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Bullish for Stock Markets When Economy Hits Bottom

Stock-Markets / Global Stock Markets Jan 19, 2008 - 04:20 PM GMT

By: Roger_Conrad

Stock-Markets Best Financial Markets Analysis ArticleSixteen years ago, I was fortunate to work on what I still consider to be one of the best guides to understanding the stock market for US investors: “Market Timing for the Nineties” by Stephen Leeb.

At first glance, this book is dated automatically by its title. Its basic premise, however, applies to any decade. In fact, it's more relevant than ever here in 2008, where recession worries have taken over the market mood.

Simply, stocks have their greatest upside when there's the maximum amount of “slack” in the economy. And slack is basically the room to grow the economy without igniting inflation.

Over the long haul, the economy—and particularly its prospects for sustainable growth—are what drive the stock market. If the current level of growth is increasing or expected to rise, stocks tend to rise. In contrast, if the current level isn't perceived to be sustainable, stocks will fall.

A bottoming economy has the greatest room for sustainable growth. Consequently, the best time to buy stocks throughout history has been when the economy has hit bottom.

In contrast, when the economy has been surging for a long time, it has the least room to grow faster without igniting inflation. Stocks' upside potential is at its lowest.

This week, I was privileged to speak for American Association of Individual Investor groups in St. Petersburg and Winter Park, Fla. The Sunshine State's economy has been hit more than most regions of the country over the past year, mainly because of the massive slump in the housing market.

The chief concern for the investors I spoke with was how much the weakening economy would continue to pound the investment market. In other words, how much worse are things going to get before we see a real bottom?

As longtime readers know, market timing has never been my avocation. In my view, investors are always better off focusing on buying good businesses at good prices and then making sure those businesses stay healthy and growing. As long as that's the case, the rest will take care of itself.

In the long haul, the stock market is a weighing machine. What's truly valuable will ultimately command a higher share price. Holding stocks or even bonds and preferred stocks in a good and growing business will always pay off.

It's always good to know, however, where we stand in the cycle. For one thing, there's absolutely no guarantee of when the payoff from holding a good business will come. Sometimes, the market will recognize value immediately. But other times, it can take months or even years for it to be fully reflected in a stock's price. Investors will literally need the patience of Job to truly cash in, and frankly, many will find themselves incapable of waiting.

It's even harder to hang in there with good businesses when the market is bashing their stocks, as is the case today in many sectors. That's a time where it can be especially key to get a read on where we stand with the overall economy and market.

When I see a stock's price fall 5 percent or more on a given day or over several days, my first reaction is something has gone wrong with its business. I immediately consult every source I can think of to find out what's behind the drop, so I can consider whether I should recommend bailing out.

In a normal market, odds are much higher that where there's smoke, there's fire. In other words, if a stock is crashing while everything else is holding steady or even going up, there's almost always a pretty good reason that's tied in to the health of the underlying company itself.

In stark contrast—painful as it can be—there's no assurance that smoke indicates fire in a falling market like this one. Again and again over the past few months, we've seen major crashes because the sellers have the upper hand and may bail on a stock for reasons that have little or nothing to do with fundamentals or even rumors about business shakeups.

One reason markets are so volatile boils down to who really controls the trading float in today's market place: institutions and money managers. In the mid-1980s, when I was first starting in this business, I noted a statistic that appeared in the Wall Street Journal, basically comparing trading volume carried on by institutions—defined as large pools of money run by professionals—and individuals.

Until that time, individuals had unquestionably ruled the market. Institutions, however, had been gaining ground fast, and the paper pointed out they had finally overtaken individual investors in terms of volume. Since then, the trend has continued to accelerate; today institutions are more in control than ever of how trading works.

There has been any number of observations made about how this sea change has affected market volatility, seasonality and perceptions of value. In my view, the paramount factor is time horizon.

Basically, individuals have financial goals and spending needs that govern how much they can invest and what strategies they use. But any deadline toward meeting them is ultimately in their control and, therefore, flexible. If the market doesn't cooperate, they can hang in there and wait for the cycle to shift to a more positive mode.

In sharp contrast, institutions have no such luxury. For the past decade, I've been privileged to provide a model investment portfolio for a small money management firm.

