When I was a child my grandfather gave me a yo-yo and told me that it was a great way to pass the time with nothing in particular accomplished. It appears the market decided to take my grandfathers statement to heart in the month of July as it yo-yoed itself to death with multiple days of up triple digits and down triple digits to end the month basically even. While the broader market indexes finished the month even there was a lot of transition happening under the surface. The first two weeks of July continued the declines seen in June with the S&P 500 breaking below March’s lows to turn course on July 15th when Merrill Lynch announced it was selling many of its mortgage backed bonds for .20 cents on the dollar. While this news sounded ugly and would leave most people to believe the market would go lower the exact opposite occurred. The reason is the news brought some short term clarity to the market in regards to the value of assets the banks and brokerages have been writing down. Subsequently we saw the market rebound the last two weeks of the month.
In addition to this market reversal we saw the leaders of the market (Energy, Commodities and Basic Materials) decline in value. Something I mentioned was a possibility in last month’s letter. This sell off in energy and commodities had a negative effect on our accounts for the month and may be signaling a possible sentiment change in the market as the big money players move some of their profits from energy and commodities to other sectors in the hopes of a market bottom. While this month’s movement in energy and commodities was a little disconcerting and has me a bit frustrated I am not convinced that the longer term fundamentals have changed enough to make me a bull in the broader market. In addition, it is very common to get “counter trend” moves which last for a month but do not change the longer term pattern. However, there are some important underlying changes that will cause me to readjust our portfolios. Most notably is the strength in the dollar we have been seeing recently. For those who may not be aware, the dollar has a significant effect on the pricing of energy and commodities. To make a long story short, as the dollar rallies and gains strength we should see oil and gold decline in price which threatens the viability of our current mix. In addition, there are some important cycles that you should be aware of which lead me to my hesitation to becoming a bull even as many market mavens are predicting that July 15th was the bottom of this market.
Bottom of the market or a Bear Market Trap?
I would not be surprised to see the market rally up over the next 2-3 months before resuming downward momentum. My reasoning on this is a result of some basic cycles the markets typically follow. Because markets move in cycles it is important as an investors to follow those cycles and attempt to invest your dollars in anticipation of the next move. The first indicator to watch is bond yields. Bond yields usually top out on average 27 months before a recession. We saw the Bond Yields reach a peak in June of 2006 which would place a target for recession for September of 08. The stock market measured by the S&P 500 also leads the economic cycle with a lead time on average of 9 months. We know the stock market topped out in October 2007 which would signal a recession near July 2008. Both the Bond and Stock Market are pointing to a recession in the third quarter 2008. The stock market follows a sector rotation model that can be used to identify opportunities in the market. Since investors speculate in the market on what the companies and the economy will do, it naturally leads the economic cycle. If we are headed toward additional economic downturn and a recession we should see certain sectors that mark the peak outperform other sectors. This would include Basic Materials, Energy and Commodities. Historically commodities peak two to three months prior to recession. The recent sell off in energy and commodities sure does feel as if those markets have topped out adding more fuel to the potential of recession in the third quarter. That being said we should begin to see money flow out of these sectors into defensive sectors such as Healthcare, Utilities and Consumer Staples (Proctor and Gamble, Johnson and Johnson, etc.). In anticipation of this we have made our first purchases into Utilities and Healthcare in the past week. Currently we still have approximately 60-70% of our portfolio in cash and will continue this until there is an opportunity which will pay us better. We have cooled our heels recently with the bear market funds as the market has been making some extreme moves from one day to the next. In addition, recently the market has been moving up on days that bad news has hit the headlines which indicates that there is some big money out there trying to predict a bottom in this market. I am skeptical that this will continue but when there is not enough clarity it is best to sit on the sidelines and wait. Moving forward I will continue to keep you informed and encourage you to contact me with any questions you may have.
Below I have listed the returns of the market averages so you can compare them to the performance of your accounts.
Year to Date Market Returns as of 7/31/08
Dow Jones– 12.7%
*The opinions expressed are those of Colby McFadden as of 8/5/2008 and are subject to change based on market and other conditions
**The S&P 500 Index is an unmanaged index of widely held common stocks that reinvests all distributions. It is not possible to invest directly in an index.