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Stock Market - Sunday thoughts - May 18th 2008

Part 1

[...]how long have you been pessimistic ? and where you optimistic during 2002-2007?

That was a question asked to us by one of our readers. I want to take a few moments to address this now.

In March of 2000, the S&P 500 hit an all time high of 1552.87. Later that same year the market began to decline and the bear market of 2000 to 2002 had begun. In 2003 the market began the rebound and climb upwards thorough out the period of 2003 to 2007. During that period of time we experienced a new wave of companies reporting healthy earnings growth with forward looking guidance that was also healthy. Those companies that created the bear market in 2000 were now "out of favor" and many of them remain that way to this day. But in 2003 a new set of companies were carrying the markets upward. While there were certain underlying economic conditions that signaled weakness in the market, the earnings were able to maintain a healthy growth trend.

Many technical analysts, including us, always kept in our minds what was going to happen as the S&P 500 got back to challenge the all time highs reached in March of 2000. In technical analysis, price levels (especially tops) are very strong points to watch carefully for how the market reacts. When a price level is challenged and subsequently fails to break that point, it becomes a "double top". The study of ‘double tops’ includes a wide variety of inputs such as the market breadth at the time of the second top, fundamentals of the economy at the time of the second top, Fibanocci time series studies, and so on. A double top is always studied very carefully by analysts for it signals a potential large and sustained drop may follow.

From 2004 to early 2007 we were still bullish on the markets as certain indexes were showing us a healthy breadth. Small cap stocks were growing well, corporate earnings were not being squeezed and reporting fairly good economic gains, and the consumer breadth indexes, while weak, were at levels that suggested that there may be a reversal back to an up trend which, if that had occured, would have given good strength for the next attempt at the all time highs of the S&P 500 a running chance of breaking through.

Our first real indication of severe trouble began in July of 2007 when, up to that time, the well hidden losses being absorbed in the financial sectors were being leaked out. It was at that time that the word ’sub prime’ was just beginning to make it’s way into everyday conversation as the financial institutions were slowly letting on how much exposure they really had to this quickly deteriorating financial asset. It was then that Lisa and I understood that this problem was going to become much worse, just as all financial ‘blow ups’ of years past have proven to be. They always start out as being "contained", only to grow into it’s own self sustaining monster that eats its way into the rest of the economy. They most always do.

When we wrote in July of last year that this problem was going to get much worse, our view was growing increasingly pessimistic of the health of the markets, and of the broader economy. As the day approached for the S&P 500 to test the highs of 2000, and that it failed to break those highs confirmed in our view that a ‘double top’ was indeed in the making and this changed the whole dynamics of the markets in an instant. Had the index been able to break through that high of 2000 then from a technical stand point the market breadth would have been strong enough to make that possible. However, as we have now seen, it was not.

Moreover, the quickly deteriorating economy shortly after that retest of that all time high further added to our bearish sentiment on the markets, and of the economy. While certain indicators were showing weakness at the time of the retest, it was not until afterwards that those economic indicators became almost parabolic down ward moves, most notably of course is the rapid acceleration of housing price declines. And the rapid increase in consumer impact that followed.

In summary, our view of the market between 2003 and 2007 was bullish, with a dash of "what if" thrown on top as the S&P 500 got back to challenge it’s all time high. But, before the S&P 500 even reached the re test in October of 2007 we were already warning people that conditions were going to get much worse as those now well known subprime, RMBS, CDO, and SIV losses were mounting rapidly. The confirmation for us was the failure of the S&P 500 to break the all time highs and has now set in motion the bear market of 2008.

Currently the market is ‘thinking’ that the worst is behind it, that corporate earnings have seen their lows and it will be up from here. However, the rapidly declining economy is going to impact corporate earnings for more quarters than previously thought by the professionals on Wall Street. Retail sales have actually deteriorated much more during this current quarter, and should be reflected in future earnings releases. This will set in motion the next wave of down ward pressure on the markets. However, I see the market as gaining an understanding of these forward earnings potential ‘misses’ now and is why the market is having trouble making any substantial moves over the last couple weeks. They are fearful of going forward with any confidence at this point and it is down to a "who will blink first" situation.

Our long term view remains intact, the markets will go much lower in the coming months and we stand firmly behind our thesis that this is a time for capital preservation, and not of care free speculative betting.

I hope I was able to answer the question our reader asked.

More later today.