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The Broyhill Letter (Q3-08)

The Broyhill Letter (Q3-08)

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The best time to panic is before everyone else does. That was certainly an appropriate market stance in past quarters, when we cautioned investors about the growing risks of low quality debt (Q4-06), the unwinding of the carry trade (Q1-07), and urged investors to examine all risk exposure (Q2-07). But good investors love situations where panic is full blown and conditions appear utterly certain to get worse. When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, the
market is more likely to register its low.

While we may not be at such a low yet, the present sentiment of panic is typically one that presents useful opportunities for gradually scaling into market exposure, as uncomfortable as it might feel over the short term. This is what good investors get paid to do - not always immediately, but over time. The essence of good investing is to strike a balance. And while there is a good chance that valuations will eventually move lower still before a durable low is established, investors should recognize that given significantly improved valuations, compressed oversold conditions and an extreme spike in the VIX, the catalysts for a rebound are quickly accumulating.
The best time to panic is before everyone else does. That was certainly an appropriate market stance in past quarters, when we cautioned investors about the growing risks of low quality debt (Q4-06), the unwinding of the carry trade (Q1-07), and urged investors to examine all risk exposure (Q2-07). But good investors love situations where panic is full blown and conditions appear utterly certain to get worse. When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, the
market is more likely to register its low.

While we may not be at such a low yet, the present sentiment of panic is typically one that presents useful opportunities for gradually scaling into market exposure, as uncomfortable as it might feel over the short term. This is what good investors get paid to do - not always immediately, but over time. The essence of good investing is to strike a balance. And while there is a good chance that valuations will eventually move lower still before a durable low is established, investors should recognize that given significantly improved valuations, compressed oversold conditions and an extreme spike in the VIX, the catalysts for a rebound are quickly accumulating.

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Published by: Broyhill Asset Management on Feb 03, 2013
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 T H E B R O Y H I L L L E T T E R 
We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. – Warren Buffett 
Executive Summary
 The best time to panic is before everyone else does. That was certainly an appropriate market stance in past quarters, when we cautioned investors about the growing risks of low quality debt (Q4-06), the unwinding of the carry trade (Q1-07),and urged investors to examine all risk exposure (Q2-07). But good investors love situations where panic is full blown andconditions appear utterly certain to get worse. When the news reports are uncontroversial in reporting that the U.S. is inrecession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, themarket is more likely to register its low. While we may not be at such a low yet, the present sentiment of panic is typically one that presents useful opportunitiesfor gradually scaling into market exposure, as uncomfortable as it might feel over the short term. This is what good inves-tors get paid to do - not always immediately, but over time. The essence of good investing is to strike a balance. And whilethere is a good chance that valuations will eventually move lower still before a durable low is established, investors shouldrecognize that given signi
cantly improved valuations, compressed oversold conditions and an extreme spike in the VIX,the catalysts for a rebound are quickly accumulating.
 Approaching a Bottom
Of our twelve bottom-watch indicators, ten have now reached extremes in conjunction with previous bear market bot-toms. The evidence has become even stronger than it was around the 2002 bottom, so as the markets have spiraled tolower lows, the case for a bottom has strengthened. The S&P has never been so overextended relative to its 200-day moving average. Previous occasions when it got close in1973, 1987 and 2002, all marked signi
cant lows for the market. We have no evidence yet that the S&P has found supportbut the more overextended it becomes, the sharper the covering rally is likely to be when the tide of sentiment begins toturn. The Dow Jones has only been more overextendedrelative to its moving average in 1938 and during the col-lapse of markets from 1929 to 1932. However, on every occasion once the indicator bottoms, it has been a reli-able signal that the market is close to an important low. The VIX (also known as the Fear Index) hit an all-timehigh of 71, re
ecting extreme levels of emotion inthe markets. We often look at this on a smoothed ba-sis where readings above
fteen over the last ten yearshave produced signi
cant rallies. The present reading istwenty six! 
THIRD QUARTER 2008
 
 The public is no longer overweight stocks, based upon
ow of funds numbers. Surveys by the American Association of Individual Investors show allocations to cash well above the historic average and approaching levels last seen around bearmarket bottoms in 1991 and 2002. Our favorite mea-sures of investor sentiment are now completely washedout, a bullish indication from a contrarian standpoint. The con
uence of factors, in aggregate, indicates that we are increasingly close to a bottom, with signi
cantupside from these levels. The largest rallies in bearmarkets since 1901 averaged 13.1% over 48 days. Morepowerful advances have been spurred after “crashes” – the average surge following the nine “crashes” since1932 was 20.4% over 30 days.
Finding Fair Value
 While market pundits and main street economists are still debating the likelihood of a domestic recession, we believe theeconomy entered a recession around the beginning of this year. Although there is considerable variance in the length of recessions and the behavior of stocks to count on the average performance, it is important to keep in mind that stock market declines triggered by the onset of a recession tend to be longer and the losses more severe than the results for the“average” bear market. Since 1950 there have been 16 declines in the S&P 500 of at least 15 percent. Nine have coincided with recessions. The seven stand-alone bear markets have had an average duration of 215 days. If this decline runs theaverage duration of past recession-induced bears, we could observe the bottom in October. It would be in good com-pany, another history lesson is that bear markets are essentially killed in October, including the bear’s of October 1923,October-November 1929, October 1957, October 1960, October 1962, October 1966, October 1987, October 1990 andOctober 2002. The average price-to-peak earnings multiple of past recessionary troughs is 10.4, implying an S&P troughin the vicinity of 885.Coincidentally, we see fair value based upon the market’s historic median price-to-earnings multiple at 1232. But greatbubbles like the one in 2000 take a long time to wash through the system, and great bubbles in history have always overcor-rected. So if the market overshoots on the downside by one standard deviation, this suggests a price-to-earnings multiplearound eleven, resulting in a level of 815 for the S&P 500. GMO’s Jeremy Grantham (who we have repeatedly quoted inthis letter over the years as one of the few remaining independent thinkers in the industry) estimates the market’s funda-mental value is 1025 by assigning a normal price-to-earnings ratio to average corporate pro
t margins. If we again assumethat bubbles overcorrect on the downside by possibly twenty percent, the resulting S&P trough would approximate 820.
THIRD QUARTER 2008
Source: Hussman Funds Source: FusionIQ

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