Last Month's Newsletter - An Apology

Thanks for reader TW for quickly pointing out the error is last month's first page article.

I said several times the 'all time high' for the FTSE 100 was around 6740 (Summer of 2007). But in reality is was 6950. I was slightly lazy in that I only looked at the past 2 years of price data when I should have looked at a longer term chart. The copy was changed within a day of being published.

If The Stockmarket Doesn't Decline We Need A Plan B

For the last few months in this Newsletter I have suggested that main risk for the UK stockmarket is on the downside. But what if stocks don't decline significantly?

This is why we need a Plan B, in case the bears among us are wrong.

What is Hidden Strength and Why It's So Important

Several years back there were a couple of excellent books published called Market Wizards and The New Market Wizards (both available from Amazon.co.uk). Each chapter consisted of an interview with some of the world's greatest traders/investors, and how they got into the business, successes, failures, tips and tricks etc.

Sadly my copies have since disappeared so I cannot remember the exact details or who was being interviewed. But one of the traders said that he started to get very bullish of US stocks during 1992-1994 (the book was written several years later). At that time share prices were moribund, trading sideways to slightly higher.

During 1992-1994 the news and general economic climate was negative. No company was doing that well and everyone was complaining, not just about the current situation but also because there seemed to be little or no prospect of good news coming in the future.

This trader however, who didn't trade stocks for a living, continued to see and witness all this economic negativity. But at the same time noticed that the stockmarket never really went lower, trading instead in a range (up and down without moving one way or the other).

After many months of this, with the market still not moving lower and the news still not getting any better he was convinced that stocks were on the cusp of a mega rally. His analysis was simple - if stocks are not going lower when the news is so negative then there must be some hidden strength in the market keeping prices buoyant.

All that was now needed to get prices moving on the upside was some shift in sentiment. Sure enough, the economy started to slightly improve and the stockmarket exploded into the famous tech rally lasting around 5 years and gains of several hundred percent for many shares.

That was a classic example of hidden strength and why listening to the market while considering the current news is so important.

The Case For Hidden Strength in The Current Stockmarket

Imagine it's the summer of 2007, stock prices are not too far from the all-time highs and the economy looks relatively OK.

You're at a lunch with some switched on market analysts and decide to do a little doomsday predicting. You suggest that within 18 months -

• A massive credit crunch will hit the global economy
• Most banks will be forced into round after round of emergency funding
• Oil will be at $130+
• Global inflation will be out of control at 8-10% in the west and 12%-20% in developing countries like China
• US property prices, and the UK to some extent will have started to plummet
• It will be much harder for the average person (sometimes even impossible) to be approved for loans, mortgages, credit cards etc
• Commodity prices will be through the roof
• No end in sight for an end to Middle East problems and the billions of dollars a week that it's costing the US government
• Gold at or around $1000
• The dollar continues to get crushed and Sterling with it
• Consumer sentiment from the average person in the street in tatters
• Etc, etc, etc

In the summer of 2007 the FTSE 100 was around 6500 and if you were at that lunch the consensus around the table I believe would suggest the market should be a minimum of 1500 points lower, if not down 2000, on the back of all the negative news.

In fact if you'd suggested the market might even be down around the 2003 bear market lows of just under 4000 you'd hardly be laughed at.

Chronic bad News, Yes - Hidden Strength, Maybe

The situation is obviously different to the early 1990s. Stocks are moving lower rather than sideways to slightly positive. But in relation to the acute bad news and the fact the FTSE 100 is only down 900 points from last summer, provokes the question of whether there is any hidden strength in the market.

So what is the answer? At the time of writing I would have to say that yes, the stockmarket is showing signs of hidden strength for the simple reason that it's only down 900 points over a year where the news has been dreadful. So the fact that it's not currently trading at 5000 or below (basis FTSE 100) means it must be closely watched over the summer months leading into September.

When To Turn Positive On The Stockmarket, Or At Least Neutral

For long term investors nothing moves quickly in the markets. The long term trends can takes weeks if not several months to change, but meanwhile there are always clues. The main clue right now as to whether the bears should move to a neutral or even mildly bullish view is to see if (and then how fast) the FTSE can regain the 6000 level and indeed hold it for several weeks.

For example, say that in July we start to move gently higher back up towards 6000 and then trade in a range say 5950- 6200 during August. This would in my view shift the probabilities that the rot has stopped.

If this scenario were to happen and we find that the bearish news starts to gently recede it's quite conceivable that stocks could post a major rally heading into the Spring of 2009. And wouldn't that surprise most people?

Summary

Obviously it's far too early to tell whether any of the above will happen. And as long as the FTSE remains below 6000 then the bearish view is the right one to adopt.

But we must have a plan B in case we're wrong, we cannot get married to the bearish view and we have to respect the idea there is the very real possibility of hidden strength currently brewing.

Finally the markets like to confound most participants. If it was all so easy then not only would we be making 25%+ a year on our portfolios but we'd have been making these types of gains for at least the last 10 years.

So right now, how easy is it to be bearish versus how hard is it to be bullish? And it's the hard things, the events that are often inexplicable before they occur that we must guard against.

To Summarise

• Plan B is bullish
• No need to act on it at the moment, see if the FTSE 100 can make it back to 6000
• If it can, and can hold 6000 for 2-4 weeks then the bear case is most probably over
• Then look to be a selective buyer of stocks, probably in those industries that are not closely aligned with the credit crunch fall out, ie no financial stocks

This story is developing so stay tuned as we'll come back to it over the next few months unless of course the market continues to weaken.

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