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THE BROYHILL LETTER

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 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 signicantly 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 bottoms. The evidence has become even stronger than it was around the 2002 bottom, so as the markets have spiraled to lower 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 in 1973, 1987 and 2002, all marked signicant lows for the market. We have no evidence yet that the S&P has found support but the more overextended it becomes, the sharper the covering rally is likely to be when the tide of sentiment begins to turn. The Dow Jones has only been more overextended relative to its moving average in 1938 and during the collapse of markets from 1929 to 1932. However, on every occasion once the indicator bottoms, it has been a reliable signal that the market is close to an important low. The VIX (also known as the Fear Index) hit an all-time high of 71, reecting extreme levels of emotion in the markets. We often look at this on a smoothed basis where readings above fteen over the last ten years have produced signicant rallies. The present reading is twenty six!

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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 bear market bottoms in 1991 and 2002. Our favorite measures of investor sentiment are now completely washed out, a bullish indication from a contrarian standpoint. The conuence of factors, in aggregate, indicates that we are increasingly close to a bottom, with signicant upside from these levels. The largest rallies in bear markets since 1901 averaged 13.1% over 48 days. More powerful advances have been spurred after crashes the average surge following the nine crashes since 1932 was 20.4% over 30 days.

Finding Fair Value

Source: FusionIQ

While market pundits and main street economists are still debating the likelihood of a domestic recession, we believe the economy 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 the average duration of past recession-induced bears, we could observe the bottom in October. It would be in good company, another history lesson is that bear markets are essentially killed in October, including the bears of October 1923, October-November 1929, October 1957, October 1960, October 1962, October 1966, October 1987, October 1990 and October 2002. The average price-to-peak earnings multiple of past recessionary troughs is 10.4, implying an S&P trough in the vicinity of 885.

Source: Hussman Funds

Coincidentally, we see fair value based upon the markets historic median price-to-earnings multiple at 1232. But great bubbles like the one in 2000 take a long time to wash through the system, and great bubbles in history have always overcorrected. So if the market overshoots on the downside by one standard deviation, this suggests a price-to-earnings multiple around eleven, resulting in a level of 815 for the S&P 500. GMOs Jeremy Grantham (who we have repeatedly quoted in this letter over the years as one of the few remaining independent thinkers in the industry) estimates the markets fundamental value is 1025 by assigning a normal price-to-earnings ratio to average corporate prot margins. If we again assume that bubbles overcorrect on the downside by possibly twenty percent, the resulting S&P trough would approximate 820.

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This past Fridays panic selling, intraday low was 840 for the S&P, at which point the market sharply rallied 7% as buying volume surged across the board and trading levels hit their highest point of the year.

Bottom Line
Let me be clear. Now is the time to stay close to the shore and not be heroic. One needs to be extremely careful when making any macro bets, particularly during periods marked by wild swings in price and emotion. But, in the meantime, we cannot lose sight of the big picture. We maintain that market bottoms end with a whimper not a bang. In bull markets, corrections end quickly, and rather loudly. In bear markets, the bottom is a longer dated process. Testing the lows, a disdainful attitude for stocks and divergences are all characteristics of bear market bottoms. We believe the market is positioned for a violent snap-back rally, but we doubt the down trend has fully expressed itself, nor do we believe that the secular bear that rst reared its head in 2000 is dead. A long, sustained bull market in stocks (like those that begun in 1921, 1942 and 1982) requires, as a foundation, a secular bottom comprised of the following factors: economically, the debt structure should be deated and there should be a large pent-up demand for goods and services; fundamentally, stocks should be unmistakably cheap based upon time-tested, absolute valuation measurements; psychologically, investors should be deeply pessimistic both in terms of the stock market and the economy; technically, major investor groups should have low stock holdings and large cash reserves; and a fully oversold longer-term market condition in terms of normal trend growth and in terms of time. Clearly, trends have corrected signicantly from the heights of optimism reached in 2000 and again in 2007 (especially after last weeks action), but not quite to what we would consider secular low oversold conditions. But as economist Stephen Roach wrote weeks ago, The most important thing about nancial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies. That fact is worth remembering here. Ladies and gentlemen, the time to sell and raise cash was last year, not here. If your exposure to risk is small, a panic is a good time to increase it, gradually, at depressed prices. That is what good investors do. Emotional investors establish leverage at tops and are forced to sell at bottom. Those investors unfortunately exist to a much larger extent than the former, but we are happy to provide them with liquidity when Source: Ned Davis Research it is in furious demand. While this period has been very difcult and in some ways painful, the combination of massive and rapid nancial delevering and unprecedented liquidity injections by global central banks, may prove to be one of the best potential buying opportunities we have ever seen. Market valuations have improved sharply, and the markets now appear priced to deliver favorable returns . . . at least for a while. - Christopher R. Pavese, CFA