August 2008	PDF Version

The stock market has bounced off the low it set on July 15th as bank stocks reversed from their death spiral and climbed 50% to 100% from their lows before they faded back down. The spark that lit the fire underneath these stocks and the market in general came from a combination of lower oil prices, "reassuring" words from some bank CEO's and some action by the U.S. Treasury. Many stock market strategists announced the end of the bear market in stocks. The great American thinker and baseball player, Yogi Berra, once said, "It ain't over till its over". Well in our opinion, it ain't over.

While some investors were relieved by the "successful test" of the stock market lows in March we were of the opinion that there was more financial pain to come. That is why we have had our clients' portfolios in a defensive mode over the last few months. Despite the recent rally off the new market lows in July, we are still not convinced that it is safe to become more aggressive and start buying some of these beaten-down stocks despite our temptation to do so.

There was good reason for the stock market and, specifically, the financial stocks to stage the recent rally. Fear of an imploding banking industry reached a crescendo following the closing of IndyMac bank. People were questioning the soundness of their own banks as the stock prices of many of these institutions continued to search for a bottom that looked like it could be zero. The market was setup for a relief rally on any good news and it got some.

The Secretary of the Treasury, Henry Paulson, made it his mission to save Fannie Mae and Freddie Mac and, with some help of Congress, it looks like he did it. The U.S. Treasury stands ready to provide these massive government sponsored enterprises whatever liquidity they need to backup their guarantees on their mortgage-backed securities and to purchase new mortgages from banks.

Beyond the lines of credit, the government would even contribute equity capital if it became necessary to do so. We found it very odd that investors were bidding up the prices of Fannie and Freddie's common stocks on this news because it is pretty clear to us that there is real risk that the current common stock shareholders of these agencies could be wiped out in a government bailout.

Additional "good news" from the battered banking industry followed with some of the second quarter earnings announcements in mid July. Several CEO's from various banks said their banks were "adequately capitalized" and would not have to issue more stock at these low prices. If this is in fact true, it means that dilution risk to shareholders of institutions like Bank of America, Wachovia, and Fifth-Third has been significantly reduced. We think some of these CEO's may end up regretting those pronouncements.

Investors were also encouraged to buy stocks as oil and other commodity prices began to fall. In a matter of a few days oil prices had tumbled about 15% from their highs as it looked like soaring gas prices had caused enough demand destruction around the world to produce a rise in oil and gasoline inventories. There is no doubt that lower gasoline and energy prices would have a positive effect on the economy. However, we disagree with those economists who say that oil prices are the major factor for determining the future strength of the economy.

Although we are as tired of this bear market in stocks as anyone and would love to be buying stocks with abandon, we don't think the bear market is over. Yes it is true that stock market valuations have improved over the past year and certain sectors like financials and consumer discretionary (retail) may have some good long-term investment opportunities. However, we think a little patience will be rewarded with some better buying opportunities and a lot less risk.

Bull markets do not go straight up and bear markets do not go straight down. Bear markets have a way of enticing investors and luring them in with these sudden rallies. As we all witnessed in the last bear market in 2002, most stocks go down in bear markets and cheap stocks just get cheaper. The average bear market in stocks takes the market down 30% or more. This one has only fallen by a little over 20%. There is potentially more wealth destruction to come before it is over.

This economic slowdown or possible recession is being caused by a significant reduction in consumer spending that we think will worsen in the months to come. Housing prices have not bottomed out yet and could fall another 10% or more as measured by the S&P/Case-Shiller Home Price Index. That would bring prices down a total of over 30% contributing to more declines in one's personal wealth.

The average person is finally waking up to the fact that he or she has too much debt and not enough savings. The baby boomers are beginning to enter retirement with not as much money socked away as they had planned for this stage of their life. Some of these people will begin to realize that they will outlive their savings. That realization should hinder their desire to spend. This reduction in spending will lead to lower corporate profits than the market is now anticipating.

Bear markets always end and this one will too. The stock market will bottom out before there is clear evidence that the economy is improving. While trying to time the market is very difficult to do, we think it is worth the effort to avoid the destruction of wealth that happens when the bear is still alive and well. We will continue to focus on preserving our clients' wealth until we see signs that the bear market is coming to an end.