A Shaky January<\/h2>\n
January started with all the usual New Year\u2019s fanfare \u2013 retrospectives, prognostications for 2010, lists of best stocks for the year. If you read a number of these stock market \u201c10 Predictions for 2010\u201d (which I did), you would find that the stock gurus were almost all on the same page: a good first half, as positive earnings drove the market higher; followed by a weaker second half when good economics would give way to fears of inflation and forthcoming rate increases. <\/p>\n
For the first few weeks of January, the market seemed to be following the stock analysts\u2019 playbooks. The S&P spurted out of the 2010 gate, jumping from 1,115 on December 31, 2009 to 1,150 by January 19. \t<\/p>\n
Then, a whirlwind of events seemed to hit the markets. In China, the government announced a moratorium on lending (despite official claims to the contrary), after a previous move to increase reserve requirements. In Europe, Greece had taken on so much debt that it was in danger of being downgraded. That spurred fears that other European countries would soon have to follow. In the US, the Democrats lost the Massachusetts Senate seat, putting a crimp in healthcare and spurring the announcement of the Volcker rule curbing bank activity. Only days after the Democratic loss in Massachusetts, Obama announced regulations that would prevent major banks from owning significant private equity or hedge fund operations. Never mind that almost every analyst argued that it was lax lending, and not private equity and hedge funds, that led to the 2008 crisis. Washington was clearly on the offensive. <\/p>\n
Market reaction was swift and harsh. By January 22, the S&P was at 1092, dropping 5% in three days. By January 29, the S&P had fallen to 1,074, 6.6% off the year highs and 3.8% down year to date. Today, February 2, the market has recovered somewhat and closed at 1,103. Here\u2019s a chart of the S&P over the last few months. As you can see, we\u2019re where we were in late November and December. <\/p>\n
In the midst of all this, earnings were positive overall, but didn\u2019t lead to any momentum in the market. This weekend, Barron\u2019s reported that three out of every four companies reported earnings that had beaten analyst estimates, and two out of three surpassed revenue targets. And yet, stocks would sell off almost immediately after their earnings reported. One after another, stocks, including market leaders such as Intel, Apple, JP Morgan, Goldman Sachs and Google, sold off immediately after positive earnings reports. <\/p>\n For a moment, it was hard to know what to do. Was it the long awaited correction? How far down could the market go? And why were earnings so irrelevant? There were lots of debates; some argued that the rally was still alive; others said it was profit taking; still others cited the unsustainability of the rally. <\/p>\n Where you come out in this argument depends a lot on your perspective. If you\u2019re a fundamentalist, you ignore the market and only look at the valuation of the companies you\u2019re buying. This is the Buffett school, and he would say that the only decision you have to make is to decide whether the price being offered by the market is a good one. Buffett has done very well, but make no mistake, there are serious downsides to this approach, and very few can invest like Buffett. Bill Miller, the legendary value investor, got slammed in 2008 for exactly this reason: he kept buying on the way down. In 2008, the quality of the company didn\u2019t matter; if you bought as the market went down, you had a terrible, terrible year. Know also that the Buffett approach also takes tremendous patience. His method works, but it can be years before you see substantive returns. <\/p>\n Those that can\u2019t quite invest like Buffett, but still like his approach, have modified the value investing thesis to incorporate macro conditions. Whitney Tilson, avid Buffett follower and partner at T2 Partners, wrote in his annual letter to investors, \u201cWe are bottoms-up stock pickers, but an important lesson we\u2019ve learned from this downturn is the importance of factoring in our macro views when determining the fund\u2019s overall positioning.\u201d <\/p>\n Mr. Tilson has also said that he\u2019s been trimming positions for the past several months because he felt that he market was ahead of itself and a correction was looming. In other words, he\u2019s been selling for the past several months. Notice though, that the market had a bit of a run in late December through early January before falling to late November and early December levels. In other words, investors such as Mr. Tilson often sell before a correction, but also miss out on the last few percentage points of a run. And let me clear, this is not a judgement on the approach, because I don\u2019t think there is a perfect system. Both Mr. Buffett and Mr. Tilson have said that their conservatism tends to make them sell early, and