As is the case with my investment advisories, my approach is to buy and hold great businesses for the long haul that generate a rising stream of generous income. As a result, I don't do a lot of trading and probably have one of the lower turnover ratios on Wall Street.

On the other hand, I also have to perform on a timely basis. That doesn't mean I can't wait for a great company to be recognized in the market place. But it does mean enough of my portfolio has to be performing well this year. Otherwise, I won't be in this business long.

Money management for me, of course, isn't my main business. But it is for most of the people who run the institutions that run the market.

Basically, if these people consistently underperform for whatever reason, they're history. And the only way they can ensure that won't happen is by being constantly alert to what the market is doing, so they can act and react accordingly.

In most markets, that basically amounts to paring back some positions and adding to others, while replacing stocks that appear to be floundering in a timely way. When overall volatility ratchets up as it's doing now, however, all bets are off.

Certainly, not everyone behaves like a lemming. But when the market is tumbling, group thinking does take over. No one wants to get stuck with stocks that are getting pummeled for fear they'll dig a hole they can't climb out of the rest of the year. So selling is accentuated, sometimes exponentially. News that might generate a 2 to 3 percent down move in a normal market may trigger a haircut of 10 percent of more.

It's no fun at all to be holding a stock that's caught up in this game as it's being played out. It's one thing to realize that recovery is assured as long as the underlying business remains healthy. It's quite another, however, to keep riding with losses that seem to escalate daily. And the more a selloff goes on, the more difficult it is.

At times like these, the most important thing to do is to keep emotions out of your decision making as much as possible. In my view, one of the best ways is to ignore the temptation to double down on a stock that's taken a dive.

Probably the most-asked question I've gotten from readers in the past few months is whether they “should buy or sell” a falling stock. The premise is I've rated the stock a value at a higher price, so it either must be an even better buy now, or the fundamentals have deteriorated and we want to sell.

On the face of it, the premise seems to make pretty good sense. After all, as long as the underlying business is sound, why wouldn't we want to own more at a lower price?

The problem is—though it seems imminently rational—this is an emotional question. Those who ask it are looking for the emotional release of taking charge of a situation that's causing them considerable grief, either by making an affirmative bet that the crowd is wrong or by throwing in the towel and walking away.

Were we true clairvoyants, we'd know for certain whether or not the crowd was wrong. Unfortunately, even the savviest and brightest analysts and investors can get it wrong for any number of reasons. All we can really do is handicap the situation and decide if we want to enter or stick with a trade based on that.

Those who held stock in the former ENRON got a great piece of news this week: A cash settlement of nearly $7 a share was reached in the long-standing shareholder suit. Those entitled to a payout should now have received information on the case, as well as instructions for how to claim what's owed.

As a former owner myself, I'm happy about the payout, which I'd given up on long ago. But the whole case does bring back a pretty unhappy memory of how Enron was able to mislead the entire market place, everyone from credit raters to those in its industry who did business with it.

Like it or not, information isn't perfect in the stock market. No matter how much you know, you can still be wrong about a company.

If you average down in a falling stock and prove correct, you'll obviously do better than you would simply by holding what you have and waiting for things to come back. On the other hand, if you double down and are wrong, you lose that much more. And if you keep averaging down—and many did with Enron, WORLDCOM and other now-bankrupt former blue chips earlier this decade—you can blow a major hole in your portfolio.

Then there's the emotional factor. Doubling down makes you that much more committed to being right on a stock. Unless you're a robot or a computer, it will be much more difficult to bail out if it becomes evident things really are going bad at the underlying business.

Neither doubling down nor selling keeps you in the position on the same basis as when you entered it. It's a losing stock, but it's just one stock. It alone is not going to blow a hole in your portfolio.

True, you have a loss on your cost basis, which you could lower by doubling down. But loss on cost basis is actually an asset that can be used to minimize taxes on future winners.

Meanwhile, the value of your position is based on today's price, not when you bought in. Your potential gain is, therefore, based on today's price or what you could sell it for now.

The other way to keep out the emotion is to keep perspective, which brings me back to “Market Timing for the Nineties.” As I wrote at the outset, the book's premise is that economic slack or room to grow at any point determines how the market will do over the next 12 months.

