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
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