I regard both as quite successful investors. <\/p>\n The technical approach is quite different and leads to a very different course of action. Let\u2019s start by looking at a technical chart of the S&P:<\/p>\n You\u2019ll see there\u2019s a lot of stuff on this chart. A lot of people like technical analysis because it\u2019s very tangible and very visual. We\u2019ll go through a few major pieces. <\/p>\n First, let\u2019s look at the retracement lines<\/b> \u2013 the dashed lines on the chart. We\u2019ve talked about these levels in previous articles, and I\u2019ve marked the 50% retracement line (~1120 on the S&P) and the 38.2% retracement line (~1,120 on the S&P). Basically, the idea is that when you have a big drop in stocks, as we did from the highs in mid-2007 to the lows in March 2009, the market rebounds to specific levels. These levels are based on the Fibonacci sequence. When you\u2019re looking at a chart technically, that means you\u2019re looking at 61.8%, 50.0%, 38.2% and 23.6% of the difference between the top in mid-2007 and the bottom in March 2009. <\/p>\n On the chart above, you\u2019ll see that the market broke above the 50% retracement line, approximately 1,120 on the S&P, in January. The market couldn\u2019t hold and fell below the 50% line. To a chartist (same as \u201ctechnician\u201d), it looks like the market could be headed toward the 38.2% level, or about 1,020 on the S&P. If it can\u2019t hold that level, it could fall to the 23.6% level, or about 890 on the S&P. <\/p>\n Second, let\u2019s take a look at the trendline<\/b>. Here, what chartists do is draw a line under the lowest points of the trend – in this case, the lows in March 2009 through, let\u2019s say December 2009. If you draw this line (the white diagonal line running lower left to upper right), you\u2019ll see that for the last nine months, the S&P fell and touched this line, and then bounced off the trendline. During the 2009 rally, the S&P did not fall below this trendline. When the trendline remains unbroken, it gives chartists confidence that the rally will continue. You\u2019ll notice that on January 22, the S&P fell below this trendline (marked \u201cTrendline Broken\u201d). In other words, the rally is in danger of being over. <\/p>\n Third, let\u2019s take a look at the moving averages<\/b>. Technicians also like to look at moving averages – the average of the last 21, 50, 100 and 200 days. It shows the trend over the recent period, and on this chart, they are marked in yellow (21-day), red (50-day), green (100-day) and blue (200-day). <\/p>\n On this chart, you will see that the S&P broke below the 21-day, the 50-day and the 100-day moving average. You\u2019ll also notice that for most of this rally, the S&P has stayed above the 100-day moving average (the green line), and that this represents a major change in the dynamics of the last year. <\/p>\n Fourth \u2013 and I know we\u2019re getting into serious overkill, but I feel obligated to mention this \u2013 looked at the lines marked \u201cresistance<\/b> at about 1,092\u201d and \u201cresistance at about 1,035\u201d. If you look at these lines, you\u2019ll see that at some point in the past, the stock rose to this level, couldn\u2019t go above it, and then returned to this level. In other words, this level was an upward \u201cceiling\u201d. Eventually, though, the stock pushed through this level, although it would fall back to these lines, bounce off, and go up again. In other words, what was once upward resistance eventually became downward support. The question now is whether the market may fall below these support levels.<\/p>\n Now, I know there\u2019s a mish-mash of lines on this chart. If it\u2019s your first time through technical analysis, I\u2019m sure it\u2019s confusing. Let me try to simplify. The important take-aways are the following: In sum, the technicians are concerned. There are many more technical indicators to look at, but based on these alone, the chartists are concerned that the market may fall further. Of course, there are no certainties, but many are on the sidelines waiting to see how the market moves. <\/p>\n If we watch CNBC and read the standard media, the bulk of conversation will revolve around valuation (fundamentals ) and technical indicators. Personally, I find both of these discussions unsatisfying because I really want to understand why the market moves as it does. So I\u2019m always in search of a better explanation of events. Ideally, a better explanation means better decisions. <\/p>\n Here\u2019s my take on the market behavior of the last month. Let\u2019s start with the macroeconomic factors, and something the standard media almost never talks about: money supply. <\/p>\n Looking back, the immediate catalyst that led to the 2008 crisis was the money supply being shut off. You\u2019ll remember that prior to the 2007 top, the Fed raised interest rates in an effort to slow down the economy. That\u2019s akin to cutting off the air for a runner. Keep