Have we seen the bottom or is it lower?

The recent decline in stocks may be the beginning of a more extended decline in share prices — a bear market. On the other hand, it is possible the rapid market drop will be viewed as a dramatic correction and stock prices will recover quickly. These two very different possibilities have serious consequences for investors. There are a few apparent clues that may be helpful in predicting which of these scenarios is more likely, allowing us to invest accordingly.

First of all — regardless of either of these outcomes —

expect global stock markets to advance in the near term, as investors who are short the market buy shares back, while others bottom fish in hopes that the worst is over. It is common at the beginning of a bear market to see an initial decline, such as we have experienced, followed by an advance which ends up being somewhat dramatic, but short lived. This type of "sucker’s rally" can be very disappointing and expensive to the bottom fishers. This is a period to be patient and reserved.

If this was a garden variety correction — within the context of a firm economic backdrop (which doesn't appear to be the case) — stocks typically bottom and then trade back up near their old high. This is then followed by weakness which "tests" the previous lows. It is at this point that stocks usually rocket up to and past their old high levels as investors realize that the decline was psychological, not fundamental. We will be monitoring the possibility of this outcome closely, as well as the health of the overall economy. We are prepared to invest if markets successfully test the recent lows and economic fundamentals improve.

Unfortunately, the global economy is not on firm footing. The economic expansion was already slowing to a crawl and vulnerable to potential recession — we had been concerned that any ill wind could push the global economy into recession due to this vulnerability. The European debt crisis combined with our own domestic problems may be enough to squash the expansion and corporate earnings growth. This is the "big" risk for stock investors. Recessions usually create bear markets which take stock indexes down 30-50 percent — much further down than where we are now. Those that fully experience this type of decline often significantly damage their longer term financial plans (another more dramatic risk).

No one knows for sure whether a recession and a bear market are imminent. However, our work suggests the risks have increased recently. In addition, the Federal Reserve has very few, if any, cures for today's situation as rate adjustments are nearly impossible and a “QE3” has negative implications for national debt.

Certainly, once markets have re-priced stocks to the right level given the economic backdrop, a great opportunity will be unveiled and we will invest aggressively. However at this point we think that the downside risk is just too great to ignore. Until we see better evidence of improvement in the economy and a successful re-test of the recent lows, we will remain defensive and look for returns that provide yield with little stock market volatility.

We hope this update finds you well — please let us know if you have any questions or thoughts.

Sincerely,

James E. Demmert
Managing Partner