Stocks have done fairly well in recent weeks. I would like to be able to tell you with certainty why but I would only be guessing. Here are my best guesses:
1) Anticipation of coordinated Central Bank policies to stimulate the global economy
2) A somewhat stronger than expected employment report which turned investors sentiment from “clearly deteriorating” to “mild, sporadic improvement”
3) Lack of volume. In time periods where trading volume is typically light (August, December) speculators tend to avoid shorting stocks because of the potential difficulty of exiting a losing position.
The S&P 500 has held the 1400 level for the past few days, which inspires a fair amount of confidence in terms of the next week or two. There are no major deadlines in Europe for the remainder of the month, so investors are more comfortable holding stocks. The consensus was too negative a few weeks ago, so a little bit of good news went a long way. My belief continues to be that we are in a (cyclical) rally with in a longer term (secular) bear market. As such, the next small move is more likely to be upward but the next big move is more likely to be downward. Proceed with caution.
One of the biggest mistakes advisors can make is to believe that what is inevitable is also immediate. What I mean by this is that an advisor might have determined in the late 1990s that the enthusiasm for technology stocks was a bubble and would ultimately end badly. That said, it would not have been a wise move to have sold all of his tech stocks by the end of 1997. He would have ultimately saved investors a lot of money, but only for those few investors who stuck with him through the strong years of 1998 and 1999. The same can be said for those few who saw the mortgage melt-down coming back in 2005. The point is it is not unusual to see a problem on the horizon. The difficulty lies in how we typically react to the danger. These are the usual steps:
1) We sell, because we assume we are the first to realize the danger and as soon as everyone else does they will sell too.
2) Time passes. The danger hasn’t gone away, only its urgency. The asset we sold is still appreciating. We feel the pain of missing out.
3) More time passes. We are comfortable with the fear because we have been living with it for so long. We begin to tire of listening to the people who originally warned us. We feel they are only trying to protect their reputation. We have bought some or all of our original position back. Higher.
4) The danger hits. The sale. The loss. The realization that we would have been better off either (a) never buying back in or, (b) holding the original long position the entire time and then selling into the crisis.
I want to keep this in mind as we contemplate the two big inevitable events:
1) The eventual turn in the interest rate cycle toward raising rates
2) The significant change in the functioning of the European Union
Both of these will be significant events in the markets, but we don’t know the timing. We can’t allow them to spook us into reacting too soon, but neither can we forget them or allow ourselves to believe that they will be benign when they occur. In the case of the former, I’m not doing a single thing. I believe that there is a glut of savings out there and world central banks are committed to keeping interest rates low. The recent pullback in rate is, therefore, a buying opportunity. If the ten year bond breaks above 1.85%, I will have to reconsider my thesis. As for the latter, I am underweight European stocks and for aggressive clients I have purchased an ETF that is short the Euro (DRR). If the Euro were to surpass and hold above 1.26 (dollars), I would have to rethink.
There is a clear preference for larger companies this quarter. Big is beating small both in rallies and pullbacks. As big stocks are still on the whole more fairly priced than small stocks, a shift upward in capitalization makes a lot of sense.
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