Sell them and you’ll be sorry,
Buy them and you’ll regret,
Hold them and you’ll worry,
Do nothing and you’ll fret.
– origin unknown
Successful investing is about balancing out the inherent risks of investing with the financial rewards possible from following a sound investment plan. It takes time, patience, and perseverance along with a longer-than-next-week perspective. Doing what is right as an investor in many cases is the exact opposite of what human instincts would dictate you do.
When things are bad … or really, really bad (March, 2009 for example), investor instincts lead many to the relative “safety” of bonds and cash. On the other hand, once the smoke has cleared and the sky seems bright, instinct dictates taking on more “risk” in the form of owning equities (individual stocks, ETFs or mutual funds). In many cases following one’s gut feeling may lead to poor investment decisions. In our opinion, the issue investors are really facing is a misinterpretation of risk and safety.
For many people the sole definition of risk is return OF principal. When you hold cash, you know that $1,000 today will be $1,000 tomorrow. As long as it is held in an FDIC insured account, you know you will be getting your money back. It is a “safe” investment. Risk, however, should also be defined in terms of spending power (or loss of spending power) and volatility. And even though a “safe” cash investment has no volatility, if the interest received from holding cash in a savings account is lower than the inflation rate, the investor would be losing spending power. Thinking in those terms, risk and safety take on greyer shades of black and white.
Turning to the markets, the first quarter of 2013 was very good to equity investors of U.S.-based stocks, with both the Dow Jones Industrial Average (DJIA) and the S&P500 posting all-time record highs. For the quarter, the Dow closed at 14,578.54 for a return of 11.25% while the S&P500 closed at 1569.19 for a 10.03% gain. Global indexes lagged with the MSCI EAFE turning in a return of 4.38%. The debt markets did not fare as well as the equity indexes as the Lehman Aggregate Bond Index ended the quarter with a loss of 0.13%. Commodity markets were mixed.
What Do We Do Now?
At the beginning of the second quarter the stock market sits in a very interesting place, in the fourth year of a bull market and just above the market highs of March, 2000 and October, 2007. After four years of healthy stock market returns, the average investor appears to be getting more comfortable with owning equities. With interest rates at historically low levels, The Fed continuing to purchase $85 billion of bonds each month, the economy growing slow and steady, it is hard to find a reason to be disinterested in equity investing. Just as important, the markets are showing little indication that this bull market is coming to an end. And here is where things get interesting.
As Chart #1 makes obvious, the stock market, as measured by the S&P500, is back in a very familiar place. In March, 2000 and October, 2007 we were at these same levels right before things went terribly wrong. The fear that some people have is this – now that we are back at these levels another great deterioration in stock prices is inevitable. We know this because we have clients who are saying just that. And by just looking at the chart, this argument seems to makes sense. What we need to do is look at the risks and possible rewards we have here, understanding history, but with a keen sense of what is happening new and what could transpire in the near future.
Chart #1 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
From a fundamental standpoint the stock market is in much better condition today than it was at both the 2000 or 2007 peaks. At the 2000 peak the stock market had run up as a result of a huge asset bubble in technology stocks. Shortly after the October, 2007 peak we entered into a global financial crisis and the Great Recession. From a valuation perspective, the market indexes are trading with higher earnings per share and a lower price-to-earnings (PE) ratio than at either of the previous peaks.
We do, however, have one big concern – corporate earnings. Since the end of the Great Recession publicly traded companies have done an outstanding job of building their balance sheets and streamlining operations. The result has been outstanding earnings growth, even as sales growth has been less than robust. More recently, the earnings growth rate has decelerated; forcing us to question if the 2013 projected S&P 500 $108 in earnings will be met. In a best-case scenario earnings will be stronger in the second half of the year. In the worse-case scenario, earnings continue to decelerate.
Counteracting this trend is the increasing numbers of corporate share repurchase announcements, which lower the number of shares outstanding, thus increasing earnings. Such financial engineering comes with a price, which is the cash used for repurchased shares will not be used to grow the business. And in an upward trending market the repurchased shares might not be the best deal. Only time will tell if this will benefit shareholders.
A secondary concern we have is the global economy. Europe is still working through its seemingly never ending problems – Cypress being the latest headline issue; China, one of the large economic motors for the past decade, has slowed to a more realistic growth rate while working through growing pains; Japan, after two decades of economic stagnation, has embarked upon a massive stimulus program designed to drive economic expansion. Just as concerning, the price of copper – a reliable proxy for projecting global economic growth – has fallen 9% in 2013.
From a technical standpoint, the overall stock market has been over-bought for some time. Such a situation can continue on for longer periods of time, and will eventually be resolved with either sideways markets or an actual market correction. So, yes, the current chart does suggest that markets will not continue upward, but it does not mean a correction is inevitable. At such an inflection point it is important to watch for the signal that there has been a change in direction, with an understanding of possible areas of support.
On the daily chart of the S&P500 (Chart #2) below we note a number of areas of support that should be considered in a stock market correction. The first support level, around 1485, coincides with the late-February lows and the 38.2% Fibonacci Retracement Level. If the market cannot find support there, the next level to look at is the 50% Fibonacci Retracement, which happens to be located at the early-January support level around 1458. Finally, the 1430 level would be the third level of support we would look at if prices continued to fall.
Chart #2 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
After being bullish for the past few months we enter the second quarter cautious on the short-term prospects for the stock market. We believe a correction is likely, but not necessarily inevitable. Earnings, seasonal trends, and an over-bought market are the underlying reasons for our concern. Any market correction, be it sideways action or a true correction, should not be drastic, and would be considered an opportunity to add to equity positions.
We have not discussed the bond markets beyond a brief mention of the quarterly performance because we believe there are no real areas of opportunity. Yields remain at historically low levels and are very likely to remain here for some time. If you are interested in a more in-depth look at income investing, please review our 2013 Market Outlook.
If you have any questions on the materials presented or would like to be added to our email list, we can be contacted at 610-437-5650 or via email.
Past performance is no guarantee of future results. Dividends are subject to change or elimination and are not guaranteed.
Stocks offer long term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investments that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than investments that are more diversified.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
Fibronacci Retracement is the potential retracement of a financial asset’s original move in price and is used in technical analysis term to identify areas of price support or resistance. Technical analysis is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future.
The FDIC standard maximum deposit insurance amount per depositor per insured depository institution for each account ownership category is $250,000.
This and/or the accompanying statistical information was prepared by or obtained from sources that Magellan Financial, Inc (Magellan Financial, Inc is a separate entity from WFAFN) believes to be reliable, but its accuracy is not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Additional Information is available upon request.
Jonathan D. Soden Robert I. Cahill
Partner Managing Partner
Ann L. Drescher Jeffrey T. Bogert