Stocks seem to be following the typical seasonal pattern of “sell in May and go away” with the S&P down 4% from the high on May 1st. It’s Déjà vu with the European debt crisis, QE2 and the Iceland Volcano frightening markets across the globe. Last year’s summer sell off saw the market’s decline over 17% before starting the next leg up. While we are not anticipating a 17% sell off, 10-15% corrections are seen as normal and healthy. In general these type of market corrections happen on average every 322 days and last about 108 days. Seeing that we are about 375 days past our last correction this seems quite timely as short term traders are using headlines to take profits and capitalize from short term reversals.
Looking at current valuations, corporate balance sheets, and the current financial environment, stocks still look attractive to us on a long term basis when compared to all other investable asset classes. We view the expected summer sell off as a buying opportunity. We have our shopping list ready and will be looking to add to existing holdings and/or initiate new positions should this correction materialize in the 10+ percent range. We are holding some cash and a small S&P hedge in our portfolios that we will look to deploy if the opportunity presents itself during the next few months.
Once again, the markets have reminded us that you cannot simply rely on conventional wisdom. For example, many people would have thought that we would have seen yields (i.e. interest rates) rise over the past few months due to the anticipated end of QE2 (the Fed’s bond buying program) and bond yields hovering at historical lows. Instead, the yield on the 10 year U.S. govt bond has fallen further to a measly 3.11%. We still believe (based on sound fundamental analysis) that the long term direction of interest rates will be up. However government intervention and technical indicators (i.e. price movement) cannot be ignored.
Several months ago, interest rates began to rise. At the time, we initiated a position in our client’s portfolios which was designed to profit on a rise in interest rates. Our risk management strategy dictated that we sell this position when the technical indicators (price movement) went against us. In other words, when interest rates began to fall again, we sold the position. We made a small profit, which would have turned into a loss if we had held the position. Selling this investment was tough because our instinct was that interest rates would resume their rise and we could make a lot more profit. However, we do not manage risk based on instinct. Risk management isn’t something that you can start and stop based on personal opinion. The position that we sold back in February is considerably lower today. This example, along with the evidence of the past decade, makes it clear that an active risk management discipline is essential to protecting your portfolio.
I frequently hear stories of people who timed a commodity trade right or just held an overly risky portfolio of stocks over the past year and are now touting their investment prowess. These are typically the same people who conveniently forgot their huge losses of 2000-2002 and 2008. Many of them still don’t understand the risks they are taking. People’s desire to make up for past losses as well as a psychological phenomenon known as “recency bias” has boosted their misplaced confidence. It reminds me of Warren Buffet’s quote “what we learn from history is that people don’t learn from history”.
Investing on emotion is a dangerous proposition. We meet many people who have been lulled into a false sense of security over the past year mistaking luck for skill. Anyone taking excessive risk over the past two years has been rewarded while risk management has been a drag on performance.
I frequently tell clients that we have no idea what the stock market will do tomorrow, next month or even next quarter. I believe that acknowledging that gives us a competitive advantage over a majority of market participants who are arrogant and/or overconfident. A Nobel Prize winning group called Long Term Capital Management once reminded us that no matter how smart you are, you can have a lifetime’s worth of work wiped out if you are not prepared for the mood swings of Mr. Market.
Robert J. Luna, CIMA