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March 5, 2007

The Markets

October. This is one of the peculiarly dangerous months to speculate in stocks.
The others are July, January, September, April, November, May, March, June, December, August and February.
-Mark Twain

In last week's newsletter I shared with you a quote from Warren Buffett who said, “We simply attempt to be fearful when others are greedy and greedy when others are fearful.” Also, prior to last week's action, we mentioned that the stock market has sustained its longest run since 1954 without a day's decline of 2%. Well, as the saying goes, records were made to be broken and that's exactly what happened. The 2% daily correction was smashed when cautious investors turned into panicking ones.

Last Tuesday's massive sell-off saw the Dow Jones Industrial Average, shed 416 points on its way to a 500 point loss for the week. The S&P 500 fell -4.4%, while the NASDAQ dropped -5.9%. All three benchmarks erased their year-to-date gains.

What was the cause for last week's market downturn? Was it:

(a) Alan Greenspan's comments on the possibility of an impending recession,
(b) Iran's decision to continue its uranium enrichment program,
(c) China's Shanghai nearly 9% market drop,
(d) The attempted assassination of V.P. Cheney in Afghanistan,
(e) Durable goods tumbling 7.8%,
(f) Concerns over the sub prime market and consumer spending or
(g) This morning's expected downward revision of 4th quarter GDP from 3.5% to 2.2% or
(h) None of the above

While any one could be said to be the reason, these were only catalysts and not causes in last weeks sell off. Most of those variables were known prior to last week's selloff. But it was too much weight for the market to carry. Most knew that a correction was coming and the markets were well overdue. But as always the timing is tricky. In the last newsletter, I told you that bull markets usually stumble through several corrections—a correction is a market decline of 10% to 20%. Early warning signs that we picked up on were heavy insider selling and overly optimistic readings on our sentiment indicators. We use these indicators as warning signs and know that they are often early but rarely wrong.

Which direction is the stock market headed? We believe J.P. Morgan said it best. When asked what he expected the market to do in the coming year, he said, "Prices will fluctuate." Will there be another financial crisis? The chart below shows some events that have transpired after the Fed raised rates and then stopped. History shows that numerous financial crises occurred after Fed tightening cycles. After 17 straight rate hikes that began in June 2004 and ended in June 2006, we see this as another reason to remain cautious with the amount of risk we are willing to accept. Fed Tightening Cycle Financial Crisis 1970 Penn Central 1974 Franklin National 1980 First Penn / Latin America 1984 Continental Illinois 1987 Black Monday 1990 S&L Crisis 1994 Mexico 1997 Pac Rim / Russia / LTCM 2000 NASDAQ Source: Ed Hyman, Chairman of ISI

Articles of Interest: In-depth commentary of last week's activity:

John Hussman of the Hussman Funds: Rapunzel Gets a Trim

Jeff Saut of Raymond James: “What time is it?!”

Paul McCulley of PIMCO: The Plankton Theory Meets Minsky

A recession is traditionally defined in macroeconomics as a decline in a country's real Gross Domestic Product (GDP) for two or more successive quarters of a year (equivalently, two consecutive quarters of negative real economic growth). However this definition is not universally accepted. The National Bureau of Economic Research defines a recession more ambiguously as "a significant decline in economic activity spread across the economy, lasting more than a few months." A recession may involve simultaneous declines in coincident measures of overall economic activity such as employment, investment, and corporate profits. Recessions may be associated with falling prices (deflation), or, alternatively, sharply rising prices (inflation) in a process known as stagflation. A severe or long recession is referred to as an economic depression. A devastating breakdown of an economy is called economic collapse.

Because cigars cannot be entirely smoked, a hobo who collects cigar butts can make a cigar to smoke out of every 5 butts that he finds. Today, he has collected 25 cigar butts. How many cigars will he be able to smoke?

Click here for the answer.

Best Regards,

* The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.
* The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.
* The Nasdaq Composite Index is an unmanaged, market-weighted index of all over-the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System.
* Yahoo! Finance is the source for any reference to the performance of an index between two specific periods.