Here's a note I sent to clients after the market close yesterday:
While it is always difficult to predict a bottom or top in a market, I think I will venture out on that limb and say that today probably marked the bottom of the current market correction. I don’t place very much emphasis or put much faith in technical indicators, but there is one exceptional indicator that I’ve noted over the years. This indicator is used in Japanese candlestick charting and is known as a hammer. Basically what it means is that a market (or stock) trades down significantly during the day and then closes near the high of the day (and above the previous close). When a market or stock has been declining and has a hammer day, it usually marks a bottom. From a supply/demand viewpoint, what this pattern really means is that sellers have been exhausted. Over the years, this has been, by far, the most reliable technical indicator I have encountered. Today, the DJIA and the S&P 500 both had hammer days. Watching the market in the last half hour today was truly remarkable. The market traded down as much as 80 points, moved back to even, fell back 80 points again and then in the last 20 minutes of trading, erased the loss and tacked on another 150 Dow points. The market moved 230 points in the space of less than twenty minutes.
One thing to be warned about though. Often, after a hammer pattern emerges, the market will retest the lows of the hammer day over the next few trading days. So we may still be in for some volatility, but I think it is time to start looking for bargains created by the correction. The disaster in the mortgage market has taken down everything even remotely related to the sector. Mortgage REITs were killed (literally in some cases). Banks and brokers, even those not involved in the sub prime mortgage market were hit hard too. Mortgage pools that contain AAA rated paper were marked down. In every disaster lies opportunity, so I’ll be looking at some of the sub prime mortgage pools as well. At some price, they are worth the risk even if many of the mortgages are in default. The mortgage pool will foreclose and the real estate has a value. Yes, that value will probably be less than the face amount of the mortgage, but if you can buy the mortgage at a steep discount to the value of the real estate, the return may be substantial. Remember the savings and loan crisis in the early 90s? Those who bought real estate from the RTC made fortunes over the next decade. It may still be too early, but it certainly won’t hurt to start poking around in the wreckage.
I know this has been a difficult couple of weeks, but I’d like to remind everyone that these types of corrections are normal in a bull market. Investors have become somewhat complacent over the last two years as volatility receded to very low levels. The shakeout over the last two weeks is just a return to a more normal level of volatility. I don’t believe the credit market problems of the last month or so will cause a recession and I don’t believe the bull market is over yet. Earnings for the second quarter are coming in now (although no one seems to be noticing) and they are quite a bit better than expected. Earnings growth so far is about 6% versus expectations for 3.5%. When all is said and done, I expect growth to come in somewhere around 8%. Consumer confidence just hit a post 9/11 high. The ISM index still shows expansion in manufacturing. Exports are still booming. Official inflation is falling. In other words, the world is not coming to an end and the economy is still doing okay. My biggest worry right now is that Congress seems to propose a new tax on a daily basis and they are still threatening to impose some kind of import tariffs on China in an effort to prove the adage that those who don’t learn from history are doomed to repeat it.
I’ll send out a more complete update sometime soon so keep an eye out. You can also check out the blog; I’ll try to be more diligent about updating things there.