Testing the Waters

Another big Monday rally of 400 points for the DOW did not set a tone for the week. Stocks were up and down with a sharp sell off this morning following a collapse of markets around the world. By mid morning the market is trying to recover but we won’t know what direction it will take until the last hour of trading. It has a lot of work to do to turn positive and I doubt that it will.

There was little in the way of economic data out this week except for this morning with the existing home sales report for September. The numbers were very good although everyone is ignoring that bit of news. Sales rose by over 5% and inventory shrank. Prices are still weak and will remain so for a while but they have come down to a point that is attracting buyers. Despite a very tough mortgage environment year over year sales were up for the first time in 3 years. New home sales will be reported on Monday but at least, for the moment, we see the first hints of a housing market that is not collapsing.

Commodity prices have and continue to fall sharply putting further pressure downward on inflation. World wide inflation is retreating at a record pace. This is very good news for the U.S. consumer who has been beaten up for well over a year in dealing with higher prices for food and energy. A sharper reduction of gasoline prices can only help both the consumer and our economy. It will act like a huge stimulus package. This package could have more impact than the Bush stimulus package because it would be on going,as long as demand for oil stays contained. That won’t last for very long, maybe a couple years, however that is long enough to help our current economic slump.

Earnings this week have been mixed but looking deeper you will see, outside of financials and builders, average earnings growth of about 8% with free cash flow at similar levels. At the same time major corporations are guiding future expectations of earnings downward. That of course is to be expected in our current economic slump.

Prices for stocks are extremely low on any basis you wish to use to determine valuations. Earnings are likely to fall. That is the definition of a recession. We are probably in a recession at this time but we won’t be certain until 3rd and 4th quarter GDP numbers are reported. We will see third quarter’s numbers next week. It will likely be negative by a small degree and since this financial crisis peaked this month, the first month of the 4th quarter, it is hard to see anything by shrinkage in our economy on the 4th quarter, thus we are in a recession as defined by two or more quarters in a row of contraction. The market knows this already. Prices of a recession are already in place, now it is the length and depth of the recession that the market is trying to determine. That is the reason for the very large swings in the prices of the indexes. It is likely to continue to gyrate at least until next month. With the conclusion of the presidential election and more time given for the reliqudfication of the financial system to work we should see some calming of the market. A return to normal volatility would be a relief in and of itself.

From the investor’s point of view, the market is one to buy not sell. Fear is rampant. I know it is not comfortable and in fact it is a test of your sanity but it is time to buy. We have not seen this market condition since 1973-74. That is where the market fell 45 to 50%. That fall was no different than the 2000-2 market fall but in 1973-4 valuations were very low like we have today, but in dotcom fall valuations were at extreme highs.

History tells us that after a major sell off, and I would consider a 40 to 45% sell off that we have experienced so far as a major event, that the market within one year will be significantly higher. However, that does not mean it is time to jump in. Cash is still king but you should start to take a dollar cost average attitude into the market. We are holding in a managed accounts a large position in cash but will trade this market, moving and in and out at certain points. We have also teased into a couple of new positions and added a little to our blue chip stocks. You will not see these low prices again in another generation. Of course stocks prices could go lower, which is always a possibility so be careful, we are.

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