“Oft expectation fails, and most oft where most it promises; and oft it hits where hope is coldest; and despair most sits.” 
– William Shakespeare

In less than a decade, the University of Cincinnati Bearcats transformed their football team from disregard into the Big East champions in 2008. Their success may have caught some by surprise, but it was not instantaneous. It was a process that included multiple coaches, players, a conference change and an attitude change. However, during the down days, Cincinnati’s fans’ expectations were so consumed in the present that they could not fathom the success that was just around the corner, even as the team showed signs of progress. Their expectations were jaded to the point where objective thinking was thrown out the door.

We are at a similar junction in our financial markets; investor expectations are being conditioned by the barrage of negativity the economy is currently facing. Understandably, it is difficult to imagine that things will get better when all you hear is how bad they are and how much worse they will get. But on the flip side, think about how much governments around the world have done to quell the financial problems and turn them around. For months, the US Government and other governments around the world have been making attempts to shore up the world’s financial problems (see appendices A – E).

In the United States, late in 2007 and earlier in 2008, FOMC rate cuts and a tax rebate stimulus were thought to be enough to prevent a deep recession. For a brief period of time, it did, but more high profile failures and their consequent panic exacerbated the problem and required more direct and immediate actions including lending programs and facilitated mergers. Now, as almost every area of the economy has been affected, the purchase of mortgages, equity injections and an infrastructure stimulus plan are in the works to attack the problem directly. Does that not warrant any change in expectation? The markets are telling us it does.

In the past week and a half, the bad news has continued to pour in. Since the media is like a pack of ravenous wolves, relentless in their coverage of “The 2008 Financial Crisis”, it is impossible to escape this tsunami of “unprecedented” information. Quite literally, as the market has begun to show, investors are becoming desensitized to the bad news. After three to four weeks of hearing about job losses, unemployment numbers, retail sales numbers and GDP expectations, the market has said “ENOUGH”.

Friday, December 5, was the quintessential example. November’s payroll numbers came in significantly below already ugly expectations. After a knee-jerk selloff to begin the day, the market rallied and ended up over 3%. This one day rally occurred in the midst of a multi-week uptick that started Thanksgiving week from the most recent lows of November 20. As of 12/8, the markets have rebounded more than 20% off those lows in the midst of the most intense negative news of the bear market. Additionally, the value of Mortgage Backed Securities, once considered toxic even with a AAA rating, are regaining some of their value. As the government steps in to buy more securities, the value of the overall MBS market will increase, relieving the stress of many institutions’ balance sheets. Not only should this lead to a further increase in lending by the banks (contrary to headline articles, the banks are lending money), it should also lead to fewer defaults, less forced selling of equities and increased confidence in the capital markets.

Another important indicator is the distinction in volume between upticks and downticks. It is important to compare volume with movement because it reveals the market’s conviction of the trend. During the recent rally, there has generally been higher volume on days when stocks are trading up versus when they are trading down. Selling pressure has begun to minimize while buyers of risky assets are slowly beginning to emerge. While this rally is likely to be followed by profit taking at some point, we maintain our belief that the important shift away from a bear market is occurring.

In order to maintain objectivity and attempt to avoid getting caught up in the negative expectations that have engulfed the markets in the past two months, THOR has been making comparisons between the 1973 – 1974 recession to our current recession. This exercise is less based on comparison of the literal events of the two downturns as every recession is caused by unique factors. Many newspaper and magazine articles have attempted to compare the current recession to the Great Depression and the oil shocks of the 1970’s, but that is like trying to fit a round object into a square peg because of the stark differences in underlying economic fundamentals and subsequent policy responses. Our analysis is based on the timing of trading behavior as investor psychology always has similar underlying characteristics. Eventually the market comes to the realization that the negativity will come to an end. Two specific comparisons are that of the unemployment figures in relation to the stock market and the direction of moving averages in relation to the stock market:

Seasonally Adjusted Monthly Unemployment Rate; 1960 – Present:

1 year chart of the S&P 500 from April 1974 through April of 1975, identifying the 1974 market bottom and beginning of the 1975 recovery (yellow line = 20 day moving average; red line = 50 day moving average; green line = 200 day moving average):

1 year chart of the S&P 500 from December 2007 through December 16, 2008 (yellow line = 20 day moving average; red line = 50 day moving average; green line = 200 day moving average:

Thoughts of the recession of 1973 – 1974 generally revert to long lines for oil and high unemployment. While both were major problems in the 1970’s, the bull market that began in October 1974 started only two months after the unemployment rate began its torrential ascent. Unemployment increased from 5.5% in August 1974 to 5.9% in September 1974 while the stock market fell by 23.3%. As the equity markets recovered, unemployment continued increasing – from 6% in October 1974 to 9% in May 1975. In that span of time, stocks rebounded 46.8%.

Comparisons of the charts (otherwise known as technical analysis) from the 2008 recession to the 1974 recession also indicate movement signifying investor psychology during downturns. By studying the movements during steep declines, during a bottoming process, and during a recovery, we can pinpoint similar movements and trends in our current market. THOR has compared the current downturn to several other downturns, but the movement between the 1970’s and today is the most similar in respect to the steepness and movements of the selloff. Where we are today is significant. The market has come off the widest divergences between moving averages and has successfully crossed over the 20 day and 50 day moving averages. It has also formed and rebounded from a higher low. Higher lows translate into decreased market pessimism. As of December 16, the market has moved through the fifty day moving average (red line). As the market moves through former points of resistance, they tend to become points of support. When this occurred in the 1974 chart, the 50 day moving average became a point of support that helped spur a one and a half month rally off of that recession’s lows. Typical of a bottoming process, the market experienced a slight selloff on lower volume, but never came close to retesting the lows of October 1974. By January 1975 the market was in a full-fledged upturn, continuing to bounce off the moving averages from which it crossed over.

From our perspective, the negative expectations that have dominated market movement in prior months are abating as progress is observable and the most direct forms of aid have yet to take shape. They will soon take shape and just like the fears of oil hitting $200/bbl in July quickly diminished, so too will the fears of the stock market’s plunge into the abyss. We know this is a scary and uncertain time and we are always available to discuss any thoughts and/or concerns. Thank you for your continued patience in these trying times!

Sincerely,
Jim, Mark and Greg.

Appendix A: Timeline of key events over period

Appendix B: Elements of Banking System Rescue Plans in Developed Countries

Appendix C: Announced inter-central bank arrangements

Appendix D: Developed Country Policy Rate Movements

Appendix E: Central Bank Open Market Operations and Lending