October 11, 2011
Why Up Can Mean Down
The Investment View from Prescott, Arizona
When I first became a director of the National Association of Active Investment Managers (NAAIM) back in 2005, one of my projects was to devise a new financial indicator called the NAAIM Survey of Manger Sentiment. I’m pleased to say it is becoming widely followed in the industry with many newsletter writers and websites re-publishing our data to many thousands of investors and money managers, including write-ups just yesterday on both Forbes.com and Jim Cramer’s TheStreet.com.
NAAIM members collectively manage around $15 billion dollars and have widely varying styles that all share one common feature. We all adapt our client’s portfolios to these changing markets. The Survey is a way to measure those changes.
Each week the Survey generates a single “NAAIM Number” which represents the average exposure to the stock market across our entire membership. This gives the world a peek at what professional money managers are thinking and doing.
Last week the NAAIM Number reached a record low of minus 4.18% meaning the NAAIM member managers were mostly out and a little “net short” the stock market, betting that it was going to decline. This is only the third negative reading in the history of the Survey, surpassing the previous record set in October 2008 when the financial crisis was unfolding.
Other “sentiment indicators” covering individual investors, newsletter writers, commercial traders, and more, were also posting very low readings recently, and these became the source of numerous articles all proclaiming that since these readings were so low, the market is about to go up. Another way to say that is that low confidence among participants is a bullish sign.
I frequently say that this is a crazy business, and the backward appearance of these indicators adds to the feeling of craziness. It is not that those surveyed are wrong, but there is more going on than meets the eye, so let me put it in perspective with a review from Econ 101.
The market’s price reflects the numbers of buyers and sellers in that market. More sellers make a market go down and more buyers drive it up.
What makes the sentiment indicators look backwards is that if all of those investors are already out of the market, it really means they can no longer be sellers, but can only become buyers. These low readings mean we are in the process of running out of sellers which will stop the market’s decline – at some point, anyway.
However, simplistic views rarely reward investors, so I would not jump back into the markets right yet based upon the sentiment indicators.
After the last record low NAAIM Number on October 8, 2008, the market declined for another five months losing an additional 31% of its value. Running low on sellers does not mean there is an excess of buyers, only that at some point it will be easier for buyers to outnumber sellers.
Sentiment Indicators are only one investment tool, and just like mechanics have more than one tool in their bag, so do wise money managers.
Other conflicting (still bearish) sentiment indicators include low mutual fund cash levels at only 3.4% of total mutual fund assets, according to SentimentTrader.com. This means two things. If mutual funds are met with a wave of redemptions they can be forced to sell stocks which in the midst of a decline can drive the market down even further.
Mutual funds also are not in a position to buy much, even if they wanted to. They just don’t have the cash, so they are not potential buyers, only potential sellers.
Another negative indicator is the “Smartest Ever” series of books for investors which advocate “A Stress Free Way To Reach Your Financial Goals”. Uh-huh.
The series, which encourages investors to buy and hold investments, was launched in 2006, just prior to the beginning of the incredible real estate reversal which was the greatest commodities collapse ever and the greatest stock market decline in generations.
The continuing popularity of this series highlights the remarkable complacency to the downside risk of investing in a buy-and-hope manner. It is one more sign that there is still a large group of potential sellers out there that have just not yet given up on the siren’s song of 1990s style easy-money investing.
Yes, there could be a lot more selling since only the quickest to react to the realities of the markets appear to have done so.
I hope that the next wave of selling will be the one that washes out these holdouts and creates a final bottom to the market. That will set up a wonderful opportunity to make money, similar to that which began in 2009, and we will want to be there when that happens.
September Webinar Recorded Online
Our first online seminar called Discover the Three Toughest Issues Affecting Your Investments Today and the Secrets of How to Deal With Them was great fun and had good attendance.
We recorded the program and posted it to our website. It is now available to you at your convenience. To listen to this 40 minute presentation, just go to hepburncapital.com/webinar.html. You will have to enter or establish a username and password if you don’t already have one – it is very easy, but required for compliance purposes.
The technology is pretty cool, and we may use it in the future for quick, 3-minute updates when the market is doing something unusual.
Q: You throw away the outside and cook the inside. Then you eat the outside and throw away the inside.
What did you eat?
A: An ear of corn
How’s the Market Doing
What’s The Trend and When Will it End?
“How is the market doing” is never a simple answer because it really depends on the time frame one is referencing. I tend to mark these time frames from turning points in the market activity rather than some fixed number of days, weeks, or months.
The short term, since September 30th, shows the market advancing, although yesterday (Friday, October 7th) was a down day.
Intermediate Term, since August 31st, shows the market declining as does the longer term, marked as beginning on April 29th.
Interestingly, these recent turning points all occurred on the last trading day of the respective periods. This indicates that fund managers are engaging in “window dressing” to make holdings reports look one way as the fund quickly changes to a different direction. This is gamesmanship in the mutual fund industry.
Over the very long term, the market, as measured by the performance of the S&P 500** with dividends reinvested is 19% below its 2007 high, and when adjusted for inflation, is even further below the highs of the year 2000.
So, clearly the market is in decline and I don’t think we will be in a position to say the bear market is over at least until the cloud of the European financial crisis dissipates.
European banks are in the same situation ours were in during the summer of 2008, as lending between banks is drying up because each bank is afraid that the other is insolvent and won’t be able to repay a loan. This creates pockets of crippling illiquidity – lack of currency to grease the wheels of the economy. This is the same type of thing that happened here in the 1930s, when 11,000 banks folded and no one could get cash.
So, Europe has serious issues to deal with and I don’t expect theirs will get cleaned up any more quickly than ours did. We need to keep in mind that it took the US stock market many months to rebound after we were at this same point, so we don’t want to get ahead of ourselves.
What’s Going On In Your Portfolio?
Our Flexible Income* model portfolio holds a large portion of a rising dollar fund, a diversified bond fund, and a long-term Treasury bond fund. The Federal Reserve declared themselves to be buying long term bonds to hold interest rates down, which ought to reduce the risk of owning this type of investment. At least that is the theory.
The Careful Growth* model portfolio is heavily hedged with two inverse holdings that go up as the stock market goes down, along with our Japanese fund and a rising dollar fund. Overall we are “net short” the stock market, meaning our goal is to make money if the stock market declines.
Our Muni* portfolio is fully invested in high yield muni funds.
What We Were Saying Back Then
An Update on Gold and Commodities
Gold has been in the headlines all year and a wild couple of months saw the price drop 16%. That loss is hardly a blip on long term charts, but since I saw that decline coming I sold off our gold holdings this summer to avoid the loss.
Silver is another story, sort of like gold on steroids, having dropped a whopping 42% from April 29 to Sept 26, 2011, giving up all its gains for the year in the process. According to the math of losing, that kind of loss will take a 73% gain to recover from. It is not easy to buy something and hold it through a big decline like that so I wish all those who are doing so a lot of luck.
Platinum only lost 23%, but did it in just 45 days. Ouch! Crude oil at $83 a barrel (as of October 7, 2011) is down from $113, and copper at $3.20 is down from $4.50, with each indicating weak industrial demand due to the economic slowdown that is going on.
While prices like this may feel good at the gas pumps, it says that the economy is a long way from getting well.
Our Spotlight Strategy
Our Flexible Income Strategy strives to outperform the U.S. bond market over long periods while taking less risk.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.