What is going on with the market? (Part 2)

Cause for optimism

Although the current sell off has been rapid compared to other corrections, it is not particularly severe. Since the launch of the current bull market in October 2002, the market has experienced at least five major sell-offs of more than 5 per cent, each of which lasted between 35 and 98 days. After each sell-off, the market not only made up lost ground but also continued to rise.

We remain convinced that this latest sell-off is a logical prelude to the continuance of a more normal market, with the potential for gains in the markets outweighing the risks. We seem to have swung from too optimistic to too pessimistic.

Some signs of sellers' exhaustion are already in place. Fearful response has risen markedly. Such things as bearish option-trading patterns, the posturing of small-time market timers and the downbeat responses to sentiment surveys have all reached or exceeded levels seen in October, before a rally. These are preconditions, although not a guarantee, of a potential recovery.

The investments purchased most during past comebacks were of a more defensive nature such as dividend stocks, consumer staples, energy, financials and utilities. This reflects a readjustment of risk appetites, as people realize that specific sector (commodity, gold), country (India, emerging markets), capitalization (Small Caps) and style (growth) investing has led to more than anticipated instability.

The current volatility is not atypical, but in fact, quite normal. Ned Davis Research Inc. of Florida maintains statistics on stock market declines and bear markets. Apparently, drops of 5 per cent or more in the Dow Jones industrial average have occurred 355 times since 1900, or an average of 3.3 times a year. So while the current market situation is certainly painful, it is hardly out of the ordinary in terms of market history.

Consequently, we are again experiencing much movement and noise, yet remain largely in the same spot. We do not know precisely when the US Fed and central bankers around the world will be finished, but we do know this: there have been 16 rate hikes to date. There will not be 16 more, there will not be 10 and there will not be 8 more. We are far closer to the end of this cycle and to the peak, even if it is an overshoot in our estimation. The relentless focus on what the Fed will do has obscured what industry is doing.

Relative to bonds, to the past 20 years, to inflation, and to earnings growth, the markets are no longer reasonably priced. In our view, they may well be attractive.

We are masters at denying the truth, even when it is staring us in the face: Corporate earnings are decent, companies have good balance sheets, 268 companies of the S&P 500 have announced share buybacks. This is because they feel their shares are attractive, deficits are being reduced and that there will be an end to interest rate increases at some point.

Future direction

As evidence mounts that growth is slowing down, we believe that Mr. Bernanke will be able to cut rates sharply. Unlike other central banks, the Fed wants to foster growth as well as control inflation. We expect they will begin to cut rates in the first quarter of next year. In contrast, markets have so far focused on the short-term problem of rising inflation, and do not yet appear to be pricing in subsequent rate cuts.

Although we will keep an eye on the Fed, our main focus is on the dynamics of our portfolios. When the Fed is done and the dust settles, so will everyone else. When that happens, it will be advantageous to have a front row seat.

To survive this turmoil, stay focused on the timeless principles of investing (your head in charge of your heart). Even though interest rates rise, people will continue to use Gillette razors, shop at Wal-mart, send packages via Fed-Ex, need their medication from Pfizer, and use their banking services.

Adopt a longer-term perspective and avoid seeking market patterns that may not really exist. Understand your continuing investment plan and stick to it. Remind yourself of the importance of thoughtful decision-making.