Saturday, January 19, 2008

Market Correction: Closer To The End Than The Beginning?

Anyone invested long equities in the stock market since late last year has undoubtedly experienced a decline in the value of their investment portfolio. A number of factors have contributed to the decline not the least of which is the sub prime mortgage and real estate situation.

From an economic perspective, we have not seen two quarters of negative GDP growth yet. An important data point to watch for will be advance 4th quarter GDP that is reported on January 30. Preliminary 4th quarter GDP will be reported on February 28 and the final GDP will be reported on March 27. The early GDP figures have a tendency to be revised.

(click on chart for larger image)

Whether we are headed for a recession or an economic slowdown, are there sectors within the equity market that are better places to allocate ones portfolio? The chart below details sector and industry group performance during recessions that occurred between 1945-2002. As the chart details, there were only a few industry groups that generated positive returns: tobacco, nondurable household products, food, beverages and railroads (old industry classification).

(click on table for larger image)

sector and industry returns in recessions
Additionally, one must keep in mind the equity market has forecasted economic weakness from time to time. On the other hand, equity market weakness has been wrong more times than not. Standard and Poor's notes in a BusinessWeek article:
Unfortunately for strategists with an intermediate-term time horizon (six to 12 months), while there have been 11 recessions since 1945, there have been 49 pullbacks, 16 corrections, and 10 bear markets. Therefore 64 of these 75 market sell-offs incorrectly anticipated the 11 eventual recessions. What's more, these alignments usually didn't last very long. Pullbacks typically recovered in about two months, while corrections righted themselves in fewer than four months. So it is imperative that we be confident of a recession before we call for defensive posturing.
As S&P notes, there have been 75 market sell offs and only 11 lead to eventual recessions.

(click on table for larger image)

index returns in recessions since 1945
index returns from 2007 market high to January 18, 2008
Keeping in mind it is difficult to forecast or time economic slowdowns or recessions, could the economy be further into this slowdown or correction and nearer the end?


Are Stocks Signaling a Recession?
By: Sam Stovall
November 27, 2007


Nick Reilly said...


Correction, pullback, bear market, recession? Let the strategist call it what they will and time will tell. You make good observations that the patient investor most frequently recovers from these situations. However, I have to ask: how do you or any other money manager for that matter, steer clients through economic downturns that lead to bear markets? Fact: the baby-boomers are the face of investing. Fact: they'll get nervous earlier in every downward cycle. Fact: your phone will ring more frequently. So, to cut-off the panicked phone calls, what defensive tactics should managers be initiating and more importantly, when? I'll quickly paint a nasty prolonged portfolio picture(PPP)for retirees: flat to down equity markets, low yields, inflation.

David Templeton, CFA said...


You make some interesting points. Your key question seems to be how to steer clients through economic downturns.

First of all, investing is really a marathon and not a sprint. One key in working with clients is to ascertain the level of risk they are willing to take on in their investment portfolio. If it is determined they are unable to withstand major market contractions, then those funds should be invested conservatively.

Diversification is often touted as the key to assembling an investment portfolio. However, in times of severe market down drafts, markets tend to be highly correlated (see what happens Tuesday). This has become more prevalent as the market/economy become more globally oriented. So at a time when you want diversification to work for you, it can actually fail. I have written several posts on this topic. You can access these posts by using the search function on my blog and entering the word "correlated."

My approach to investing is to assemble the foundation of an equity portfolio consisting of higher quality larger capitalization stocks. These types of stocks tend to hold up well in market downturns. These higher quality equities tend to be dividend growth stocks as well.

You also note baby boomers will get nervous earlier in every downward cycle. If this is truly the case then maybe we really are nearer to the end than the beginning of this corrective phase in the market.

Lastly, I do not know any famous market timers; hence, the type of market we are experiencing at the moment. In this regard, I believe it is appropriate to take profits in stock positions in a disciplined way. Additionally, rebalancing a portfolio should be done based on a predetermined framework.

Nick, thanks for your comment.