Stay Defensive After Stocks' Sell-Off

03/06/2007 12:00 am EST

Focus:

James Stack

President, Stack Financial Management

Jim Stack, the contrarian president of InvesTech Research, says last week’s sell-off was a reaction to the complacency that ruled the market, but he recommends that investors remain defensive in light of a weaker economy.

While [last] Tuesday was the eighth largest point drop in [the history of the Dow Jones Industrial Average], it only qualified at the 237th largest in percentage terms (since 1900). So “historically” speaking it was almost a non-event.

[This] knee-jerk reaction was partially due to the complacency from this long-running correctionless market that we have warned about. Yet on the other hand, we have to keep our eyes open for the possibility that the bull market top may now be in place.

A lot more can often be discerned technically from the days immediately following than from the day of the big decline. On the day of the plunge, both leadership and breadth get distorted – with most selling from profit-taking in the recent big run-up stocks, and the advance/decline data unable to keep up with, or offset, the size of the decline.

We are somewhat surprised the decline stopped where it did on Tuesday. The volume ratio of declining stocks over advancing stocks was more than 100 to 1. In essence, there was no buying or support on that sell-off. The only times our database shows such negative extremes in the past 40 years was on one day during the Asian Crisis in October 1997, and on Black Monday (plus one day a week later) in 1987.

Tuesday’s stability near the close, and the lack of serious currency/monetary turmoil, obviously played a major role in the market’s ability to continue to stabilize last week. But we have ongoing concerns about the fragile liquidity in this market and the dominating presence of hedge funds. In other words, we fear Tuesday was not the last downside surprise this year.

More fundamental statistics raised our concern about the risk of recession (which Alan Greenspan even acknowledged last week): We saw a growing negative divergence in “future expectations” from both consumer confidence surveys; there was a huge downward revision in fourth-quarter GDP (meaning the economy is operating closer to recession than was originally thought), and construction spending fell for the tenth consecutive month as sales of new homes fell again--by the largest amount in over a decade.

The only reason we don’t have portfolio changes is because we are already defensively allocated –in line with the level of risk we have seen. The last couple of days [of last week were] encouraging from a market stability standpoint as there hasn’t been a serious increase in downside leadership or a bearish breadth divergence--at least not yet. [But the market’s action didn’t reduce] our longer-term concerns or our conviction to keep our portfolio defensively positioned for now.

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