Battle of wits

Some investors abide by the buy “when there is blood in the streets, or to the rumble of cannons” rule, while others argue against this unscientific approach. But markets often rally after a crisis, writes Vanessa Drucker from New York.

On June 5, 2002, 14-year-old Elizabeth Smart was abducted from her bedroom in Salt Lake City, Utah. Nine months later, when she was presumed dead, the Dow Jones Industrial Average touched a new year low of 7416, down 108 points on the day. Traders despaired that nothing seemed to work. That same afternoon, a bulletin interrupted the television shows: Elizabeth Smart had been rescued. The market turned and rose 28 points that day and within a week had rallied 13.5%, to close at 8522.

“When world and financial news is depressing, sometimes a ‘feel good’ story can change investors’ perceptions for a little while,” explains Vernon Isaacs, who advises on debt management at California Managed Accounts in Cocoa, Florida. “Maybe they just stop selling, and the shorts begin to cover. It may be entirely unrelated to macroeconomics. There have been few better times to buy equities than that March day.”

In 2002, after their spending splurge on Y2K, firms were no longer buying new technology. Kenny Landgraf, president of Kenjol Capital Management, watched despondently, as every software or technology company on the floor of his building complex in Austin, Texas, went out of business. The stockmarket floundered, against the drumbeat of a pending war with Iraq, and investors stopped opening their statements. “It felt like a wet blanket that would never lift,” Landgraf recalls.

Yet it did lift. The Dow Jones Industrial Average went on from a low of 7286 in October 2002 to end 2003 at 10,453, a gain of 24.32% for that year. Buy when there is blood in the streets, or to the rumble of cannons, advised Baron Nathan Rothschild – and sell to the sound of trumpets, or violins. While sometimes crises punctuate market lows, real bear markets typically grind down like Landgraf’s wet blanket. In 2002, the Dow had plunged 18.8%, as corporate scandals at Enron, Worldcom and Tyco rocked investors’ confidence. CNBC, a financial television channel, instituted programmes on shorting about six weeks before the market lows. Fund managers and brokers no longer talked about buying, only about preservation of capital.

Individual companies did not escape the blight. In 1991, Citibank appeared to teeter on the verge of insolvency. It was setting aside billions of dollars in reserves to cover soured domestic real estate leading, and crippling loans to Latin American countries. Media headlines warned of a possible bankruptcy. In December 1991, Institutional Investor magazine illustrated its feature on the bank with a full-page photo of a dead fish. But that did not deter Prince Alwaleed bin Talal of Saudi Arabia, who invested $590m (£295m) in the struggling firm, for a 3.6% stake.

Meanwhile, the American stockmarket was already stirring. As the market was poised to take off in 1990, the Federal Funds rate was at 9.75%, and inflation ran at 6.5% – double today’s levels. The Dow had suffered a 21% loss in 1990, triggered by Saddam Hussein’s invasion of Kuwait and an undeclared recession. The average was flirting with a tantalising 3000 mark, only to pull back several times from that milestone. On April 17, 1991, the index finally crossed the barrier and went on to new heights. A few headline events provoked corrections: the Los Angeles earthquake in 1994, the “Asian Contagion”, the Russian rouble default in 1998 and subsequent collapse of Long-Term Capital Management, and a Taiwanese earthquake in 1999. Only in March 2000, as the dotcoms imploded, did the averages start heading south. A litany of grim news spurred lower lows: the USS Cole was bombed in Yemen, terrorists attacked on 9/11, and at a nightclub in Bali, and held hostage a theatre in Moscow. American unemployment touched 6.3% in June 2003, a disappointing number, but then retreated as a bull market resumed.

Although 2007 has seen gains in almost all stockmarket averages worldwide, except for Japan, volatility has interrupted four years of steady gains. Financial history does tend to repeat itself, especially in replayed scenarios of exuberance and pessimism. James Livingston, professor of history at Rutgers University, sees today’s credit crisis as a direct consequence of a capital glut that has flooded the banking system. He draws a parallel with the 1920s, when “surpluses had nowhere to go except idiotic places like Peruvian consols and German municipal bonds. Pessimism today is right on the money,” he warns. “This economy is driven by household and consumer deficits, and core inflation is about to increase.”

