Insight Line—February 18, 2008

Lately one of the most frequent questions I get is, “When will the market bottom?” To answer that question, I could draw upon any number of approaches typically employed by investors, academics, strategists and financial professionals.

One potential answer lies in investor psychology. Many examples throughout market history show that the point at which investor psychology reaches an extreme consensus is also a point of demarcation for an unexpected shift in the markets away from the consensus. Therefore, one might expect the market to begin a bottoming process when investor psychology reaches the consensus that only negative news is an absolute certainty.

Another answer to the question might be found using technical analysis—the use of charts. Technical analysis, which is the study of historical price patterns, considers the past as prologue. Market technicians often cite previous lows, and known patterns called double-bottoms, right shoulders or completion of a fifth-wave as being a necessary condition for a market bottom. Unfortunately market technicians can only project, not decree. Support levels can only be confirmed after the fact. Therefore the answer to the question of when will the market bottom expressed in technical terms is that the bottom will be evident only in hindsight.

Yet, another answer might come from fundamental analysis. Fundamental analysis is the interpretation of macroeconomic data, in conjunction with firm specific financial statements in order to develop a working model of economic and financial activity. This approach is appealing because the sheer size of the historical databases for economic and market statistics provides a treasure trove of information from which to draw informed projections. Thus, a fundamental approach to the answer would come from highlighting and anticipating economic and financial data favorable for a turnaround in equity performance.

Lastly, the answer might rest with corporate earnings and market multiples. Investors associate rising earnings with rising stock prices. The multiple investors are willing to place on those earnings is derived from numerous factors such as interest rates, inflation, the quality of the earnings and comparative valuations. Therefore, as earnings in general improve, investors can reasonably expect a bottoming process to unfold as a recovery in corporate profitability becomes recognizable.

All of these answers have some legitimate support for being the one right answer. However, as I see it, determining when the market might bottom may have more to do with the professional investor than any of the popularly cited identifiers of an impending market bottom. Instead, I suggest looking beyond the headlines to the inner workings of the market.

By far, the largest pools of money in the market are controlled by professional investors. More often than not, the performance of the professional investor’s portfolio is benchmarked to the performance of an index or peer group, which represent a narrower universe of securities than the total broad market. Managing to an index or peer group enables the professional investor to measure and report performance on both a relative and absolute basis. In other words, it is possible to outperform a specific index or peer group while underperforming the market in general.

I believe that it is relative performance that holds the key as to when the market sell-off will end. You see, in a down market one of the most commonly utilized methods by the professional investor to accomplish relative outperformance is to invest in cash.

Why?

Without exception, market indexes do not contain cash. Therefore, during a protracted downward move in the market, more and more professional investors seek to bolster relative performance by using cash as an asset class. The professional investor is not penalized for owning cash as long as the market continues to move lower.

The strategy is not without risk. If the market decline ceases and reverses to the upside, an under-invested position will most certainly result in relative underperformance.

Thus, as I see it, the most applicable answer to the question of when the market will bottom is: the market will bottom when the professional investor concludes that cash is no longer a desirable asset class.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 2/15/08)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

January 2008’s payroll employment data, contrary to consensus expectations, registered its first contraction since August 2003. The decline of 17,000 moved the payroll total to 138.102 million workers. Granted, such flash statistics are subject to wide revisions in subsequent months. However, newly revealed updates to the payroll and household surveys, pegging the total employed in the labor force at 146.248 million suggest to me employment growth is, at best, merely absorbing new entrants into the labor force. As such, I am electing to move the circle to down until such time that employment growth is once again sufficient to absorb the growth in the labor force. Please circle Down.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

December 2007 personal income data was in sharp contrast to other less upbeat data points over the course of the month of January, but it was not without caution. While year-over-year inflation adjusted income rose 3.1 percent in 2007, the same as in 2006, measures of compensation (wages and salaries) rose only 4.8 percent versus the 6.4 percent in the previous year. With total personal income registering a new record at $11.9 trillion, I suggest Up remains the appropriate circle on the table.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down^*

January 2008’s retail sales defied predictions of further declines by advancing a seasonally adjusted .4 percent. The monthly total of $383 billion reflected higher gasoline and auto sales. With that being said, year-over-year growth trends remain below those seen 2004-2006 and as such still strike a note of concern. However, the newly enacted fiscal stimulus plan may drastically alter this trend. For now, I suggest the continued appropriate circle on the chart remains Down—but with an asterisk.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

New orders for durable goods in the month of December 2007 were at odds with recently published reports from the nation’s manufacturing sector. Total new orders jumped 5.2 percent to $226.1 billion, which is the third highest in the history of the series. Nevertheless, the overall picture in the nation’s manufacturing sector continues along the lines of inventory and sales replacement rather than business expansion. As such, I continue to position the durable/manufacturing goods activity is not meaningfully contributing to economic expansion. Please continue to circle Down.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures, as reported in the December Personal Consumption Expenditure Index (ex-food and energy), at 2.2 percent year-over-year sit slightly above the FOMC’s preferred range of 1 to 2 percent. Nevertheless, in that FOMC members do not seem overtly concerned over the recent uptick, I suggest keeping the circle as Low on the chart until public utterances to the contrary from voting FOMC members is commonplace. Please circle Low.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

With a slowing economy and newly authorized spending/rebate legislation, January’s federal fiscal situation bears little resemblance to that first projected at the onset of fiscal 2008 last October. A back-of-the-envelope calculation suggests the deficit swelling to 2.5 percent of GDP over the coming months. The appropriate circle on the chart, reflecting economic stimulus, is $In.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The FOMC reduced the overnight lending rate to 3.00 percent on January 31, 2008. The committee next meets on March 18. In that monetary policy works with a lag, the FOMC’s 225 basis points in cumulative easing since September 2007 is only now starting to appear in the short-term funding markets. With that said, public utterances from FOMC voting members appears to suggest further rate cuts remain very much in consideration. Therefore, please continue to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield, reflecting recent Fed moves, now measures in at a positive 157 basis points on February 15. Please Circle Positive

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

The nation’s fourth quarter annualized GDP growth slipped to 0.6 percent. Due to negative contributions from new housing construction, inventory sales and trade, the advance estimate was markedly below consensus of 1.6 percent annualized growth. As of this publication date, subsequently released data argues for slight upward revisions. While I believe calls for a recession are highly suspect, the prospect of slowing growth in the first half of 2008 is all but certain. Therefore, please circle Below.