A Slow Leak Or A Cascading Waterfall?

November 27, 2007

137

“Be wary of the man who urges action in which he himself incurs no risk”

Watching Cramer tonight it was amusing that he was contrite in declaring that his “bullet-proof” stocks such as Altria, Transocean, Freeport Mc MoRan & Medco Health, highlighted on November 8, were not going stand up to the market onslaught as originally expected. He commented “terrific earnings growth cannot make a stock bullet-proof in this environment”. Essentially Cramer was saying “Sentiment will dominate the price action of even the most fundamentally strong stocks”. This follows from John Maynard Keynes who famously wrote that the stock market “can remain irrational longer than you can remain solvent”.

We were inundated today with members forwarding comments from established market commentators. One market pundit observed that the only certainty in this period of investing is that uncertainty is certain! We are staunch advocates of the power of sentiment and how it can dominate price action to the detriment of fundamental or technical data. We follow our own actions at Stock and Option Trades and have remained in “hunker-down”, hedged mode for weeks now. Having seen many a sharp downtrend in the past this is the market that separates the successful investors from the ‘hopefuls’.

We consider the ‘hopefuls’ to be those looking to turn a fast-buck, diving in and out on the whim of a comment or a hot-tip without a proven methodology. The successful investor knows the game is long and patience is rewarded and seeks a time-tested methodology. Sometimes the smart approach involves betting heavily and sometimes the smart approach involves hedging heavily. For weeks we have been espousing the merits of hedging heavily.

Hedging inherently means that one position is losing money and generally implies one is not making quite as much during churning markets. It is at this time that the ‘hopefuls’ become impatient and search for a quick exit to satiate the inner pain. But the successful investor knows that a little pain is part of the game and grows increasingly numb over time to the periods of uncertainty when the account value fluctuations are less pronounced, recognizing that safety is paramount. In the words of Buffett “don’t lose money” is goal number 1.

With all that said let’s turn our attention to the market. With the overnight strength in Asia the futures were predicting a bullish feast following Thanksgiving. And then the slow death march began. The trickle lower, the market stabilized, returned higher briefly and then the last few hours of the trading day that have been so crucial arrived and the decline gathered pace, and the markets ended miserably at their lows.

Optionator described the market action as a ‘slow-leak’ as opposed to a cascading waterfall. Imagine you had a bucket of water and cut a sizeable hole in the bottom. Out would come the gushing water. The market equivalent would be the Dow down 300 points and every stock joining it. But what if smaller holes were cut? Then the level of the water in the bucket decreases but not quite as fast (until maybe the holes start to merge!). In this market some stocks remained strong despite the sell-off indicating that as bad as the market ended, the leak has not turned into a cascading waterfall, yet.

Many stocks held up reasonably well today in spite of the carnage: Apple, Transocean, Amazon, Best Buy, and Boeing for example. Some like Potash and United Healthcare gave up some intra-day gains but didn’t fall dramatically on a percentage basis.

Our retail analysis indicates that the results from Black Friday were very positive indeed. Although you would never have known it looking at CNBC today, we have not lost faith that the consumer, representing over 70% of the economy, will remain buoyant despite the concerns. The data may say otherwise since reports coming out will reflect the fear injected by the media over recent months but the proof of how the consumer feels is in the action the consumer takes and the action so far has been positive. This isn’t a gushing report of how wonderful everything is but the lower we go the more we evaluate the level of hedging we have. Ideally, we would be ecstatic to see this march of slow declines turn into an intra-day collapse and a subsequent reversal. We won’t rush into predicting when that might be but when it occurs we will be rapidly offloading puts and repositioning more bullish. As always predicting the market is a game we leave to gamblers and ‘hopefuls’. We hope you are keeping your powder dry too as we move into the traditionally more bullish stock season through to May.