So the immediate question is, are we heading towards an abyss in capital or other markets? It does not look that way among the global equity markets. Although 2007 has been volatile, most industry sectors, except for financials, were up on the year. Even when an index pulls back 5%, the move constitutes little more than a retracement, with 10% ranking as a correction.

Still, possible candidates for bottom hunters include the financial sector, American and certain European real estate, asset backed securities for the brave of heart, and of course the beleaguered dollar. This season, it is primarily a dread of the unknown, in terms of banks’ exposures, that has sparked gloom and pessimism. Media headlines have inflamed concerns.

However, when the valuation problems have been worked through, bank and corporate balance sheets should at least have been scrubbed cleaner. “We have low unemployment, inflation and interest rates in the US. We should be able to avoid recession and big layoffs, because companies are still making profits,” says Neil Hennessy, who runs Hennessy Funds from Novato, California.

Japan offers another potential fertile hunting ground for bargain seekers. True, the equity markets there are trading at 18-month lows, down 11% in yen, on some legitimate economic concerns. “Exporter earnings have been negatively impacted by the strong yen, but Japanese equities already priced in economic softness several months ago,” says James Berman, of JBGlobal in New York. He suggests that if the yen were to weaken just a little, the move could ignite a short-term rally. Cross shareholdings and other structural issues have still to be addressed, but the market can trade on earnings.

History teaches that markets frequently rally surprisingly quickly after particular crises. Extended bear declines, based on economics imbalances or unresolved geopolitical threats, are more difficult to predict. Efficient market theorists, who maintain that current prices reflect rational expectations and known information at any given moment, insist it is a useless exercise to try to pick bottoms. “Market participants don’t have to disclose why they bought or sold at particular prices. We only know they did so, and the quantities,” points out Robert Wright, associate professor of Economics at New York University’s Stern School of Business. “In the late 1990s, retail traders followed their own kooky trading rules and caused a lot of movement.”

That efficient view would leave investors bewildered as they seek out palpable signs of recovery, in the wake of the volatility of 2007. What would be indications that the credit malaise and housing woes are bottoming? One hint is that stocks continue to rise, or hold steady, even as more announcements of bad news continue to flow in.

Since early December 2007, the financial sector has held its ground, despite further announced losses. “We are beginning to absorb the subprime situation. Each day they report larger write-offs, yet the financial stocks are no longer falling,” says Larry Connors, who runs the Connors Group, a research firm in Sherman Oaks, California. “What will happen when a little good news comes in?”

Some good news is already at hand, in the form of capital infusions, which enable financial firms to obtain lower borrowing costs. More might follow, with a disclosure that credit is flowing, as banks begin to lend to one another again, and then to the public. Or are we in a recession already, perhaps slated to begin recovering even as it gains official recognition?

Typically, recessions are only dated 12 to 18 months after they begin. Both the stockmarket and the yield curve are considered some of the best harbingers – and vice versa. Equities often predict recession a couple of quarters in advance, while “academic literature points to the yield curve,” says Scott Mosley of Cimarron Capital Consulting in Austin, Texas. Many economists follow the Chicago Fed National Activity Index, a weighted average of 85 monthly indicators, including production, employment, consumption and sales. “The conversation now is how long a recession might last, or whether we will get a soft landing,” Mosley reports.

“Today’s crisis is not provoking the same degree of hysteria as we saw in 2002. Most people have the attitude of riding this one out,” says Tom Wilson, managing director of Institutional Investments at Pennsylvania-based Brinker Capital. “To call a bottom, you might want to see the ‘wall of worry’ grow higher.” Moreover, the American property market, on the other hand, has not yet stabilised. Investors and homeowners wait keenly for a sign of a turnaround. The key metric is the inventory of vacant homes, which stands at 750,000 units. According to Moody’s, inventories will probably peak in the second quarter of this year, at about 825,000. Nevertheless, home prices may continue to slide into 2009.

