Now what?


Reflecting worries about the complete collapse of the credit markets and the potential for a deep global recession, stock markets have plunged around the world. Over the past month, the Dow Industrials have dropped 17% while the Dow Transports have dropped 19%. With both indexes reaching new lows, the Dow Theory is squarely in the bearish camp.

While subscribers should not succumb to panic and abandon stocks altogether, holding a sizable cash position is prudent. Our Focus List, Buy List, and Long-Term Buy List have about 30% in Vanguard Short-Term Investment-Grade ($10.05; VFSTX), a relatively low-risk bond fund.

Vicious cycle
Despite unprecedented government efforts, financial markets remain mired in a crisis of confidence. Because of solvency and liquidity concerns, banks remain very reluctant to lend to each other. As a result, banks are hoarding cash to make sure they have enough on hand, making it difficult for even creditworthy customers to get loans.

As this cycle of debt destruction and declining asset values continues, the real economy suffers from a shortage of credit and a drop in confidence, raising fears of another leg down in employment and home prices. Expectations for U.S. corporate profits have dropped considerably, especially for companies tied to consumers, natural resources, or overseas growth.

So, when will this vicious cycle end? Nobody knows for certain, but our exposure to stocks will hinge on the following:

The Dow Theory. The market’s primary trend is indisputably down, and the Dow Theory can’t tell you the likely duration of market moves. However, Dow Theorists divide bear markets into three stages, providing some historical perspective. The first stage represents the abandonment of hopes that lifted stocks to inflated valuations; the second reflects declining earnings and cash flow; and the third is caused by forced selling of stocks by those who need cash.

With investor sentiment verging on despair and hedge funds being forced to liquidate because of redemptions, it seems safe to conclude that this bear market is well into stage two — and getting close to stage three.

Sentiment. Based on the expected volatility implied by option prices, investors have rarely been more fearful. Based on surveys of individuals and newsletter editors, sentiment has rarely been so gloomy.

Sentiment can always get worse, but fear is running high. As legendary investor Warren Buffett says, you should strive “to be fearful when others are greedy and to be greedy only when others are fearful.”

The opportunities in individual stocks. Even based on the most pessimistic profit estimates for 2009, there is no shortage of quality stocks trading at very attractive valuations. With earnings season nearly here, investors should soon get some insight on how companies see their prospects for 2009 and beyond.

Using guidance from managements, profit-estimate trends, and reports on the global economy, we intend to look for modestly valued stocks with sustainable operating momentum. To the extent we can find more such stocks, our cash position will be decreased.

The recent sell-off may have opened a once-in-a-lifetime buying opportunity, especially for selective investors. But the market’s price action suggests the majority money opinion is worried about the financial system becoming truly unhinged. Balancing the potential opportunity against the risk of fighting the primary trend, we are holding about 30% of equity portfolios in a short-term bond fund.

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