Happy 2014!??

Written by Jerrold "Lex" Grecu, CFA, CFP(r) on 03 February 2014.

January was a rough month for stocks and today saw another sharp decline on Wall Street.  Some have concerns about whether the recent selloff is the start of a long-feared correction.  I suspect that this recent downturn will not turn into a true correction.  I simply don’t see the market facing as many hurdles as some people think and we’re probably going to see a bottom to this mini-correction in the weeks ahead.

  1. The U.S. Economy is growing.  The U.S. economy has some great momentum and last week’s release of the government’s GDP report, which showed the economy grew by 3.2 percent in the fourth quarter of 2013, was in line with expectations.   If we continue to see good numbers in the U.S., the market will forget about emerging markets which were the impetus to this recent pullback.  We’ve seen emerging markets suffer in the early to mid-90’s and that was an amazing bull market in the U.S.  One can’t claim that “as emerging markets go, so goes the world.” 
  2. U.S. Stock market valuations look reasonable.  At a current PE ratio of roughly 17, the S&P 500 is valued near its historical average.  Stocks neither appear cheap nor expensive at this point.
  3. There are a lot of buyers on the sidelines that missed last year’s big rally.  They are kicking themselves and still waiting for an entry point to get back in.  If the market stays down and shows some sign of bottoming, many of these new buyers could be coming into the markets to provide support. 
  4. Bond yields are very low so there isn't a compelling alternative to stocks at this moment in time.
  5. Investor optimism is still pretty low.  Typically, major corrections are setup by investor over-confidence and, in the words of Nobel Laureate Robert Shiller, “irrational exuberance.”  We’re not seeing the sort of excesses that come with irrational exuberance.  

Markets frequently correct and those investors who have gone through the many market corrections of the past 40 years have been handsomely rewarded if they sat tight and were disciplined enough to rebalance their portfolios (which we do for our clients).   The stock market is currently down about 6% from its December 2013 high.  This recent correction came after a strong 4th quarter run-up in stocks which capped off the best yearly return for US stocks in 16 years.  A pullback is as inevitable as its timing is unpredictable.  We know it’s out there but nobody knows when it will happen and what it will look what to do?!

Well, the good news is that you do not need to time the inevitable ups and downs of the markets in order to successfully invest in them.  No crystal ball is needed.  If we accept two premises – 1) that markets are going higher long-term (I believe strongly that this is the case) and 2) dips will occur along the way but we won’t know when – then the only prudent strategy for the long-term investor is to take advantage of the dips through rebalancing (selling asset classes that have outperformed to buy asset classes that have underperformed, or in other words "buying low and selling high").  Does it work?  Simply put - Yes!  Not all of the time, but thankfully most of the time...and enough of the time to make rebalancing a great tool for adding to our long-term returns.

Of course whenever markets drop suddenly, especially after a run-up in the previous three months, many investors think “the party is over!”  But historically has that been the case?  The answer is no.  I searched our returns database to find all periods in which the S&P 500 dropped 5% following a positive three-month period.  I then collected the returns data for the following 12-month period to see if the typical 5% sell-off following a hot quarter was truly a sign of what was to come…or just a "breather" before the race resumes.  The data is below:
Table 1: S&P 500
Data from January 1972 to December 2012.

Date of > 5% Correction Return for Month Return for Subsequent 12-Month Period
November 1978 -10.82 -23.76
July 1975 -6.59 +21.20
October 1978 -8.91 +15.34
October 1979 -6.56 +32.04
March 1980 -9.87 +39.85
August 1981 -5.54 +3.31
May 1984 -5.34 +31.99
July 1986 -5.69 +39.24
September 1986 -8.22 +43.36
October 1987 -21.52 +14.74
January 1990 -6.71 +8.39
August 1997 -5.60 +9.05
August 1998 -14.46 +39.82
January 2000 -5.02 -0.90
December 2002 -5.88 +28.69
June 2008 -8.43 -26.22
May 2010 -7.99 +25.95
AVERAGES -8.42 +17.77%

Two things become clear to me upon examination.  First, a crystal ball would be a wonderful thing.  Secondly, in a world without crystal balls it’s probably a good strategy tobuy on large dips that are preceded by positive quarters.  More often than not, the monthly drop isn’t a harbinger of what’s to come but instead a short breather before momentum carries the markets higher.  Of the 17 major monthly corrections above, only the drops of November 1978 and June 2008 were followed by a meaningful period of negative returns.  The average subsequent 12-month return was +17.77% which is about 8 percent higher than the annualized long-term return of 9.76% for the S&P 500 (1972 to 2012).

In summary, the current economic data doesn't tell me that the bull market has ended and the historical data doesn't support selling after large monthly dips.  Interest rates are still low and GDP is projected to grow in 2014 at a Goldilocks rate (not too hot, not too cold).  Investor and consumer confidence, though much improved since 2008-09, is still pretty low for any significant correction to occur.  Stock market weakness in the current economic backdrop is likely a buying opportunity and if the “tolerance bands” around our targeted asset class weightings deviate by a significant amount, we will use the drop as an opportunity to buy stocks at lower prices.  We think this strategy has a high probability of adding value over time.

So let’s hang in there during what will likely be a bumpy ride in 2014 as the Federal Reserve slowly removes stimulus from the economy.  And by the end of 2014, I believe investor confidence might be stronger as a result of the Fed tightening monetary policy.  Just knowing that the Fed would not be turning off the spigot unless they thought the economy was strong enough to move forward on its own should provide increased confidence to a great number of investors….including yours truly.  While we may pause in 2014, the stock market probably still offers considerable upside beyond this year.

Thanks for reading!

Jerrold "Lex" Grecu, CFA, CFP(r)