Market Perspective for 11/26/12

Domestic Stock Market

The proximate cause of the recent market declines seems to be the “fiscal cliff” or the combination of tax increases and government spending cuts set to take place at the beginning of 2013.   In addition, we are seeing both the normal tax loss selling and also tax gain selling (taking profits in order to realize a 15% capital gains rate rather than a potentially higher rate in 2013).  Stocks have broken below both their 50 day and their 200 day moving averages, which is a bearish technical signal.  Investors are beginning to fear that we at the threshold of another major collapse in stock prices.  I don’t believe we are.  Here is what I believe we should keep in mind:

• Markets sell off from time to time.  The magnitude of the recent decline was -7.6% (9/14 – 11/15).[1] This is still less than the -9.7% decline from early April to early June.[2] It is an unusual year that we don’t see at least two -7% declines.  Statistically, single-digit declines usually don’t become mid-teen declines (and for that matter, mid-teen declines seldom become -40%+ crashes).[3]
• We may be seeing the emergence of a “stock vigilante” movement.  In the early-mid 1990s the bond market forced politicians to pursue bond-friendly policies by selling off (pushing interest rates up) anytime they acted in a fiscally irresponsible manner.  Pres. Clinton famously complained about the bond market, but the bottom line was that during his administration the bond market got what they wanted and the country prospered.  Stocks sold off in the summer of 2011 as the two political sides bickered, then rewarded us with strong gains once a (fairly) credible agreement was reached.  It appears that stock investors are again putting the pressure on.  If the fiscal cliff is resolved favorably, this could be a positive catalyst.
• The period from November 17^th through the end of January is historically the most favorable time of the year for stock investors.  No guarantees of course, but I always prefer the wind at my back as opposed to in my face.
• Mathematically, a significant part of the overall market decline has been the -25% plunge in Apple Inc. from its September 20^th peak of over $702 to its Friday 11/16 close of $527.  (As of 11/26 Apple trades at $577 or -21.6% off its high) Even at its 11/16 low, Apple was worth $100 billion more than ExxonMobil, the second largest U.S. company.  Its decline alone cost the stock market $164 billion in market cap.  With Apple appearing to have found support, a major downward force in recent weeks may be ready to resume pulling the market upward again.[4]

I don’t want to minimize the risks that investors face, both short and long term.  I just don’t think we are on the edge of a significant down move.

International Stock Market

International stocks have outperformed U.S. stocks so far this quarter by about 4% (+4.46% vs. -0.23%)[5].  Much of this is tied to the special factors described above (the U.S. fiscal cliff, the plunge in AAPL).  Some is because of the misguided belief that things are getting better in Europe.  They aren’t.  There is an investment case that can be made for Latin America, for Africa, and even for much of Southeast Asia but not for Europe.  Last Spring, when Bill Gross made his “cleanest dirty shirt” remark with regard to preferring the U.S. to pretty much any place else in the world to invest, he was pretty close to calling the top in the market.  The U.S. got overbought in a relative sense, and foreign markets began performing better (as any contrarian would expect).  Going forward however, Bill may finally be right.

Bond Market Perspective

One concern I do have is with regard to high yield bonds. According to Moody’s, covenant quality is near record lows. In other words, the protections granted to the investor by the issuer are at the lowest level since 2007 because investors are so hungry for yield they are willing to accept unfavorable terms.  This is a cyclical phenomenon that we have seen since high yield bonds were first invented in the 1980s and it NEVER ENDS WELL.  Whether the peak is two months or twenty months from now is unknown, but the last few crumbs of profit are best left to others.