Street was selling to their clients the Buy and Hold (BAH) strategy. Essentially you buy good stocks and mutual funds and hold them for the long term. Icons like Warren Buffet and Peter Lynch of Fidelity Magellan fame provide credibility to the strategy. Our thought in 2000 was that if a Secular Bear Market were to unfold nimbleness and flexibility would have to be key components for profitable portfolio construction. The Secular Bull Market of 1982-2000 taught most of the current herd of investors that BAH was simple and effective. After two 50% corrections in the major indices within the last ten years, some feel they may have been sold a bill of goods. Prior to a couple of years ago not many investors were aware of the Secular Bear Market of 1966-1982 when the Dow Jones Industrials made no appreciable progress. Or how about the Japan Nikkei which is at the same level it was in 1984? That is twenty-six years of no progress!
A reason to be circumspect of BAH, certainly for now, is the amount of debt in the global system and what it will probably do to economic growth for the next several years. Public debt crowds out private debt, carrying costs can be exorbitant, and tax hikes will probably be a way to pay for them. These are not the key elements of economic growth. We believe that neutered economic growth will lead to a trading range type stock market at best. With the current economic backdrop, the probability of a Secular Bull Market beginning anytime soon is slim.
Remember BAH works best in a market moving up and to the right. For a pretty cool comparison of the current dynamics and those in place in 1982. Many of the major Wall Street firms require their salespeople to promote BAH while their trading desk is engaged in a strategy called “flash trading.” Computers can consummate buy and sell trades in fractions of a second using this system (a long term hold is an hour and a half). Some estimate that this type of trading represents over 70% of the daily volume in our markets. Seems just a bit inconsistent that they are major promoters of BAH but they will not hold positions overnight?
Many think the thousand point drop a few weeks ago was caused by this dynamic and hence the moniker “Flash Crash.” This event is considered to be a “Black Swan” technology event. A Black Swan is considered to be an outlier event that no one could predict. The Crash of 1987, the internet, the Long Term Capital fiasco, and the sub-prime meltdown, were all considered to be “Black Swan Events”. We are thinking that if the regulators and policymakers do not do something to address what happened May 6th we may have another episode sooner than later. Another concern we have is what appears to be a growing number of Black Swan Events surrounding the financial markets of late, with most of them seemingly negative. We are afraid these events will become common place and just another aspect of the investment playing field investors have to deal with. If that does occur nimbleness and flexibility may become event more important.
The ability to quickly move out of the way of a swift, steep correction is a key objective of our strategy. The volatility of late is reminiscent of the fall of 2008 and the flexibility to move to a 100% cash position can be the difference in taking a 30% drawdown or just a nick in single digits. We know of no system that works all the time as DAAS failed to participate significantly in the rally of the past year. The strategy was more concerned about capital preservation during the period. Remember if you take a 50% hit in your portfolio you have to earn 100% to get back to even. One important question to ask an advisor you do business with or who is courting your business is “What sell discipline does your strategy use?”
We believe it could be a few more years of up and down markets before another Secular Bull Market begins. Buying and hoping (BAH) could be a mistake especially if we take out last years March 9th low of 6,470 on the Dow Industrials. On the bright side we think the recent correction is near its end and we may make a new high for the year (11,258) later this summer. You can’t be vigilant enough though.
Chart Spotlight
The daily chart below is that of the S&P 500 from last December to the end of May. The steepness of the correction is somewhat worrisome as often these types of pullback lead to further downside. We think there are a number of dynamics that could lead to higher stock prices through the fall. First is the correction may have been due to institutions who were chasing performance (buying stocks because they were underperforming the overall market) the last several months being quickly spooked by the “flash crash”.
Chasing performance brings less conviction than when chasing fundamentals and those money managers could have been quick to hit the sell button with 2008 still fresh in their minds (European headlines did not help). If we are correct and that is a central reason for the swift decline the possibility of a quick recovery might be at hand? We do have some decent short term corporate fundamentals and economic data. There is an important election this fall and it is amazing how well the stock market tends to do during crucial campaigns The MACD (moving average convergence divergence) in the lower frame is turning higher which is often bullish. We believe we could get near or possibly exceed the April highs. If we significantly take out the May lows we would change our mind and become bearish. We think the type of volatility that occurred in May will be a constant factor in the market for a few years. Bleak headlines and quick trigger fingers will probably be the driver of this dynamic.
Did You Know
At the end of 2008, 8% of mortgages had at least 1-payment past due and another 3% of mortgages were in the foreclosure process. At the end of 2009, 10% of mortgages were late and another 5% of mortgages were in foreclosure. At the end of March 2010, 9% of mortgages were late and another 5% of mortgages were in foreclosure (source: Mortgage Bankers Association). Also it was about 2 months ago today (3/31/10) that the Federal Reserve’s year-long program of buying $1.25 trillion of mortgage-backed securities (MBS) ended. There was concern in the real estate industry that mortgage rates may increase after the Fed stopped its daily purchase of $4-6 billion of MBS. The average 30-year fixed rate mortgage nationwide was 5.08% on 4/01/10. The average 30-year fixed rate mortgage was 4.78% last Thursday 5/27/10 (source: Freddie Mac).
Final Thought
You can lead a man to Congress, but you can't make him think. -- Milton Berle
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