To be honest, I must admit that right now I don't really have much of a sense of where either the stock and bond markets are heading. This is only mildly unusual for me as I've never considered myself as a seer of where the overall markets are going. However, I typically have more of a strong opinion than I do now, relying on what I consider decent evidence to back it up. (Not that I am always right, of course, but at least having a strong opinion helps in knowing what one's plan of action should be.) But now it seems, almost every piece of data available can be taken to mean either the economy isn't as bad as expected, or even if it is, we're getting close enough to when it is likely improve, ergo a positive view, or, the economy is BAD IN A RELATIVE SENSE, and shows no real signs yet of an impending recovery, ergo "don't try to catch a falling knife"; that is, don't buy any investments whose prices are still likely to keep falling. At this juncture, which view will be proven correct is impossible to tell.

Thus, lacking any clear sense of direction, I do not see any reason to modify a portfolio much one way or another. In other words, for me, the status quo, as defined in the April newsletter still prevails until things become better defined.

If, however, I had to venture a guess, I believe stocks are likely now in what I would call a bear market rally. That is, they are showing a positive, but temporary spurt in what will only later be able to be identified as an overall, continuing down market. Why? The five year price chart of the Vanguard 500 Index Fund (nearly identical to the S&P 500 Index) clearly shows that the correction that began this past Oct. is different from how prices behaved going back to May 2003. (See here) Actually, the S&P 500 had been in an uptrend going back to Oct. 2002, or for a sustained period of 5 years until Oct. 2007.)

Since long-term trends (or sometimes called momentum, especially when on the positive side) play such an important role in understanding asset prices, it looks to us that the reversed downward trend is more likely to be the one that will continue going forward rather than relying on the expectation that the long positive run that had been in place up until Oct. is merely going to pick up soon where it left off.

The same patterns appear to hold, and even more so, when looking at small cap stocks. (See here).

Some people might dispute that we are currently in a bear market, usually defined as a 20% drop in stock prices. The S&P 500 Index reached its most recent high (intra-day) on Oct. 11 at 1,576.09. The low (intra-day) was 1,256.98 on Mar. 17, 2008. Thus, the actual drop in terms of price alone was 20.2%. However, if we just look at the closing prices on Oct. 11 and Mar. 17, the drop is reduced to 17.9%. Perhaps this is why it might still not be widely accepted that we are in a bear market. (The total intra-day drop of the Russell 2000 Small Cap Index was 24.5%, and 22.9% based on closing prices.) Quibbling over a few percentage points seems silly. Stocks certainly have shown a significant downtrend since Oct. 11th and this downtrend will remain in place until stocks get back above where they left off that day (or 20% above their eventual final low of this cycle). In order for the S&P to get back to 1,576.09, it will need to rise from yesterday's (May 30, 2008) closing level of 1400.38 by another 12.5%. It would take quite a few good months of rising stock prices for that to happen. (From the Mar. 31 closing low of 1,312.18, 2 mos. ago, it has managed to rise 6.7%. So, 4 straight months of nearly equally good performance would have to occur for the downtrend that began in Oct. 2007 to end by the end of Sept. of this year.)

Of course, these charts cited above aren't magical; investment results can reverse course no matter how compelling a given trend may appear. And maybe that is what has been happening over the last few months. But this flies in the face of all the difficulties that have been hitting not only the US economy hard, but a significant part of the most important economies of rest of the world as well. But even more significant to our way of thinking: Many years of observation suggest to us that sooner or later, usually after 5 to 10 years, investments that had been doing extremely well will fall on to an extended period of hard times. That's just the way things seem to happen. We personally don't think that the downtrend in stocks that began in Oct. and seemed to stop this March was a long enough period to resemble the kind of relatively longer-term reversals that so frequently characterize the cyclical ups and downs of the investing world.

And what to make of the bond market? While high quality US bond prices (excludes high yield funds) had been slowly losing ground for much of the last 5 years, things started to turn around just about a year ago. But apparently reversing course again a few months ago, many investors are now of a mind to unload these bonds again.

Was a "mini" bond bull market lasting a total of less than 10 months all that we will see of the apparent bond trend reversal of last year? It's certainly possible considering how low bond yields had gotten a few months ago, and the fact that inflation is now worse than it's been in quite a long time. But, in the absence of further data that the still relatively short, but still existent uptrend has vanished, we think it somewhat more likely that the nascent positive bond trend reversal that started in 2007 will continue to survive, perhaps for another year or more.

For what it's worth, we offer the following piece of investment insight: Do not be quick to assume that once an investment trend has started, it will end quickly. But this is exactly what the majority of investors usually do. For example, back in 2000, when stock prices first started to turn south, there were so many people who refused to acknowledge the new downward trend. Stock prices kept falling through Oct. 2002, and these people were left holding the bag for too long before finally recognizing that stocks were not going to recover quickly.

Right now, many aggressive investors likewise feel that the dip starting in Oct. isn't going to last much longer. They still feel that the positive trend of 2002-2007 is a more accurate picture than the so far less than 8 month current downtrend. After all, it makes sense to buy an asset when prices appear low and headed higher perhaps 6 months out. But this appears to ignore the fact that once started, investment trends tend to last considerably longer than the majority expect. And, we would add, once a trend has been established for at least a year, it is no longer just a "flash in the pan." It may be here to stay for at least several years. That is why the next 4-5 months could be crucial in determining how far the stock downtrend will go. If stocks can "wipe away" the downtrend before a full year has past, the prognosis is a lot better than if they can't. But remember that we have already stated above the difficulty that stocks will have in getting back to where they left off by as early as the end of this coming Sept. Thus, the odds do not appear to favor breaking out of the current downtrend before a full year elapses. But, as I stated at the start this newsletter, I still recommend a holding pattern for your investments at the levels of a few months ago.

Tom Madell, PhD

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