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Investing Baby Boomer Demographics - Independent Money Manager Atlanta, GA

Stock Market Is Vulnerable

02/27/2009 - Complacency, Lack of Support Highlight Need for Risk Management: In our office during the trading day, we usually have Bloomberg TV on in the background. When something of interest is being discussed we turn up the volume. Indirectly and in a very unscientific manner, it serves as a way to gauge the sentiment of a wide variety of market professionals. Since the November 2008 lows, we sense a level of complacency about the downside risks to the economy and financial markets. It is almost as if people feel the market cannot inflict much more pain after a 50% drop or as if the market owes them something. Even though the primary trend is down, many Bloomberg guests talk about it being too late to short or a good time to go shopping for “bargains”. We have no preconceived notion about whether stocks will move higher or lower from current levels. However, we are interested in trying to assess the downside risks, as well as the upside potential of all markets. As stated in Fundamentals, Valuations and Technicals Stress Need for Patience, the S&P 500 could drop to 525 in a worst case valuation scenario (normalized earnings and a 1974-75 bear market multiple). So buying stocks based solely on a valuation call has some merit, but quite a bit of risk as well. We rarely, if ever, make a call based solely on valuations. Investors in SPY, DIA, SH, SDS, or DOG can benefit from a big picture risk-reward analysis.

With a glut of houses on the market, especially given the tepid rate of sales, home prices have not yet hit bottom (not even close). Consequently, the banks have more troubles ahead. The consumer is concerned about debt levels and job security. In short, the fundamentals remain very weak.

On the technical front, stocks remain firmly in a downtrend. Anyone with experience as a money manager or trader can show you at least a few scars from incorrectly betting against the primary trend. At the October and November 2008 lows investors did have the comfort of serious historical support clustering in a range between July 2002 and March 2003 (see label 2, 3, and 4 in chart below). In recent weeks, the November 2008 lows (label 1) have provided a psychological reason to remain open minded about a possible turn (which still holds a little water). Every day that goes by without a sharp rally, the odds increase that we will see a serious breach of the 2002-2003 and 2008 lows.

As we have listened to guests on Bloomberg TV over the last several months, we have not heard much about contingency plans in the event we do take another leg down. Almost all major indexes have already made new closing lows below November 2008 levels. One ray of hope is the S&P 500 Index has yet to make a new intraday low (741.02 is the level to watch – Nov 2008 intraday low). Another rare bright spot is the Dow Jones Wilshire 5000 Index is still holding above its November 2008 low.

The chart below can help us better understand the need for a very specific and detailed game plan should the market move significantly away from the November 2008 lows. A close below 741.02 on the S&P 500 would increase the odds of another significant leg down. Stocks could surprise many in the "we have to be close to a bottom", "it is too late to sell", or "a chance of a lifetime" camps. The support below the market during another leg down would be significantly weaker than what we have had since October 2008. Why should we care? Because it means stocks could fall further and faster in a worst case outcome. While making no predictions about how things may unfold, the factors discussed above could spark the proverbial "I can’t take it anymore, get me out now" capitulation. Weakening support, complacency, and still deteriorating fundamentals must be respected.

Regardless of the market climate, you should always have a stop-loss and risk management strategy in place. If the markets rally, then your stops will not execute and we can all be on our merry way back up. But if the support gives way to weaker support, with stops in place below the market, you will be ready to protect your principal to fight another day. On a brighter note, from a contrarian perspective, articles like this are often published right before a big rally. Hence, the need for bullish and bearish game plans, and more importantly an open mind. Rather than worrying about forecasting, investors would be better served to think in terms of probabilities associated with numerous outcomes, both favorable and unfavorable.

Disclosure: Author and CCM clients have postions in SH.

Chris Ciovacco
Ciovacco Capital Management

Atlanta Independent Money Management Atlanta

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com

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