When the tide turns, aggressive investors are first to the party. Already, the bottom feeders, vultures, value managers, contrarians and sovereign wealth funds have begun to nibble in the financial arena. The government of Abu Dhabi agreed in November to invest $7.5 billion into Citigroup for a 4.9% stake, overtaking Prince Alwaleed’s share. On December 11, the government of Singapore announced it would inject $10 billion in fresh capital to prop up UBS, reeling from subprime losses, for a stake of about 9%. China Investment Corp, another sovereign wealth fund, is investing $5 billion in Morgan Stanley, which had reported a fourth quarter write down of $9.4 billion.

On January 11, Bank of America announced it would buy troubled Countrywide for $4.1 billion in stock, on a strategic ploy that provides the domestic mortgage platform the bank was missing. Countrywide’s shares had fallen 57% since Bank of America bought its preferred stock last August, for $2 billion. Will the latest takeover prove to be a brilliant manoeuvre? Or is chairman Ken Lewis saving face, and throwing good money after bad? Stay tuned.

No one ever said it was easy to catch a falling knife. Edward Lampert, a hedge fund manager who runs Sears Holdings, also bought 17 million shares of Citi between January and September. He acted too early, however. Citi’s stock price has been cut in half over the period.

Likewise, a British property developer, Joseph Lewis, who took a 7% position in Bear Stearns in September and then boosted it to 9.6% in December, experienced paper losses of more than $100m. And Warburg Pincus, a buyout firm, which poured a billion dollars into MBIA, a bond issuer, in early December, saw its investment fall by $180m in a just 10 days.

If the most talented and sophisticated managers find it so challenging to time a turnaround, how should other mortals act? Eventually, all markets will revert to the mean, but that can take a while. Part of the solution is to take a long-term view; another key aspect is to maintain a discipline.

In larger firms, normally an economics department is examining the macro level, while their value managers recommends purchases based on fundamentals, when price earnings ratios and other metrics come into alignment. “They set a threshold at which they are prepared to buy, even if it means an investment will go lower. Because they know they are getting a good discount, they are still willing to ride it down,” says Mosley.

One way to keep the process simple is to rebalance each year using asset allocations. Take Cisco as an example. If you had invested $10,000 in that stock in 1994, you would have witnessed its rise to $298,000 at the beginning of 2000, followed by a subsequent decline to $73,000 at the 2002 lows. “Had you just rebalanced, you would never have needed to go through all that,” Hennessy points out.

It is fine to preach, but the truth is that most investors become nervous at 10% declines. After 20% loss levels, especially in the broader markets, they may panic and go to cash. It is especially bitter, on a psychological basis, to suffer losses from a high watermark. Both managers and individual investors should resist that impulse, Mosley cautions. It makes more sense to use a metric such as a three-year moving average.

Once the bottom is in, however, the next question becomes where to reinvest any available cash. At the end of bear markets, new companies generally emerge as leaders, frequently in the technology sector. During the upheaval, competition will have dropped by the wayside, enabling the survivors to prosper. For instance, after the internet bubble burst, the industry did not vanish.

Instead, it reformed itself to become a real business. In a similar fashion, the current bubble in emerging markets will eventually pop, warns Connors. He explains, “although it may take a few years to wring out the excesses, there are now real infrastructures in place in the Brics [Brazil, Russia, India and China]. The surviving operations will be viable economic entities.”

During turbulent times, it may not even be critical to catch a bottom. In perspective, even the middle can be quite comfortable. It is hard to judge sentiment, where one man’s anxiety is another’s profit opportunity.

