Shifting Sands

This year, it appears few investors paid any attention to the well-worn adage “sell in May and go away.” The adage is premised on the notion stocks generate the bulk of their annual returns between the months of November and April. Had investors minded the rule, there is every chance stock prices would have declined, in a self-fulfilling way. Just the contrary, measured by the S&P 500, stock prices advanced 2.1% for the month of May. The stock index is now up 15.4% year to date, and an astonishing 27.3% for the trailing twelve months. Stocks have moved higher 11 of the last 12 months. The last down month in the market was a full year ago, May 2012.

This juggernaut stock market is confusing investors, many of whom have not recovered from the emotional trauma of the financial crisis. According to Bespoke Investment Group, June may in fact be the month the May adage takes hold. Data on the Dow Jones Industrial Average shows that over the last 100 years, the index is up less than 50% of the time in June. During the last 20 years, June has been the poorest performing month of the year (up only 40% of the time). In the shadow of months of steady returns, I would not be surprised to see some profit taking in the near term. This does not mean the bull market will end. It does mean that some profit taking and re-orientation of the leadership in the markets is apt to occur, and once it starts it will stir fears.

In my opinion, while stock prices in the U.S. are rising across the board, the foundation of these price moves is somewhat directionless. There has not been a consistent pattern of return to measurable factors. The tides, invisible on the surface, are shifting in ways that can make one fearful of going into the water. Often, stocks with discernible characteristics will lead the market. For example, often a characteristic such as dividend yield, growth, valuation, short-interest (you get the idea) will tend to lead the stocks sharing those characteristics higher (or lower). The recent tendency in stock prices has curbed the effectiveness of this type of analysis. Stocks are herding higher and the leadership changes from month to month.

The natural inclination is to attempt to correlate the behavior of stock and bond markets with news/data. Recent economic data is mixed, and supports the continued, if somewhat lumpy path of improving conditions for stocks. Consumer confidence, housing prices and the price of gas at the pump are a few of a multitude of economic indicators pointing in the

right direction. We are in an interesting place, where the growth figures are not strong enough for us to expect any changes in policy from the Federal Reserve. The Goldilocks economic data is allowing for an extension of quantitative easing. If and when the economy begins to heat up, (remember the Fed’s 3/20/2013 press release has targeted unemployment below 6.5% and inflation of 2%) there will be a period where the markets will likely re-set.

From a fundamental perspective, stocks look fairly priced. According to FactSet Research, the current forward 12-month P/E ratio is 14.4. The 10-year average P/E ratio is 14.1, so the market is in the ball park. Calendar estimates for 2014 are for earnings of $122.55. Extrapolating the price of the S&P 500 forward, using a 14 multiple, we might see the S&P 500 priced in the 1,715 range next year, roughly 5% higher than today’s 1,630 level. One could argue there is not a lot of upside in stocks, but a dividend of 2% and potential appreciation of 5% is more appealing than many alternatives.

The big institutional investors are pressed to direct new funds into stocks immediately. Institutions represent about 67% of stock ownership. They cannot afford the risk of a performance lag. When the gun goes off, they go. While acknowledging the risk of a performance gap, I think it much more prudent to work into the market, to attempt to buy favored assets at favorable prices. The opportunity cost of missing some near-term return is not nearly as great as buying into a heated up market only to see it begin to slide. Bear in mind, the S&P 500 has typically seen an annual pullback of at least 10% from its high. The largest decline this year has been 3.5%.

I expect some turbulence in the markets in the coming months, if for no other reason than the market will need to digest its recent gains. While I do not think there is evidence the bull trend will change course, I see inflated levels of investor greed and fear. This makes me feel this is the wrong time to stray from our established play book. Please do not hesitate to call if you would like to review you asset allocation.

Bruce Hotaling

CFA Managing Partner

The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.

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