January’s Whipsaw and Relief

From a contrarian’s view, January was both an abysmal month and a month of promise. Let me start with the abysmal. For the month, US equities were down 8.5%, one of the worst Januarys on record and one of the worst months period. One recently published statistic stated that 80% of the time that January is down, the market is down for the entire year. And the other 20% ain’t so good anyway. Doom and gloom.

To continue the bad news, we learned that the economy shrank significantly in December and home prices were in the toilet again in November. That, added to the horrifying losses by the banks in the fourth quarter does make one wonder when it will end. Of course, destroying general sentiment is the disclosure that in 2008 the major banks spent nearly $20 billion on bonuses while they lost tens of billions more. And I thought that my younger sister has a sense of entitlement! Seems that the bankers don’t get it either. Similar to how the three Detroit auto executives flew in three separate corporate jets to ask Washington for help, the egos running corporate America haven’t seen the writing on the wall.

As the contrarian, let me parse the news into a reality check. To start we knew that November was going to be a bad month for housing – no one could get a loan. And to that end, we knew that December was an awful month for the economy – just look around. In short, much of this is old news being recycled in an official capacity, which now sets expectations for the future. As a society people are incredibly myopic in their expectations: it is no wonder that doom and gloom is the standard in the New Year. Studies have shown that investors use the experiences of the past 30 days as four-fifths of their reference points in setting expectation for the next 30 days. Our sense of history is amazingly short, and when it comes to exuberance or fear, we often allow the tail to wag the dog.

Range-Bound

The most reported aspect of January was the performance of the equity markets. When viewed in the context of a “range-bound” market, January’s performance was actually well within expectations. If you look at the range of movement in the S&P 500 over the past four months, the length of the current market crisis, each month the S&P touched a low point during the middle of the month and then rallied during the last few days. January was the exception to this pattern, where the market failed to rally on the last two days of the month, closing near the month’s low.

Put another way, the market was at this same low each month, but you never saw that level on your statements since it didn’t coincide with the month-close. January did close at the low-point, making it look far worse in comparison. In addition, the media fixates on month-end figures making the hype all that more intense.

In fact, the market has been moving within a well defined high and low point for four months now, or trading within a “range.” It has not broken out of that range, either on the high side or low side, during this time. This is both good and bad news. The good news is that the market has not gotten any worse during this period, but conversely it has not gotten any better.

What has improved, however are the “fear statistics” that we closely follow. Two primary gauges, the implied volatility of the S&P futures (VIX) and the actual standard deviation of daily movements in the index have both dropped by half during this period. While we are still double levels seen during stable markets, we have significantly retreated from the hysteria of a market in collapse.

Another sign of improvement is the bond market. During the past two months, investment grade corporate bonds have shown dramatic improvement in price and liquidity. During the past three months, this market is up by nearly 20% with an enormous flow of new debt offerings coming into the market in January. In fact, while January was one of the best months ever for new debt issuances, the appetite of the market was insatiable – even more debt could have been issued.

Getting Better, Not Great

My message is simple, while this in the economy is pretty bleak, a lot of this news relates to damage that has already occurred. We believe that a “recovery” is still many months if not quarters away, but a bottoming of the economy may be taking hold right now. The evidence for this is in the market, as we’re seeing both a range-bound equity market that has not broken any new lows and a bond market that is as hot as ever. Again, it will be years until the equity markets recover their full value but the prospects to halt the losses is compelling as we look forward to how and when the recovery will take hold.

I have deliberately not commented on the Obama stimulus and bank rescue packages since the details are still being formed and the rumor mill is running overtime. I will add this commentary in my next update, eagerly looking forward to the details of the most important legislation in 80 years.

With only five weeks of winter left, I wish you all a healthy and happy February,

David B. Matias, CPA