Week in Review

Horrific Year Just Got Worse!

Another bad week as the S&P and NASDAQ both experienced sharp weekly declines of 8.4%and 8.8% respectively. As bad as the weekly declines were, it could have been worse had it not been for an amazing 5% rally on Friday. November could end as the worst month ever in what has been a horrific year. Stock market gains achieved over many years have now been eliminated. In fact, new lows hit last week essentially erased all gains experienced from the start of the bull market in 2002 and the S&P dropped to levels not seen since 1997. Year to date, this has been one of the worst market periods ever recorded. So what will happen next?

Fears of Protracted Recession

Fears of a protracted and global recession escalate as the economic evidence pours in. A big concern is that consumers will stop spending as fears over their own financial security grow as investment assets plunge and job losses mount. Last week, jobless claims hit a 16 year high as the job market continues to deteriorate. No signs of life yet in the Housing market as housing starts declined again in October. The big three automakers are clearly in dire straits with bankruptcy looming unless a government bailout is approved. The uncertainty with approval of that bailout program weighed heavily on the market and resolution will like not come until the next meeting with lawmakers on December 3. The other remarkable development was the flight to safety with Treasury securities. Yields on treasury securities reached their lowest levels since the 1950s. Short term treasuries yields approached zero, which would be negative yields after accounting for transaction costs! In essence, investors are paying the government to safe keep their money, with no expectation of return! This flight to quality is another barometer of fear in the marketplace, which has arguably reach irrational levels as interest rates trend to zero. On a positive note, producer and consumer prices are dropping as inflation concerns subside. But lower inflation offered no solace, as investors just viewed this as another sign of the weakening economy. Clearly, the market concern now has transitioned to deflation. Despite the difficult week, the market did rally late on Friday after news reports that Obama had selected the NY Fed president Geithner as his appointment for Treasury secretary. By most reports Geithner has an excellent reputation on Wall Street, and will bring continuity with the current crisis, but also brings a reputation for creative problem solving and crisis management.

Volatility Extreme At Historic Levels

Market volatility remains at extremely high levels. The historic average for volatility as measured by the popular VIX index is 30, versus the off the chart levels we see today near 80. The volatility level has been above 30 for 50 straight trading days, which is truly remarkable. But it is also the dramatic swings that we see each day that has investors running to the safety of cash and treasuries! Over the past two months, the daily average percentage change on the market index has been 6% versus an historical average of 1.17% that is almost 5 times the normal level of volatility. There is little doubt that volatility is extreme and at historic levels, as fear runs rampant and drives investor behavior. Turning points usually occur when reliable measures become extreme, and that is where we think the market is now. The critical question is how long will we stay in this period of high volatility and when will it normalize which at some point it will. Market Beating Stocks believes that volatility will remain high at least through the end of the year and likely well into next year. There is simply too much uncertainty and moving parts with regard to financial stability, government intervention programs, the new administration, and other bailout programs. More time is needed for the storm to settle, and consumers have to begin to feel safer when it comes to their jobs and financial assets.

Market Beating Foresight

Economic reports will be released on existing home sales, consumer sentiment, and weekly jobless claims which will further weigh on the market, along with a Black Friday that carries a bleak forecast. The viability of Citigroup is being tested as the share price falls below $4. Government intervention may be necessary to avoid a failure, concerns that certainly trouble the financial sector. As we have said before, we think that volatility will remain very high over the near term. However, we also believe there are signs the market has reached extreme levels in volatility, interest rates, and equity valuations, and levels that usually represent turning points. Are we at the bottom? No one can predict, but we may have hit bottom on Thursday last week, but as investors you do not have to worry with calling the exact bottom. Market Beating Stocks believes we are at a trading range bottom based on extreme volatility levels, near zero treasury interest rates, and compelling equity values following market losses nearing 50%. Are there ways to profit in this environment? Fear and risk aversion is very high which drives up the price investors pay to manage risk. Now may be a good opportunity to play the volatility in your favor by trading options, particularly writing puts in spread positions. We are also going to look for more short term trading opportunities with the market indexes to take advantage of large daily price swings. As for stocks, defensive industries should do better over the near term, particularly utilities and healthcare. In addition, companies that provide staples that consumers will still need in difficult times should also do well. We also look for companies that have strong balance sheets, are well capitalized, and have high cash levels. These are the companies that will survive and even prosper in difficult economic times. The breakout stocks that currently show on our buy list are Gentiva Health (GTIV), Emergency Medical SVCS (EMS), ACETO Corp (ACET), and Emergent Biosolutions (EBS).

We may continue to test the market lows set last week, but overall we think equities have reached compelling price levels despite an economy that has a long way to go before it gets better. That does not mean the market will rise sharply in price over the short term, but we do think the worst of the decline is over. But frankly, as long as volatility and fear remains high, it will be a crap shoot over the near term. We are planning to invest some of our cash into stocks over the next few weeks as we find good opportunities, and would suggest that investors sitting on cash do the same. Patience will reward the long term investor as positive momentum and confidence will eventually return. Investors buying stocks at these levels will be rewarded in 2-3 years even if they are early on the market bottom. Despite the terrible market, all of our portfolios still show positive returns since their inception, which is truly exceptional given that the corresponding market returns all show significant losses.