ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Nervous Investors Approaching a Trap?

February 20th, 2013

by Jerry Wagner

of Flexible Plan Investments

With the S&P 500 reaching new post-crash highs, it is interesting, to say the least, that most individual investors are not bullish on stocks. Rather, as the market has moved relentlessly higher this year, individual investors have turned more and more bearish.

https://flexibleplan.com/hotline/2-19-13-bullishsentiment.jpg

Source: Bespoke Investment Group

While these declines do seem to eventually become a self-fulfilling prophesy, the chart above demonstrates that market rallies (that the pessimistic turn often begins in) usually continue for some time after these investors’ opinion on the market starts to sour.

It is true that the S&P 500 Index closed up for the seventh week in a row last week, which has not happened since 2011. But when it did occur thirteen times in the past, the result was a higher S&P a month and six months later almost 70% of the time.

Just because the S&P was up so many weeks in a row does not mean that it cannot keep rising. Besides, the six-week winning streaks on both the Dow and the NASDAQ Indexes were broken last week. So to the extent that a run in good fortune means bad news must be on its way, that contrarian belief no longer is supportive with two of the three major indexes.

It may just be “too much of a good thing” for most investors. 2013 has been off to a fast start. January was one of the strongest first months in some time. But as Bespoke Investment Group reports, this year the period from the beginning of January to Presidents’ Day was the weakest in the last three years. And if 2012 is any indication, stock prices can go still higher before the next correction begins.

https://flexibleplan.com/hotline/2-19-13-presidentsday.jpghttps://flexibleplan.com/hotline/2-19-13-spytd.jpg

Source: Bespoke Investment Group

Still, there is plenty for investors to be nervous about. While there has been no declaration of war, a currency war among all the nations is currently under way. The developed nations are all deeply in debt, yet few display the willpower to tighten their belts. Instead, all have decided that they will try to skate by their respective looming economic crises by letting their currencies fall in value. Both the governments behind the US Dollar and the Euro have fallen prey to this line of thinking, but the absolute leader of the pack is Japan and their rapidly falling Yen.

At the same time, an undervalued currency has been an accepted way of life in the emerging economies. The Chinese have used it to build a trading empire that allows them to be the lender of last resort to the rest of the world. Now these developing countries find they have to move quickly to head off investors who are bidding their currencies higher and making them less competitive.

Since this strategy of everyone letting their currencies head for the exit at the same time cannot possibly work for everyone, the fiscal crisis they seek to avoid will no doubt reappear. This will mean some disruption in the financial markets once it happens.

Meanwhile, in the U.S. we move inexorably closer to sequester the simultaneous cutting of defense and supportive service spending in response (as the Obama administration’s suggested solution) to last year’s crisis. This is further complicated by the Senate’s failure to deliver a budget in four years (or to even put the budgets passed by the House during that time up for a vote), and the need to do so by next month, or have a battle like the government shutdown of the nineties over a further continuing resolution to run the government.

Either of these Congressional events could provide the impetus for a quick sell off in the market should the focus again return to the halls of Congress. Or… a settlement of some kind could act as a springboard to new all-time highs on all of the major stock market indexes.

While only time will tell, it is interesting that the market appears to be like a coiled spring at the moment. One of the indicators we look at is the ratio of short-term volatility to longer-term volatility. When that gets very low, as it is now, the market often makes a big move.

Similarly, the range of price movements seem to be coiling ever tighter since September in the chart below, waiting to explode like some economic bear trap. While price charts are still pointing higher, the range of the price moves has diminished to a level that indicates that a major move is imminent.

https://flexibleplan.com/hotline/2-19-13-hilospread.jpg

Source: Bespoke Investment Group

But which way? Will the move be to new heights or to some support level far below the present price level?

Of course, no one knows for sure. At times like these I fall back on trend following to ascertain the best probability. Trends once started have a tendency to continue, usually for longer than most people think. Academics, after decades of scoffing at the approach, have now authored hundreds of papers acknowledging or even championing the methodology as one of the proven exceptions (along with small-cap and value investing) to the random walk hypothesis.

At the moment the trend is clearly higher and it is supported by better-than-expected earnings and revenue reports from US companies in the fourth quarter reporting period that ends this week, and the improvement in economic reports of late.

The fly in the ointment continues to be interest rates. They have been heading higher. Ten-year government note yields are approaching the level of dividend payouts on the S&P 500. While this has been a rare period when such yields trailed stocks’, and blue chip yields have provided a welcome tail wind to higher stock prices, it is a fact that during most investors’ lifetimes bond yields have actually been higher than stocks’ and yet stocks have still prospered.

Furthermore, the Federal Reserve shows no indication that it is finished with providing its support.

It appears that the Fed will be in supporting the markets every day this week. And it will do so to the tune of more than $20 billion in purchases this week alone. It’s hard to have a sustained downturn with that kind of a Wall Street welfare program. It’s even harder to bet against it.

At times like these when you are understandably nervous about the future, it should be reassuring to know that you have investments that are being actively managed and as a result can be responsive to markets. Furthermore, rather than having a single buy-and-hold strategy working for you, with Flexible Plan you can have numerous actively managed strategies utilizing a diverse range of asset classes.

Whether we are approaching a bear trap or a springboard, I for one would rather be active than passive. How about you?

All the best,

Jerry

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