Insights on the Current Financial Markets Wednesday, November 25th 2009 Asset Value Destruction: One Year Later What’s the Opposite of a Credit Crisis? Investor Behavior: As Predictable As Ever. We’ve Seen This Before... a Possible Road Map.

I’ve spent the last few months speaking and attending various professional investment events around the country. One of the most common discussion points has related to whether or not we are witnessing the start of a new Bull Market.

I have much to share with you about recent market events, and could probably fill a few dozen commentaries. But since Thanksgiving is upon us, I thought I would keep things brief and share a few ideas from my recent presentations.

Asset Value Destruction: One Year Later

What a difference a year makes. It was twelve months ago that global financial markets were in utter turmoil. After falling -9.2% in September 2008, the S&P 500 went on to lose an additional -16.8% in October, marking one of the worst monthly performances for the S&P on record. Stocks, Commodities, Corporate Bonds, Treasury Bonds, and even Gold fell in unison. Diversification failed to protect. It was a massive dump of anything that could be sold, a classic example of a liquidity crisis-- a true bear market.

Where was the “safety” of asset class diversification Wall Street has been promoting for the past 15 years? Where was the Modern Portfolio Theory crowd and the brilliant PhD’s? After first making the rounds in the early 1990’s, Asset Allocation finally met its first true test as a risk management tool. It failed miserably. In its wake, investors and professionals were left scratching their heads. “How could this happen?”

What’s the Opposite of a Credit Crisis: A Liquidity Rally.

When the entire credit system comes under pressure, other holdings must be sold to meet cash demands. During periods of relative stability, hard selling in one asset class usually results in buying in another, as investors rotate from one class to the next. For example: in the 2000-2002 Bear market stock market declines resulted in commodity and Real Estate rallies, as market leadership shifted. In 2000, the asset class shift from equities to Real Estate and Commodities was no fluke: it was exactly what the Fed wanted, and needed.

Just like in 2003, actions by the Fed to resuscitate the financial markets have worked, sparking a spectacular recovery rally in the equity markets. As of now, The S&P 500 still remains more than -30% below values seen prior to the crisis, but are significantly better than the levels seen in March of this year. While the stimulus actions will have significant consequences down the road (which we will discuss shortly), the actions were necessary to keep us from utter financial catastrophe. What has been even more impressive however, is the shift in investor sentiment. In March, investor fear reached its peak, with a crescendo of voices screaming at their advisors, angry that the investment community had no way to protect them from the catastrophic selling. Just 7 short months later, panic has reverted to greed with the public chasing the market indexes ever higher, somehow feeling left behind.

Investor Behavior: As Predictable As Ever.

The human desire to know the future is well documented. Yesterday’s fortune teller is today’s Wall Street analyst, as we champion those with the clairvoyance to see the future. Many analysts achieve notoriety, stretching an entire career out of a single market prediction. But betting the security of your retirement account on the ability of continually predicting the future is a low probability strategy. While many try, we can’t accurately forecast the future. Nor do we need to.

We can’t predict tomorrow’s headlines, but investor reaction to headlines is VERY predictable.

Each generation of investors has had their share of Bull and Bear markets. Each generation has had to deal with what they believed at the time was “the worst yet…” market event. While the specific catalyst to each Bull and Bear market was different, investors actions in response to news is as predictable as my morning stop at Starbucks.

We’ve Seen This Before... a Possible Road Map.

While history never repeats exactly, it often rhymes. Looking to see how investors reacted to similar market disruptions may give us some indication of what’s to come.

There has been a lot of discussion lately regarding the similarity of the recent credit crisis and ensuing market action with that of the 1937-1938 market decline and recovery. The correlation of 2008-2009 to that period is actually quite compelling. Just a few years after the panic selling of the Great Depression, another horrific bear market took hold in 1937, with the Dow Jones Industrial Average declining nearly 50%. To help prevent another Great Depression, the government took unprecedented action to stimulate the economy, cutting interest rates and introducing massive government spending programs. The market bottomed in March of 1938, recovering nearly 60% of the declines before topping out in mid November of that year.

The following charts were prepared by my friend and colleague Larry McMillan (one of the best options and volatility traders I know, by the way). The correlations to our current market and economic environment are surprisingly similar.

Chart courtesy of McMillan Analysis Corporation. All rights reserved.

Just as in 1938, today’s market has been rallying on the liquidity fuel provided by “drunken government spending”. But in 1938, once that fuel was used up, there was little to support further price advances. After topping out in November 1938, the market began a slow grind back down to the lows that lasted more than 3 years. It took 7 years for prices to exceed the November 1938 highs.

Chart courtesy of McMillan Analysis Corporation. All rights reserved.

Market events in 1973-1974 also had a similar Bear Market and recovery pattern. After a punishing 1974 market decline, stock prices rallied strongly recovering almost the entire decline, again based largely on government action. Once that fuel was exhausted however, the market was left with little reason to advance, and began another slow, grinding Bear market that lasted 4 years. Yet again, it was more than 6 years later before new highs were seen in equities.

Chart courtesy of McMillan Analysis Corporation. All rights reserved.

Another highly correlated period which saw a punishing Bear market followed by a stimulus rally was the 1907 Rich Man’s panic. The outcome was the same: an initial rally from the lows, followed by a long period of sideways to declining markets.

Chart courtesy of McMillan Analysis Corporation. All rights reserved.

It would be foolish to try to use these past events to think the future will match exactly. The point of looking at these past events is that it gives us some insight into how investors of the day reacted to similar bear market declines and government stimulus rallies. In each period panic selling was followed by euphoric buying, that resulted in multi-year market hangovers. There are already cracks beginning to form in the current rally, as volume shrinks and fewer stocks are pushing the indexes higher.

Of course there is always the possibility that it is “Bull Markets and Blue Skies Forever” from here, and that somehow the excessive yet necessary actions by the Fed have made it different this time around. I don’t think so. The road is littered with the bodies of investors who proclaimed “it’s different this time.”

Whether stocks can continue to push higher in the weeks and months head or not, one thing is clear: We have been here before. Once this current rally ends, it will likely represent the top for stock prices for five to six years to come. Successful investing is once again going to be the result of an Absolute Return methodology that exploits both rising and falling market trends.

To find out how to put Anchor Capital portfolios to work for you, click here.

Have a safe, restful Thanksgiving Holiday,

Until next time,

Eric Leake
Chief Investment Officer,
Anchor Capital Management Group, Inc.
http://www.anchor-capital.com

Chief Executive Officer,
Anchor Research, LLC.
http://www.anchor-research.com

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