Sensible Investing

It appears that the market correction that started in the beginning of the year has run its course, and at this time around the infamous anniversary of 2009 multi-year market lows, the markets are on the rise again.  This year, the economic reports were mixed; they are never overwhelmingly positive in any recovery and this one was no exception.  Some disappointing showings in housing market statistics and new unemployment claims earlier this year, as well as the Greece debt crisis were major catalysts of the correction.  But the latest statistics and especially the Friday unemployment report alleviated the fears.  The Greece situation appears to be at least temporarily under control, but I don’t think that’s the end of it.  There are other countries in the PIGS world (Portugal, Ireland, Greece, Spain) that also have potential to shake the markets with the news of their debt issues; the euro is likely to continue to be pressured against the dollar.

Still, there are many reasons to be optimistic about the markets in 2010, although no one expects repeat performance of 2009.  Most of the stimulus money is still not spent, corporate earnings continue to surprise on the upside, inflation and interest rates are low, and apparently unemployment rate has peaked.   Regular corrections are quite normal during the upward movement, and I don’t think this market is going to be different in this regard.

About of half of S&P 500 companies reported Q4 results, and so far, these results are very similar to those of previous few quarters.  Not only most of the companies are beating estimates, the guidance going forward is also generally exceeding analysts’ expectations.  That had been the case with a number of bellwether companies, such as Intel, Apple, Goldman Sachs, etc.  The economic news have also been fairly positive.  While there were some disappointments in recent employment and housing data, manufacturing and consumer confidence are on the rise.  During the fourth quarter of 2009, U.S. economy grew at 5.7% rate, much higher than expected.

Nevertheless, the markets reacted in decidedly negative fashion to these benign reports and good earnings.  We saw a drop of about 8% from the 15 month market high reached just two weeks ago.  Skeptics are ready to point out that such a negative reaction to positive developments indicates that good news are already reflected in stock prices and that more trouble lies ahead.  Indeed, back in March 2009 the news were overwhelmingly negative, and yet that marked the beginning of the rapid market rise.  On the other hand, a correction such as we are experiencing is normal and is to be expected on a regular basis and especially after a huge rally we had last year.  In fact, since March 2009 there were three corrections already of the similar magnitude and the market kept marching higher after each one.

Who is right this time?  You know that no one can possibly answer this question.  In my view, we have reached a point where easy money has already been made on the way down and on the way up.  Any “dartboard portfolio” lost money in 2008 and made money in 2009.  I think that at present, stocks are reasonably valued and the skill of stock selection will once again become important going forward.

There are some global developments that definitely merit watching.  Financial crisis in Dubai, downgrade of Japanese bonds rating, and high debt obligations of Greece are troubling.  You are probably familiar with the acronym BRIC, which refers to fast-growing developing economies of Brazil, Russia, India and China.  Now we have another acronym: PIIGS.  This one stands for Portugal, Italy, Ireland, Greece, and Spain — countries in European Union that have high debt loads and face a possibility of default that would strain the whole Euro zone.  I even heard views that the euro as a currency may cease to exist within the next five years.  If indeed any of the PIIGS of the world comes even close to a default, you can be quite sure that this will not do wonders for any of the world stock markets.

We do have a lot of uncertainty at this point but this is nothing new.  In my view, a sensible investor must keep a well diversified portfolio of high quality stocks and be always positioned to take advantage of positive market moves.  This has worked extremely well for me last year.  In addition to that, caution and certain downside protection would also be warranted.

Here’s a an interesting article that presents a history of major market tops and also discusses clear signs of one.  An excerpt follows:

We’re nowhere near a market top now, but it pays to remember the signs in advance, like: (1) A general market euphoria, with talk of a “new investment era,” in which major corrections are a thing of the past, with the business cycle being softened or repealed. (2) Books like Dow 36,000 will replace the perennial “beware the coming crash” books on best-seller lists; and (3) market gurus will praise the virtues of “buy-and-hold,” while mocking the futility of “market timing.”

Right now, after a major crash, I can’t find anyone who will defend buy-and-hold.  Newsletter rating guru Mark Hulbert made a study of this phenomenon back in 1996 and found that investors disparage buy-and-hold when buy-and-hold would serve them best (as in the 1990s). Then, they become disciples of buy-and-hold at market peaks, when they should unload their big winners.

Ken Fisher echoed those findings in his 2007 book, The Only Three Questions That Count, saying (on page 277) that “at a bull market peak, there is endless advice saying you should never turn bearish and you should never ‘time the market,’ and that people who do are destined to miss the big returns of bull markets.  In 2000, this advice was rampant. The financial services industry marketed heavily that any professional who turned bearish was a quack or a charlatan.”

Year 2009 marks the end of the decade, and I say Good Riddance!  The Naughts, as some people call it, turned out to be the absolutely worst decade in stock market history, with S&P 500 losing 3.3% on average every year.   Compare that to the 30’s: during that decade, the market rose 1.8% annually!  Clearly, as bad as the Great Recession has been, it still can’t even begin to compare in economic terms to the Great Depression.  The main reason for the poor market performance during the last 10 years is that stock prices rose very fast in the 80’s and 90’s.  By the way, those 20 years followed poor 70’s; 30’s were also followed by a decades-long stretch of market gains.  By this historical perspective, next major move should be up (despite that good 2009).

My sentiment about last quarter of 2009 remains very similar to that of a couple previous quarters.  The economy continues to exhibit more and more signs of clear recovery, in GDP growth, improving housing market, stabilizing unemployment, strong corporate earnings, low interest rates, and even consumer sentiment.   The sentiment of market advisors, however, remains decidedly guarded since the gains occurred much quicker than anybody could have anticipated.  Many believe that this is still a bear market rally.  Indeed, can the market really go higher having already risen so much and so fast since March?  The short answer is — yes, it can.  It was unimaginable to think that it could drop even further from the levels of one year ago – and yet it did.

