Musical Chairs

Stock prices, measured by the S&P 500, continued to move higher in March, gaining 3.6%. The market is now up 10.6% year to date and 13.96% for the prior twelve-month period. While many other popular measures of stock prices had already hit new high water marks, the S&P 500 chose to wait it out. The April fools aspect to the new high is that it’s not a new high at all, on an inflation-adjusted basis. I will leave that discussion to the market naysayers. We are in a bull market, and until something shifts, the prevailing trend is positive. Recent returns are above long-term averages, prices have moved higher in 9 of the last 12 months, and the last month of any true “stress” was May of 2012 when prices tumbled 6%.

One might think the relatively smooth pattern of stock returns during the last year would allow investors to begin to embrace the “bull” and allocate a higher percentage of funds to stocks. Yet, for individual investors, fund flows into fixed income mutual funds continue to outpace flows into equity funds. Investors seem to be busily listening to the chatter of Wall Street media pundits as though it were the background for a curious game of musical chairs. There is a sense of imminence, that everything is about to come to a stop, and no one wants to be the person without a chair.

In light of the markets recent high, we can look back to the last two times the market reached a high-water mark for some clarity. In early 2000 the S&P hit a new high. The market was coming off a period of growth like never before. Between 1995 and 1999 stock prices rose over 130%. Then, the technology bubble burst, and the market lost 50% of its value over the course of the next three years. In October 2007, the S&P again hit a new high. Investors had only just dusted themselves off from the Y2K debacle, when the subprime mortgage and subsequent banking crisis hit, again taking the market down by 50% over the course of the following 18 months.

So here we are today, the S&P touching a new high of 1,569 to close out the first quarter, and no surprise, investors are processing every bit of news as to whether or not this is the onset of the next crisis. I think this is somewhat misleading and unhealthy. The media attempts to attach meaning to every global event, and the resultant daily change in the prices of stocks, and this simply has no bearing on the long term merit of the assets you hold.

The characteristics of a bull market, one that is about to become a bear market, are quite a bit different than what we have today. Today, low but improving GDP numbers, high but improving unemployment numbers, low but improving sentiment numbers and moderate but improving P/E figures do not add up to the backdrop for a bubble or crisis. The fundamentals behind the market’s trend are positive and unlikely to turn on a dime.

When the market’s direction eventually changes, it will likely result from one of three sources. Interest rates are attractively low today, but when they begin to rise, and Federal Reserve policy changes course, this will have a negative impact on the markets. Inflation too is quite low, but when it begins to take hold (particularly wage inflation) this will also put some pressure on the markets. There is also the constant of the unknown event, the unanticipated thing that causes a true directional change in the markets.

April is one of the best months for investing in stocks. Just the same, prices are high. The market as a whole and most sectors of the market are overbought. This overbought state will temper itself with time. The transition from cash to financial assets at this moment requires some patience. Selectivity is critical. Moving from one market exposure to another (seeking better value or higher opportunity) at this point is highly recommended. Our indicators show certain stocks in the large cap growth space (domestic industrials, technology, health care) look attractive.

Long-term results require, in my opinion, a technique that allows investors to stay in the game. Deciding in absolute terms to invest, or not, is a game no different than guessing when the music will stop. To maintain, the focus must be on owning high quality investments (no products), transparency (the ability to identify and accurately price your assets) and liquidity (the ability to sell without holdbacks or other limitations). These are the same aspects I have long emphasized along with regular attention to asset allocation. Please feel free to contact me if you have any questions.

Bruce Hotaling, CFA

Managing Partner

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