Getting Ready for the Bottom

What to buy and how to know when it’s time to buy them

written August 2008, posted November 18, 2008

Note- This article was written in August for a professional magazine aimed at brokers and financial advisers. It was never published.  And clearly it did not anticipate the slow motion market crash that was to follow. While the techniques covered here are still valid, we have to step back a bit from traditional analysis and allow for a lot of volatility and false starts. 

The biggest question on investors’ minds is when will it be safe to buy stocks again. It seems that every time the stock market surges higher there is some bit of news or some event that sends investors heading for their bunkers once again. But then again, that’s what a bear market is all about.

Rather than trying to time the bottom, investors would be better served to let the market take care of that on its own. The good news is that when the actual bottom gets near, the market also will generously provide many signs to tell us. We won’t be able to pick the absolute bottom but we’ll get in fairly close - and with much less risk.

One of the better observations made about the stock market came from Sam Stovall, chief investment strategist at Standard & Poor’s. He observed that during certain portions of the business cycles different sectors of the stock market outperform the others. For example, during the early growth phase, technology tends to lead the pack and it makes sense as corporations ramp up their investment spending.

When we overlay to business cycle over stock market performance in general, we can prove what most investment professionals already know – that the stock market tends to top and bottom several months before the business cycles tops and bottoms. What this means is that technology stocks, for example, will start to improve many months before the economy actually starts to expand.

For those attempting to forecast when recession turns to expansion, the observation of when the stock market moves from bear market to bull market will give them a time frame for the economy’s change. A stock market bottom in late 2008, for example, will suggest that the economy will show great improvements by mid 2009.

But investment professionals and investors alike are not concerned with the economy’s bottom. They want to know when stocks are bottoming and clearly we cannot do that by observing the economy. Let’s state the obvious: we cannot predict the present using the future.

Stock market investors are luckier than those playing bonds or commodities. There are so many cross currents in the stock market and ways to slice and dice it that there are multitudes of clues to use to figure out what is going on. Sector rotation analysis, where we examine not just which sectors are making gains but which ones are leading and lagging the others is one of the more forward looking.

Where are we now? (remember, this was written in August)

Let’s put the sector rotation model into practice in today’s world.  As anyone with an interest in the stock market knows, financial stocks were disasters for investors in 2007 and early 2008. In contrast, basic materials and energy were hot. Steel, fertilizer, gold, oil and coal all did quite well, not only beating the S&P 500 by wide margins but also making healthy absolute gains. In other words, they were leaders while banks and brokers were laggards and that is just what we’d expect to see as the general stock market is peaking.

In June 2008, as the stock market was already caught in a bear market, basic materials and energy hit their respective ceilings and began to fall at a severe rate. Their leadership role evaporated and they actually began to underperform the market.

In troubled market times, and a bear market certainly qualifies, investors tend to move their money into so-called “defensive” areas that are less dependent on the economy and enjoy more stable demand and cash flow levels. Healthcare and consumer staples, a.k.a. consumer non-cyclicals provide that “shelter from the storm” and indeed both the Select Sector SPDR healthcare and consumer staples exchange traded funds (ETFs) began to outperform the market in June.

July saw the continued strength of selected health care groups as relative performance turned into absolute performance (tangible price gains). The iShares Trust Nasdaq biotech ETF moved higher from its trading range at the start of the month and by month’s end it had gained 12%. Not bad in a bear market!

It’s not a perfect road map but it does point us in the right direction in terms of stock selection. And it helps us in our goal of determining when it might be time to start looking at a broader approach to the stock market as it begins the bottoming process.

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