I am sure you realize that I am not actually making a prediction here; I never do.  The future is unknown and my guess is as good as yours.  There is a very good possibility, however, that the market will continue its climb of the wall of worry.

Take a look at a recent monthly commentary from Legg Mason Capital Management.   Here’s an excerpt from the report:

Before closing, we’d like to leave our readers with two views of the market—the inside view and the outside view—and let each reader decide which is the more relevant framework for investing. The inside view says that the market can’t go up because our current circumstances are too perilous and uncertain. The laundry list of worries has been well chronicled by the media: a still-fragile financial system, a likely sub-par economic recovery, yawning budget and trade deficits, a vulnerable dollar, threats from both inflationary and deflationary forces, high and still-rising unemployment, continuing wars in Iraq and Afghanistan, nuclear saber-rattling by Iran, massive funding requirements for Social Security, Medicare and Medicaid, the burden of health care reform and a probable rise in tax rates. Yada, Yada! It’s a wonder any of us can get ourselves out of bed in the morning.

The outside view says, yes, we’ve got plenty of things to worry about, but that’s been true throughout history. Worries, concerns and problems are always an unavoidable part of the investment landscape, just as they are an unavoidable part of life. The outside view asks us to look past the current situation at the bigger picture. Over the longterm, stocks have been great wealth builders. This has been especially true after they have suffered extended periods of poor performance, such as the 10-year period we have just witnessed. To be more specific, according to data compiled by Jeremy Siegel at the University of Pennsylvania, stocks have provided average annual real returns (after inflation) of 6.66% for all 10-year periods going back to 1871. There have been fourteen 10-year periods, including the current one, where stock returns were negative. In every one of the previous 13 instances, the subsequent 10-year returns have averaged 10% real, about 50% better than the long-term average, and more than twice the return of bonds.

With funds currently flowing out of domestic equity mutual funds and pouring into bond funds, investors are being overwhelmingly influenced by the inside view. We think they are making a big mistake.

Today, we had some really good news on unemployment.   Contrary to predictions of rising to 10.5% or even 11% rate, it unexpectedly dropped to 10%.  The economy did lose 11,000 jobs last month, but as you can see from the graph, it was the smallest amount since the recession began, and considerably smaller than estimated 125,000 loss.

The government also revised job loss amounts for the previous months downward.  If this trend continues, there is a very good chance that we will see job creation as soon as the end of this year or in January.

More details in this CNN Money article.

According to this article from Investors Business Daily, investors are still very skeptical of the equities.  In September and October, for example, they pulled out $17 billion from stock market funds and directed the proceeds mainly into bond funds.  Year-to-date, $1.91 billion was pulled out of the stock funds.

From a contrarian perspective, this is great news.  This means that investors stayed skeptical all the way up during the current rally and chose to either sit on their cash or funnel it to “safe” bond funds (with interest rates near zero, I don’t think bond funds will be safe for long).

The wall of worry is still alive and well.

Good news on economy continue rolling along. Here’s a summary for the last week or so:

- Q3 GDP grew at 3.5%, so now the recession is finally officially over.
- Retail sales were better than expected.
- Auto manufactures, such as Ford, Nissan, Toyota reported (relatively) good results with sales higher than a year ago. Ford reported $1.8B profit. Apparently, it is still possible to make money in the auto business.
- Job cuts by employers are moderating, and unemployment claims are falling. In fact, more employers are planning to add jobs than ones planning to eliminate them.
- The housing market continues its recovery. Pending home sales rose by 6.1% and are now at its highest level in three years.
- Earnings reports continue upward trend of the last two quarters. Fully 80% of companies beat earnings estimates, which is a record.

Note that consumer spending and unemployment have been thorns in this recovery for quite some time. As you can see, now we are getting more and more positive news for both.

The market, in its infinite wisdom, decided to greet these news with a sell-off earlier this week, and continued high volatility later. One could argue that a consolidation is due after a rally we had, or this could be a case of “buy on rumor, sell on news”. In any event, markets can be quite irrational in the short term, but in the long term, it is the fundamentals and earnings that matter.

It appears that the cockroach theory is right, at least as far as earnings surprises are concerned.  Just like in Q2 and shown in this post, a vast majority of companies are exceeding earnings estimates, as evidenced in weekly summary from briefing.com.  Once again, the market advance has been validated by excellent quarterly reports.

The overall market sentiment now is very similar to that of the previous quarter.  There is still plenty of skepticism around, driven by uncertainty of this recovery and the very fact that market gains happened so extraordinarily quickly.  We are still climbing the wall of worry, with many investors remaining on the sidelines convinced that we are in the bear market rally (which from the contrarian point of view is the ideal market condition).  Similarly to the last quarter, the coming earnings season is going to be hugely important.  Q2 (as well as Q1) results exceeded expectations, and of course the markets are driven by the earnings.  If this trend continues, so will this rally.

There are also important differences between current and previous quarters.  Major economic indicators improved significantly.  For example, then the economy was still contracting (although at a lower rate of decline) and housing prices were falling.  Now it is a virtual certainty that GDP rose in Q3 and the housing market is stabilizing.  Not everything is roses, of course.  Just a few days ago, manufacturing, consumer confidence, and unemployment reports were worse than expected.   This recovery, as any other, will have its hurdles and the markets could get bumpy.

The market action over the last two years confirmed my long-held belief that market timing is impossible and that one has to stay invested to participate in sharp upward moves.  Chances are, someone who sold on the way down is still on the sidelines waiting for a good market.  And they often buy after the market has already been good.