Aren't We Out of the Woods Yet?

George Hosfield, CFA, is Ferguson Wellman’s chief investment officer and chairs the firm's Investment Policy Committee. In addition, he is a member of the equity team with responsibility for management of the consumer discretionary sector on a global basis. He is a principal of the firm.

Now that the election is behind us, the G7 members have initiated significant rate cuts, and the Troubled Assets Relief Program (TARP) has been spread to provide cover for an increasing array of financial institutions. If there is seemingly greater certainty than one month ago, why has the market retreated 12 percent in just five trading days to flirt with its October lows? At the risk of oversimplifying, the panicked selling of September and early October was in response to fears about the very integrity of the financial system. Unprecedented government intervention worldwide has reduced systemic risk to the financial system, but investors are now coming to grips with adequately discounting the effects of a global recession.

How low might stocks fall?
Though no one can answer with certainty, we believe the floor will be near the intraday low established last month. As of this writing, the Dow was trading at 8,282. The lowest close this cycle was 8,176 on October 27, but the absolute low was intraday on October 10 at 7,883. Fundamentally, the stock market is discounting a 40 percent decline in corporate earnings. If this comes to pass, it would be the most severe earnings decline since World War II. For stocks to rationally fall further from here, actual earnings would need to decline materially from the current projection, which is something that we are monitoring closely.

What will we do if stocks penetrate October’s low?
We would modestly begin adding to stocks. Current recession notwithstanding, given what we know now, a Dow below 7,900 offers a compelling value to long-term investors. We are clearly not alone in this sentiment as we need look back only 30 days for validation of this theory. Specifically, when the Dow hit 7,883 intraday on October 10, it attracted a wave of buyers from the sidelines, fueling a rally that brought the Dow to a close of 8,451 on that day and continued up to 9,387 on October 13.

When might stocks mount a sustained rally?
In the months ahead, we expect headlines to be grim as economic activity falters and unemployment likely (painfully) rises above 8 percent. At this juncture, we believe current consensus expectations of a resumption of economic growth in the third quarter of next year are too optimistic. Rather, we believe sustained economic growth is not likely to return until 2010. That said, equity markets are likely to be locked in a volatile trading range for the next six to nine months.

Currently, our mission with respect to asset allocation and stock selection is to balance protection of principal and income production from dividends with an opportunity to participate when the market inevitably rebounds. To this point, I would like to close with a quote from Warren Buffett’s op-ed piece from the New York Times on October 17: “I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month – or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

The information provided herein is for educational purposes only and should not be construed as investment advice or as an offer or solicitation. Not all securities are suitable investments for all investors; therefore, Ferguson Wellman Capital Management will not necessarily implement any particular strategies discussed herein for all clients. We recommend that you discuss questions regarding your individual portfolio and investment strategies with your portfolio manager.