June 6, 2014 | by Scott Miller, Jr.
You may have heard of the January barometer, which hypothesizes that the movement of the S&P 500 during the month of January sets the stock market’s direction for the year. It is reported that the January barometer has been correct 88% of the time since 1950. The S&P 500 declined 3.6% this past January. Steep market declines in 2008 and the first quarter of 2009 drove many market speculators to the sidelines. Speculation became a dirty word and was replaced with phrases such as “the market is rigged” and “I am waiting until things get better to invest.” People with the fortitude to remain invested adopted the much more sensible mantra, “I am a long-term investor.” It has been five years since the market bottomed in March of 2009 and it appears as if speculators may finally be returning to the equity markets. Some concerning signs include the amount of money borrowed to purchase stock, also known as margin, is nearing pre-crisis levels. I have never believed in using margin to buy equity. Money flows are also concerning as movement into more speculative areas of the markets including small caps are accelerating versus the more conservative large caps. New found market confidence is evident in financial publication headlines including the Wall Street Journal, where a February 21st headline read: “Individual Investors Pile into the Market” as stocks rose. It was just 8 months ago that Market Watch published a headline titled, “Five Reasons Everyone Hates this Market.” Such a drastic change in headline sentiment typically indicates that the markets are closer to a short-term high than low. Still another sign, TD Ameritrade reported January trading volume up a whopping 28% from the previous year and their February volume was even higher setting a company record for trades per day. Bull markets generally see a correction of 10 to 20% and hardly a day has passed over the last four years that I have not heard a market guru predict that a 10%-20% pullback is looming. Should we be concerned that we have not seen a 10% correction in over 3 years? Concerned is not the right word. Rather investors should be aware that a 10% pullback is a common occurrence when investing in equities. Studies conducted by Dalbar concluded that it is not the pullbacks that hurt individual investors rather it is their reactions which diminishes returns. In other words, unsuccessful investors allow markets to dictate their actions. I believe investors will have more success implementing a long-term strategy regardless of market conditions.
A common recommendation for investors on the sideline has been to wait and buy stocks on market pullbacks. The problem with this recommendation is that there have not been any pullbacks, and even if we see a 10% pullback, market levels would be considerably higher than when many of the so called gurus began offering this advice. This is an example of reactionary advice; if the market does this you do this. The market rarely does what the majority believes in and subscribing to this type of advice is worthless in my opinion. Perhaps some of the increased volume in equity trading is from those that were fed up waiting for pullbacks as they saw the markets continuously move up. This is another example of reactionary investing as opposed to investing with discipline, and these late comers have already put themselves behind the eight ball.
So here is the dilemma: the retail investor is back, there is increased speculation and trading, the markets have lacked a 10% correction in 3 years and the January barometer suggests a poor outlook for 2014. So what should an investor do now?
We do not recommend to investors try to time the market and certainly do not suggest getting out of the market as most of these worries have been with us for some time. We recommend you understand the investment vehicles we manage, and continue to ask questions and relay concerns you may have with your accounts. Most important is maintaining long-term investment goals and continuing to invest with discipline. Avoid the major pitfalls of becoming over confident and aggressive after market advances and overly fearful and conservative after market declines. It is most important that you know yourself as an investor and maintain your objectivity during all inevitable market cycles. There will be ups and downs and there will be a 10% decline in the market, and the worst thing an investor can do is attempt to time or react to these market gyrations.
Possibly the best chart I can share with you comes from Morningstar showing the premium (very unusual) and discounts of closed-end funds. When investors’ emotions become strained as it did in 2008-2009, the discounts of CEFs tend to rise in some cases to significantly under-valued levels. As you know, our approach is to purchase closed-end funds at the greatest discounts possible and reduce our positions as discounts narrow. The exact opposite appears to be happening and is additional evidence of reactionary investing and its detrimental effect on investment returns. We are carefully monitoring your investments and always welcome any questions you may have.