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Jubak's Journal
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Get ahead in this range-bound market
The market has been swinging through an 800-point trading range. With no end in sight to the underlying uncertainty, consider a portfolio that takes advantage of the volatility.
By Jim Jubak
The more things change, the more they stay the same. Take the stock market, for example. When summer started, the market was range bound. Now that summer is winding down, it still is.
Stocks continue to swing between the extremes of fear and hope. And the key to making any money from stocks is still buying when everybody is running in fear and selling when everybody says theres smooth sailing ahead.
The odds are that the financial markets and the economy will muddle through, but dont expect this market to break out to the upside. Indeed, the trend, if there is one, is toward a gradual drift downward in the major indexes.
No end in sight to uncertainty
Lets review. On Aug. 25, the Dow Jones Industrial Average ($INDU) rode its seventh gain in nine sessions to within striking distance of 10,200. At the close that day, the Dow had climbed almost 400 points, roughly 4%, in the prior two weeks.
The setup for a huge rally, right? Well, probably not. You see, weve been here before. The Dow Jones industrials broke above 10,200 at the very beginning of June, before that in the last third of March and before that in mid-December.
And the index dropped below 10,200 in mid-July, the first third of May and the beginning of March.
Despite all the rallies that, like the one at the end of August, took the index above 10,200 with what looked like solid momentum, the Dow industrials have never been able to move above the February 2004 highs near 10,600.
And, on the other hand, the index has never dropped below 9,800 in any sell-off this year.
That 800 points from 9,800 to 10,600 has defined the Dows trading range for 2004. And I wouldnt bet much money on an upward move anytime soon.
Why not? Because none of the uncertainties that have driven investors emotions from top to bottom in that range are anywhere near anything like a resolution.
Expect continued volatility in oil
Take oil. Remember in mid-August when the press was full of speculation about $50-a-barrel oil? You could even find Wall Street experts willing to speculate about $60 a barrel. That overheated speculation, however, marked a high for prices. Starting with Aug. 20, oil futures began a four-session decline of almost 11% that took prices from near $50 to $43.47 on Aug. 25.
So the oil crisis is over -- but only for as long as it takes oil traders to unwind their bets on prices above $50 a barrel, lick their financial wounds and find a set of news events that revives fears of supply disruptions.
The reality is that the oil market has moved from a situation where everything seemed to be going wrong with supply to one where everything seemed to be reasonably OK. Turmoil in Venezuela, pipeline bombings in Iraq and open warfare between the government and oil companies in Russia had given way to relative stability in Venezuela, a return to pre-war export levels in Iraq and predictions that oil exports would stay at current levels no matter how bitterly the government and the oil oligarchs fought in Russia.
But notice that this good news (like the bad news before it) hasnt changed the underlying dynamics that are driving oil prices. Thanks to rising demand, with unexpected strong increases in consumption coming from China and India, and relatively stagnant supplies due to underinvestment in the oil sector and to recent difficulty in finding big, easily exploited new fields, the world has been operating with very, very thin supply reserves. According to oil industry experts, it takes about a 4% surplus of supply over demand to produce stable prices. Right now the world has less than a 2% surplus. If current investment in oil supply works as anticipated, the world could move into a 2% surplus in 2005.
In other words, for the foreseeable future, expect oil prices to be extremely volatile since the surplus of supply over demand will remain so tight. In that situation it doesnt take a whole lot of bad news, real or imagined, to send prices spiraling upward. Oil producers are almost powerless to intervene in the market because they dont have the surplus to pump. Good news, either real or rumored, such as recent speculation that the United States will stop buying oil to fill its strategic reserve, is enough to send prices sloshing back in the other direction.
Additional worries arent hard to come by
You dont have to look hard to find similar situations with high volatility and low likelihood of near-term resolution all over the economic and political landscape right now.
All summer, the financial markets have worried that terrorists would strike the Democratic convention in Boston or at the Olympics in Athens or at the Republican convention in New York. Now that those events have passed quietly, the markets are ready to exhale in relief. That big sigh is probably worth a couple of hundred points on the Dow Jones industrial average. But terrorism certainly hasnt gone away, its not solved and the markets (and the rest of the world) remain vulnerable to the next round of fear and actual violence.
Same for worries over earnings growth. The summer brought a spate of warnings about growth in the quarter that ended in June, and troubling notice of potential weakness in third-quarter earnings. By the very nature of how Wall Street works, the fall in stock prices those warnings engendered and the lowered expectations for the September quarter the warnings produced are likely to lead to higher stock prices on better-than-anticipated reported earnings in early October.
Will this answer questions about how fast the economy is really growing, what the true level of demand is for high-tech gear and software, or the possibility that stocks are still over-valued? Not a chance. Well need a lot more than another quarter of numbers to answer those questions. But absent real answers, the financial markets will move in shorter cycles of fear and hope on temporary emotional responses to essentially ambiguous data.
Ditto for the elections, where uncertainly about who will win will certainly diminish in November (setting up the potential for a relief rally no matter the winner if we simply get a clear-cut result). But that vote isnt likely to end the policy gridlock in Washington, built as it is on a striking absence of creative ideas and the cold, hard facts of the federal budget as the Baby Boomers get set to retire.
And for Iraq, where success in any one battle certainly is news, the market will cheer. But the reality is that for quite some time to come any completed battle is likely to be quickly followed by another.
Managing a portfolio amidst volatility
I can live with the range-bound market that this describes. In the part of my portfolio I reserve for long-term positions such as PepsiCo (PEP, news, msgs), Berkshire Hathaway (BRK.B, news, msgs), Newmont Mining (NEM, news, msgs), The St. Joe Company (JOE, news, msgs) and Donaldson (DCI, news, msgs), Ill continue to use market drops to build bigger positions. Ill also try to avoid getting spooked by those drops into selling at temporary bottoms.
In the trading portion of my portfolio, Ill continue to look for stocks with more volatility, such as Smithfield Foods (SFD, news, msgs), Micron Technology (MU, news, msgs) and Cell Genesys (CEGE, news, msgs) that have dropped more than the fundamentals warrant but that have greater-than-average pop potential when the market reverses direction. Ill try to limit my risk in this trading portion of my portfolio by keeping my eye out for strong fundamentals that will eventually produce gains in a stock no matter what the markets fluctuations.
What worries me, however, as I come back from my vacation, is the downward drift in the tops and bottoms of this markets range in 2004. Just look at a chart for the Dow this year: Each peak since February is lower than the previous top and each bottom is slightly below the prior bottom. Add the 50-day moving average to a chart of the Dow industrials to see the trend even more clearly. The line moves steadily and relentlessly downward from the February highs.
So far, Im willing to say that this is the normal response to the big gains of 2003. I also think the seasonal strength that in most years kicks in after September and October, the years roughest months for stocks, will be enough to reverse or at least temporarily halt the downward drift.
But the pattern certainly bears watching. Seasonal trends arent guarantees, but a stock market that goes down during a strong seasonal period such as November and December is sending out a warning.
Anything less than muddling through for the remainder of 2004 could be setting up a really ugly 2005.
See, theres still plenty to worry about. Welcome back.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Berkshire Hathaway, Donaldson, Micron Technology, Newmont Mining, PepsiCo and The St. Joe Company. He does not own short positions in any stock mentioned in this column.
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