May 2009 Report
On May 5th, the market, as measured by the S&P 500 turned positive for the year. Typically a statement such as this would be trivial, but in a market that has lost in excess of 65% over the prior 17 months, including a plunge of 25% in the first seven weeks of this year, is significant.
Of course the question on everyone’s mind is where do we go from here after the 34% rally of the past eight weeks. For every bull there are still two bears (a good thing) and for every positive economic data point there are probably three backward-looking negative points used as an explanation of the market’s future direction. In this newsletter I will focus on the impact investor psychology has on the market, which, as much as anything else, explains why the market overreacts in both directions.
Thinking back to early March when the market was down 65% and capitalism as we know it was disappearing, many people were contemplating major changes to their economic lifestyle or worse, implemented major changes in their investment strategy and sold heavily into the downward spiral. As the selling investors “luck” would have it, the market began to rally in mid March, and these tens of thousands of individuals and institutional investors began to face the investor malady of regret, and mostly, stupidity.
Every day they see the market rise after locking in large losses burns at their psyche until it becomes as painful as it was losing their money on the downside. Many succumb to the pain and jump back in and buy stocks on the rise. As more and more people realize they may be missing a bull market, the rise becomes self fulfilling. Every little market dip is met with even more buying. Compound this with the fact that 40% of the entire value of the stock market was being held in cash by individuals and institutions provide the ammunition to sustain a long bull market.
Strangely enough, this is how most bull markets begin: in disbelief and rage. Just as bear markets begin when everything is great, bull markets begin when everything stinks. The inflection point comes when emotions run so high that economic and investment decision makers overcompensate. The market hits bottom when stocks have been run down so much that there are basically no more sellers-when the last holdouts throw in the towel. The tell tale sign of the move off a bottom comes when the absolute worst stocks rise the fastest. In this market, it was the financials, with many down 80-90%, and a few bankrupt. Banks, which are nowhere close to making a real economic profit despite their claims, have risen 100%-300% off the March lows while another beaten up group, retailer, have done the same. J Crew Group has doubled since we
purchased it earlier this year. Coach, another retailer held in our portfolios, has risen 125% off its bottom.
So has the bull market begun, or is this just a rally within a bear market? At this point the key issue all sides must recognize is that the U.S. government has declared war on depression and will do whatever it takes to win. They will let banks paper over insolvency and provide loans to bankrupt automakers. They have decided what is good for Citigroup and GM is good for America. Couple this with the fact that at least half the economic cycle is about confidence; just shoring up the psyche was enough to get the ball rolling. Finally, good things are starting to happen. Layoff announcements and new unemployment claims are declining, consumer confidence and spending is improving, housing is showing signs of bottoming, interest rates are low, and container exports are beginning to rise.
This is not about hope or misperceptions. It’s about both economic and investment activity having swung so far in one direction that it was time to swing back. We have experienced boom, bust, panic, and depression which has created expectation so bleak that the numbers being reported by most companies have easily exceed them, causing stock prices to rise further. Michael Belkin, an independent analyst said you should just think of the market as a “big squeeze” machine—constantly forcing the majority to do the wrong thing at the wrong time.
In our last newsletter on March 18 I said that “at a minimum I would suggest that the rate of deceleration of the economy and markets appears to be basing. I believe investors will be well rewarded for the risk they take at this level”. This turned out to be very prescient. The portfolios of Shapiro Asset were rebalanced to a higher level of equity exposure in March and April to reflect this belief. Most all our portfolios at this point have target cash weighting well under 3%, after being as high as ten percent prior to March.
Shapiro Asset continues its value focus on companies generating free cash flow with a strong balance sheet; this positioning has allowed us to participate on the up side and gave us the confidence hold most of the securities in our portfolios despite the market disregarding their fundamentals.
Marc Shapiro