When there's more room for sustainable growth, there's more upside. When there's less, there's more downside.

The book points out several factors that determine overall economic slack: commodity prices, unemployment, the level of interest rates, money supply and price-to-earnings (P/E) ratios for stocks. The combination of these generally shows where we stand.

One of the things that makes anticipating this market so difficult is that several of these indicators are going in different directions. Most are indicating relatively little slack.

Commodity prices, for example, have been off to the races for several years, though they've backed off a little in recent months. Unemployment insurance claims—the only number on this front that's never revised—actually came down sharply this week. Money supply is growing, but “real” or inflation-adjusted interest rates are very low, which means companies aren't borrowing at rates much above inflation if at all. Finally, P/E ratios have been higher at times but are still on the higher side historically.

To the investing public, we're already in a recession. Yet according to these time-tested indicators of economic slack, more adjustments are in store.

That's the bad news. There is, however, one indicator that's starting to point more and more in the opposite direction. And more often than not, it tends to trump everything else: Namely, big declines in the stock market tend to create enormous economic slack and ultimately lead to huge returns for stocks.

At this point, we haven't seen the magnitude of stock market losses of, for example, the 2000-02 bear market. But we're starting to move that way--fast. The Dow Jones Industrial Average is off nearly 15 percent from its highs and almost 10 percent this year alone. The S&P 500 is also off nearly 10 percent this year and 15 percent from last year's highs. The Nasdaq Composite, meanwhile, is off almost 20 percent from recent highs.

We still have pressures from commodity prices in particular, which as I've pointed out are being fueled by demand from other global growth engines and supply issues like resource nationalism. But very dramatically, the stock market's demise is blowing off the froth in the economy and creating slack.

Sooner or later, the cycle will end. We'll hit bottom and the market will have a lot of room to run on to higher highs.

That doesn't mean there won't be some pain in the interim. And that brings me to my third antidote for getting emotional in these dangerous times: Keep holding some cash.

Prices are coming down sharply across the board in this market, and bargains are emerging as stocks of good businesses sell ever-more cheaply. But in my view, there's absolutely no hurry to deploy resources for a recovery.

Again, I'm no market timer. In fact, I think it's self-defeating for most people to try to be one. I do think it makes sense to take incremental positions in certain areas, but it also looks like things could get cheaper still in the near term. That means take it easy and keep some cash on hand.

The fourth and most important key to surviving what appears to be an emerging bear market is to keep monitoring the health of the underlying businesses of the companies you own. Today's announcement of earnings from GENERAL ELECTRIC was encouraging and a pretty good sign that a good chunk of the economy is doing OK. It also indicates the company is still in pretty solid shape and executing on its plans to focus on higher growth areas.

In my view, we'll see the same kind of result from the recommended stocks in my advisories Utility Forecaster ( ), Canadian Edge ( ) and Vital Resource Investor ( ). But the numbers will tell the tale, and we're going to have to wait for them to trickle out during the next several weeks.

Over the past several weeks, we've seen an emerging ethos of zero tolerance for companies that either report bad numbers, indicate they may report bad numbers or are rumored to be reporting bad numbers in the future. The report that triggered the AT&T selloff last week—alleging it was losing consumer business to the recession—has since been retracted. But the selloff it created in this blue chip's blue chip is a pretty telling signal of the market's mood, and it's not pretty.

We do have one big thing on our side as we enter earnings season, however. For the past six months plus, fear has been radically slashing the expectations built into share prices marketwide. There's still room for disappointment, particularly in the more sensitive sectors. But there's a lot less in the utilities and other essential service companies, which have sold off in recent days despite indications that results will continue to be strong not just for the fourth quarter but throughout 2008 and beyond.

Solid results indicating minimal economic impact will go a long way toward stabilizing prices for utility and essential service stocks, which have slipped lately in the growing wave of investor panic. That will go a long way toward calming nerves and taking the emotion out of this as we wait for the macro picture to improve. More important, they'll mean our companies have passed the stress test, again proving themselves worthy of buying and holding for the long haul.

By Roger Conrad
KCI Communications

Copyright © 2008 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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