Depressing world news does affect consumer attitudes, so in conjunction with other market indicators, one needs to be alert for any oasis in the news coverage. “Markets won’t raise a flag, but you will suddenly get a rush of short covering,” says Isaacs. There will not necessarily be a defined inflection point when the next chapter is beginning. As Isaacs adds, “they didn’t end the Stone Age because they ran out of stone.”

Gamblers and hot hands

The science of behavioural finance deals with inappropriate reactions and predictions, both in overly optimistic and excessively pessimistic directions. “You need to be clear how much information you have at your disposal,” says Hersh Shefrin, professor of finance at Santa Clara University in California. “For example, people didn’t understand the risk in the CDO [collateralised debt obligation] market.”

Two important statistical illusions lead investors and managers astray. According to the gamblers’ fallacy – the tendency to predict reversals – is more often observed in professional ranks. It is akin to a regression to the mean, gone overboard. Think of the false temptation to expect that a tail is “due”, after a sequence of five heads in the toss of a fair coin. You may think you know the underlying environment better than you do. Shefrin (pictured) explains, “most individuals fail to learn the lessons of history, and keep asking themselves what the underlying financial conditions must be, based on their observations.”

Consider how few significant tops and bottoms are available to observe from market history. “So people treat a small number of observations as if they had a larger amount of data than they do,” says Shefrin. We are all guilty of overconfidence in our investment decisions. We use confidence bands that are narrower than those that would reflect the degree of uncertainty we are specifying. As a general lesson in controlling emotional vulnerability, it makes sense to avoid extreme pessimism, and to temper the hope that next year will be blow-out success just because this one was a miserable dog.

The second bias, the hot hand fallacy, the market will continue to follow the same path, either up and down in the future, as it has recently taken. (The term is coined from basketball, a game in which spectators believe that a player who has repeatedly scored will probably do so again soon). This bias, which is more common among individual investors than professionals, causes them to engage in unwarranted extrapolation. Although the past may indeed play some small role in independent and identically distributed behaviour, it is insufficient for forming accurate judgments.

American policy rates

Reading the tape

Technical analysis goes in and out of fashion. It is an ongoing debate how significant a role it should play, in conjunction with the fundamentals. There is a strong case to be made at least, that a chart can illustrate optimism or pessimism, reflected by supply and demand. Since the tape reflects investor sentiment, it can even describe when the last trader has chucked in the towel.

Many people fail to recognise the patterns, which may not emerge picture perfect. The neckline of the head and shoulders might be slightly crooked. The typical ‘M’ formation, for a double or triple top may not turn out truly tidy. Islands, which display a gap down after a long move in that direction, represent capitulation. They are rare but powerful. “Intermediate term and major market lows are different creatures, and it’s unclear which is which until after the fact,” advises Larry Connors, who runs the Connors Group, a research firm in Sherman Oaks, California. His favourite warning for trouble ahead is the 200-day moving average. When the market crashed in 1987, it broke under that level.

Many investors try to pick bottoms, as happened this past summer. Once the tape breaks below that average, “all bets are off”, according to Connors (pictured). At the end of 2007, the average was sitting right on the line.

After the first low comes in, it pays to wait, says Tom O’Brien, author of Timing the Trade: How Price and Volume Move Markets. First, the market must accelerate up with real conviction, volume and wide price spreads, which indicates the large amounts of money are flowing in. The market then pulls back to test the initial low, this time on lighter volume. “That tells us we have no more sellers,” O’Brien says.

Take a few recent charts. Bank of America is sporting a possible triple bottom, at $42. When so many are tiptoeing around the financial sector, perhaps it is time for bargains. The euro is developing a classic head and shoulders, with the neckline broken at $1.45. Over the past six months, the S&P has formed both double tops at 1550 and double bottoms at 1400. Whither?

Tom Wilson, managing director of institutional investments at Pennsylvania-based Brinker Capital follows a simple rule of thumb to mark short-term peaks and troughs. Two good or bad days in a row in either direction signifies a reversal, and works for both tops and bottoms. Investors who have cash on the sidelines are looking for entry points to deploy it, perhaps not on that second day, but going forward.