in mind that this isn\u2019t a bad thing, because it\u2019s the only tool that the Fed has; it doesn\u2019t have a choice. Think of the economy as a runner going full speed. The Fed knows this is too much, so it starts to reduce the amount of air available to the runner. The Fed hopes that the runner will notice and slow down, but the runner ignores the Fed and just keeps going, full tilt. Eventually, there\u2019s not enough air to keep the runner going, and he crashes. <\/p>\n That\u2019s what happened in 2007. Easy money made people buy and spend beyond what was realistically possible. For me, money supply is a major driver in markets. <\/p>\n Let\u2019s fast forward to post-crisis. As the economy started to fall apart in 2008, the Fed brought interest rates to zero (effectively). Essentially, the Fed flooded the market with money. Our runner collapsed, and in an effort to save our runner, the Fed gave him as much air as possible.<\/p>\n Fact is, the US Fed wasn\u2019t alone. Everybody around the world did this \u2013 China, Europe, emerging markets. Basically, governments created demand: low interest rates and stimulus means spending. For the last year, China has been buying commodities and most agree that there\u2019s a real estate bubble in China. That\u2019s the result of the stimulus. <\/p>\n For the most part, the stimulus worked; witness the rally of 2009. All the governments gave our runner an oxygen tank, and sure enough, our runner is back up and recovering. <\/p>\n But eventually, the governments have to take away the oxygen tank. China, when it announced that it was increasing reserve requirements, was trying to shut down the stimulus that it had put into its economy. With higher reserve requirements, banks lend less, and there\u2019s less money in the economy. In January, it announced that it was suspending lending \u2013 another blow to the money supply and one of the triggers for the recent market decline. In the US, the Fed has maintained that it would end the quantitative easing program in March. In effect, the Fed is withdrawing stimulus from the market. Finally, in Greece, the government also put a great deal of money into the system. So much so that Greece\u2019s credit was is danger of being downgraded. The solution ? Issue more debt at higher interest rates. And higher interest rates means a reduction in the money supply. <\/p>\n So while these January events \u2013 China, the US and Greece \u2013 might seem different, they were all really the same: they signaled the beginning of the end of stimulus. And the end of stimulus means that buyers are dropping out of the market. <\/p>\n No wonder then, that the market went down. Investors knew that this was coming, but they were waiting for confirmation. That happened when the news from China and Greece hit. <\/p>\n This helps explain why stocks sold off despite good earnings. If you\u2019re a fundamentalist, you\u2019re confused, because earnings are good but the market is selling off. You believe it\u2019s a buying opportunity, but the market continues to fall. A difficult situation to be in. If you\u2019re a technician, you know that the market is down because you\u2019re watching the price action, but you\u2019re not quite sure why it\u2019s happening. Some technicians say you don\u2019t need to know, which is indeed, a valid point. Still, to be a technician, you have to react very quickly, something that isn\u2019t always possible for people that aren\u2019t watching the market every day. <\/p>\n If we look at the macroeconomic factors, the market is in for some challenges in 2010. On the whole, we can say that earnings are good and the economy is in recovery mode. Still, we\u2019re approaching the end of stimulus; major real estate problems still have to be resolved; inflation and possible rising interest rates lurk in the shadows. <\/p>\n Most analysts still forecast an up year and many place the S&P in the 1,200-1,300 by the end of the year. Yet many agree that we could easily have as much as a 10-15% correction in the process. <\/p>\n How likely is this scenario? I tend to agree, although I’m afraid that I don\u2019t expect much for 2010. I think it\u2019s likely that headwinds will cause a correction in 2010, and that these same headwinds will limit the market\u2019s upward movement. How much of a correction is hard to say, but 10-15% wouldn\u2019t surprise me. <\/p>\n Historically, we have a recent cycle that may serve as a template. Take a look at the following longer-term graph of the S&P:<\/p>\n<\/a><\/p>\n
A Matter of Perspective<\/h2>\n
The \u201cBuffett\u201d Fundamentalist Approach (aka value investing, also known as \u201cbottoms up\u201d). <\/h3>\n
The \u201cModified\u201d Buffett Approach. <\/h3>\n
The Technical Approach. <\/h3>\n
![\"S&P](\"http:\/\/www.asiancemagazine.com\/files\/201002_Finance_Vulnerable_S&PTechnical_sm.jpg\")
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A More Robust Framework<\/h2>\n
What\u2019s Next<\/h2>\n