May 3, 2007

If you haven’t already, I urge you to read the “Charts & Graphs” article in then Market & Economic Overview section.  In particular I want to draw your attention to the following table:

There has been very, very little volatility in the past four years (i.e. not many corrections), so this table reminds us that markets frequently go down – it is what the market does.  Specifically, more than three times every year we should expect the market to go down five percent; and at least one of those three pullbacks should shrink portfolios to the tune of ten percent. 

I don’t like being the bearer of bad news, but there it is – sometime in the next twelve months the market should go down 10%.  And the next 5% correction  should start soon – maybe within the next few months (summer doldrums?).  I certainly do not want to come across as cavalier or uncaring about your portfolio, but these “smaller” corrections I largely just shake off. 

Yes, I cringe when they happen.  No, I don’t like admitting that we’re going through a tough time in the market when a client is invested in said market.  But that emotional pain is a just a function of what, almost by definition, the market does; and while I’ll probably never get used to it I have (somewhat) learned to accept it.  So please don’t think I’m lecturing (I don’t mean to be), it is just that when the next correction comes I don’t want you to think I’m ignoring the risks (or your portfolio) by not going to 100% cash.

And if a correction is coming, why wouldn’t I go to 100% cash?  Well, the quick, easy answer is that the tools do not exist to accurately predict these little 5-10% bumps.  Cyclical calls are easier to forecast because indicators are less mixed at those junctures (which is why Berkshire has had nearly perfect success in making those types of prognostications).  These smaller price swings in the market typically are a factor of short-term swings in demand.  For example, if “sentiment” is optimistic then everybody who wants to buy stocks (at that time) has already purchased stocks (i.e. there is no more short-term demand) and stocks will likely dip lower.   (Then the question becomes how big of a dip and when does it reverse – more confusing questions).

Currently I find overall sentiment on the stock market to be confusing; that is to say there are mixed indicators (stock/bond ratios, momentum, stochastics, breadth, open trading, bond yields, earnings yield, monetary growth, relative valuation, etc, etc., etc.).  At least a couple of my favorite indicators show that I should be cautious over the short-term.  Yet other indicators simply will not confirm that. 

In particular, there is what you might call “healthy skepticism” in the UBS/Gallup Index of Investor Optimism.  A week-ago hedge fund surveys show 23% bulls versus 69% bears (again, healthy skepticism).  And NYSE Short Interest has grown in February, March, and April to 9.6, 10.5, and 11 billion, respectively; that’s about 7.5 times average daily volume.  These are not numbers that confirm a major high in the stock market (thus limiting my fear of a correction to the 5-10% type and not a crash).

But on the other side of that healthy skepticism is the scary optimism of mutual fund managers (one of the reasons I believe a correction is coming).  Domestic equity mutual funds are fully invested, leaving no cash to buy and requiring stock sales in order to raise cash if investors decide to exit these funds.  In March mutual fund inflows were mediocre at best, but funds still bought a net $15.5 billion in stocks, pushing down the cash/asset ratio to a record low of 3.6%. 

And then, of course, the adage “Sell-in-May-and-Go-Away”.  Maybe it’s because the saying rhymes, but I get more inquiries about this one “strategy” than anything else.  Yes, there is, historically, value to this strategy, but there are several other sayings/cycles that counter this (not the least of which is that the third year of a Presidential Cycle tends to be a fantastic year for the stock market). 

Since 1979, the S&P 500 has gained an average of 2.8% over the six months from the end of April to the end of October (versus an average 7.8% gain from the end of October to April).  Even at its most threatening (April-September), the S&P has gained an average of 1.9% (and the market gained an average of 9.2% over the September-April period). 

So let’s not fret over this rhyme because money is, on average, still made in the stock market.  Instead let’s fret about investors being too happy, too optimistic.  Somehow that seems to make more sense.