Tuesday, November 18, 2008

Seeing Both Sides of the Tape

"Surely, this can't be happening again" I said to myself in the last hour of the market today. Once again, the US and global markets went parabolic into the close on no news. "I don't think I've ever seen a chart pattern like this before," was something I thought numerous times in the last few days.

Anyone who has read my thoughts in the past knows I've been extremely bearish on equity markets. And I remain that way for a number of reasons (poor valuations, poor demographics, poor policy making, etc.) But one of the first things I learned about trading and investing was that I should never, ever allow my convictions trump discipline. Following this one rule has saved my butt so many times that I have lost count. So while I expect the markets to break down into another leg lower, I have enough respect for the market to know that it may not happen right away.

Bear markets have an uncanny ability to stage massive short and intermediate term rallies back to previous levels of support. Support becomes resistance and the next leg down begins. Such an occurrence for the S&P 500 would be toward 1200-1250. That would be a 50% rally from our lows of today. Doubtless, there would be massive opportunities for profit in an event like this.

Additionally, it should be noted that depending on your time frame, buying certain stocks at these levels may not be a poor choice when looked upon in 5 or 10 years. I outlined a small number of companies that I think would fare the best in a poor economic environment in Looking for Relative Strength. I've got my eye on a few others that I will share with readers at a later date.

In this week's note from John Hussman, he points out the other side of my analysis on the potential pitfalls in earnings estimate reductions. From the article:
Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are “uncharted territory.” Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions. Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows.

Indeed, nobody should buy or sell a solid company because of fears or euphoria over next year's earnings. That is a rational argument. Unfortunately for Mr. Buffett, the market is not always a rational place. Fears about lower earnings this year can evolve into lower expectations for not only the next year, but the next 10 years. A company that has performed well in the last 60 years of consumption binges may not necessarily perform well in a prolonged period of social aversion to excess consumption. That is, what has performed well in inflation, may not perform well in deflation. Mr. Buffett included.

Kevin Depew had a fantastic article on the changing social mood today, titled, "Social Mood Shift Brings Stark Changes." He outlines perfectly why certain symbols of affluence are being shunned at a rapid pace. I'm wondering what the perception of America's role in "starting" this crisis will have on foreigners' willingness to purchase symbols of Americanism - things like Mr. Buffett's beloved Coca Cola Co (KO). Consumer preferences are extremely finicky. Anything can happen in a time of social revolution.

For this reason, I think the Buffett model of "buying for the long term" may turn out to be extremely dangerous. Even when it comes to presumably safe companies of what could be an old paradigm.

As always, there are two sides to the tape. One side points toward the buying opportunity of a lifetime in companies with historically predictable cashflow, or in companies that may lead the way out of a massive recession. Another side points toward a major shift in social mood where values of the past are rejected in favour of something else.

The massive volatility in the markets over the last 3 months seems like a see-saw between the two ideas. One hour, market participants are sure that what was old will be hung out to dry along with the ideals of American-style materialism, risk-taking and the willingness to go into debt. The next hour, participants are sure that the former are over-reacting, and after a little bit of pain, things will return to normal.

It is my belief that the former are correct, for the reasons Kevin Depew lays out, and for other reasons. But in the interest of full disclosure, that may just be my own personal preference bias as one who loathes our lack of social values. I'm prepared to be wrong and am willing to make major adjustments to my current investment posture of doing *almost* nothing.

In summary, this is about more than stocks being cheap or expensive. It is a battle between the status-quo and a new paradigm. Hopefully, seeing both sides can assist you in making the right decisions.

Note: This will likely be my last post for a while. I am relocating to Germany for an undetermined amount of time. Please bear with me while I make the transition. As always, thanks for reading.

1 comment:

rick said...

"In summary, this is about more than stocks being cheap or expensive. It is a battle between the status-quo and a new paradigm."

Yes, no one knows how to value stocks anymore. Only stocks paying dividends have definite measurable value. GE paying 10% for example. But dividends are not guaranteed and bankruptcy is a remote possibility for any company.

Good luck with your move.


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