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Back From Vacation – Market Strategy Update

sp-500-boxed

Well I am back from vacation and wanted to touch base on the market and what we’ve been doing while I was out of town.

If you recall before I left I noted that we had raised a significant amount of cash into the rally from the January/February correction when the market was in the process of forming a topping pattern as shown by the blue box on the chart. We were looking to put that cash to work in the “Buy Zone” as shown by a purple box on the chart as that present good value for reinvestment purposes.

John and Charlie were hard at work implementing the strategy while I was out, and I am happy to report that in spite of the market being down around 8% in May, the purchases they implemented in the buy zone were up a net 0.80% as of today – naturally some were up and some were down from their buy price, but on an aggregated basis, the purchases have worked out pretty good.

That is the good news. The bad news is that as I look at the chart, I see we have had a change in character in this market. If you look at the mid-May timeframe on the chart, you will see that we were unable to break back above the 50-day moving average, which led to a failed rally and a drop back into the buy zone. We then moved below the 200-day moving average (a bad sign – you may want to review previous posts that discuss the importance of the 200-day moving average if you are curious about it) and have not been able to break above it, even on some fairly strong rally days. We now even have the 50-day moving average line curling down and looking like it wants to move to the 200-day line.

Given these issues in the character of the market (which provide observable clues to investor behavior based upon their otherwise non-quantifiable sentiments and feelings) we will continue to hold onto the balance of the cash that we raised to see if there will be another buying opportunity. That buying opportunity might consist of a lower Buy Zone than the current one, you just never know.

I had a couple of emails from readers that wanted to know if we were headed back to the crash lows of last March. I thought I’d share with you a couple of thoughts on that.

1. The crash was precipitated by a systemic problem with the world’s financial markets, particularly a freeze up on the credit market caused by the Lehman Brothers’ bankruptcy. Below I have posted a chart of the TED Spread which I’ve written about here before. Back in 1987, I learned that this chart is a consistently reliable indicator of systemic failures in the financial markets.

ted-spread

You can see that in May 2007, the chart started to get elevated. I wrote to you at that time that we were eliminating our exposure to the financial sector (eg, banks and brokerages) due to the systemic risks building in the system from the sub-prime mess. That proved to be a good decision as those mortgages ended up bringing down many former financial powerhouses. You can also see that as a forecasting tool, the TED Spread reliably told us ahead of the crash in September 2008 that there was something major wrong with the financial system.

Looking at today, though, we are in the historically normal range on this 5-year chart. Yes, it is above where it was in the past several months, but it is still in a normal range. We will continue to monitor it, obviously, but at this time it is not telling us that we have a systemic financial system issue that could lead us back to the crash lows.

2. The corporate fundamentals being reported (eg, earnings, earnings growth, improved corporate balance sheets and reduced debt to equity levels) along with valuations (ie, lowered P/E ratios due to the current correction) are so much better than they were at the crash lows. Things have changed since then and many of our favorite companies are in so much better shape than they were 15 months ago. That’s not to say their stock prices can’t go sown some, but the fundamentals show that any pullback would present a good investment value.

3. We are still in an easy money environment and we will likely stay that way until unemployment gets below 8%. If you look at a chart of the Fed’s M2 money supply data, you can see that money supply is still growing (M2 is a measure of the nation’s money supply and you can see that it grew dramatically during the official recession, but has trended up much more slowly since then as the Fed has reduced some of its more aggressive policy measures). As long as the money supply doesn’t contract, this will continue to provide support for stock prices.

So, for now, we are watching and analyzing. As things change, I’ll keep you up-to-date on our activities, but for those of you that may be concerned that we are headed back to the lows of 15 months ago, there is nothing currently out there to indicate that is the case. If something were to rear its head, we would act on it and advise you.

Hang in there and we need to let this correction run its course and pick up some quality companies when the opportunities present themselves.

Mark