Tuesday, November 18, 2014

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

From the Desk of Joe Rollins

October was clearly a volatile month. Although the stock market had been soft during the latter part of September, it really became unpredictable during October. This is not terribly unexpected, but at the same time it does not happen on a regular basis. As corporations start to announce earnings, the traders that make their living in volatility hedge their bets against whatever the companies will eventually announce. At one point during the month, the broad market was down to almost 10%. It got so bad that I even wrote an interim blog Conundrum where I indicated that even though the market was volatile, the underlying fundamentals were intact and there was no reason to abandon the market due to this volatility.

Looking back at that period in the middle of October, it was a scary time for many investors. However, having watched the markets for close to 40 years, these volatile times are not a rarity. Once volatility begins, it is important to understand why, and whether it is something you need to be afraid of or should just ignore.

As the end of the month rolled around, it was clear that my message to investors in “Conundrum” was correct. After all was said and done, the market rallied back to fully recover its 10% decline and actually ended up positive for the month of October. Who would have ever thought in the extraordinary volatility of mid-October that we would actually end the month in a positive light?

For the month of October, the Standard & Poor’s Index of 500 stocks was up 2.4%. The NASDAQ Composite grew 3.1% and the Dow Jones Industrial Average was up 2.2%. Even the beleaguered Russell 2000 was up a stunning 6.6%, which was the best of all the indexes. The S&P 500 is up 11% for the year as of the end of October and up 17.3% for the 12 months ended October 2014. The NASDAQ Composite was up 11.9% for the year 2014 and 19.6% for the year ended in October. The Dow Jones Industrial Average is up 6.9% for 2014 and up 14.5% for the 12 months ended October 31, 2014. In contrast, the Russell 2000, which has been extraordinarily volatile, is only up 1.9% for 2014 and only up 8.1% for the 12 months ended October 31, 2014.

Just so you have a basis for comparison, it is also interesting to see that the Barclays Aggregate Bond Index was up 1% for October and continues to be up 5.1% for 2014, but only up 3.9% for the one year ended October 31, 2014. While many people hide out in bonds in order to avoid volatility, we are almost certainly in a rising interest rate environment.

When interest rates rise, bonds move down. The Federal Reserve has already announced that they will begin increasing interest rates in 2015, and it would not surprise me to see rates move up faster than most people expect. As I will illustrate below, the economy is quite good and it is only a matter of time before the Federal Reserve begins moving interest rates up to offset an economy that might end up being “too hot.”

I recently spoke at a seminar on investing and thought I would go back over the years and illustrate why market timing is an absolute waste of time. When I first became active in investing in 1987, we were all crushed by the market crash on October 21, 1987. In fact, I saw many so-called experts using this time during October 2014 to surmise that the market would go down as much as it did in 1987. On that day in 1987, the Dow Jones Industrial Average went down 22% in one day. For those of you who are not familiar with this time, that was 22% in just one trading day - not a week, month, or year. Please look at the chart below illustrating this dramatic activity.

At that time, there were many forecasters that predicted the world as we know it would clearly end with the stock market sell-off. Many proclaimed that the financial world would never be the same and clearly a Great Depression was upon us, as they braced themselves for long bread lines and mass hysteria…

I have identified on the chart below when the stock market crash of 1987 occurred. On that fateful day, the Dow Jones Industrial Average ended down at a level of 1738. Today, the Dow Jones Industrial Average is 17,380. That means that the market has gone up tenfold since 1987. For those of you interested in statistics that is 1,000% higher than it was in 1987.

I only remind you of the 1987 crash because it was clearly on display in mid-October as the reporters on the financial news channels were exclaiming all the negatives that were set to occur. However, they missed many very clear signs that the economy was strong and earnings were stronger. Not a single day passes that I do not hear that the market will crash because it has gone up so much and so quickly. While certainly nobody knows what will happen over the short-term, I do know you can predict what the market will do over the long-term based upon interest rates, earnings, and the economy. If all three are intact as they are today, it is much more likely that the market will move higher rather than lower.

I started this blog by quoting Peter Lynch, who was maybe the most famous investor of our lifetime. Peter Lynch managed the Fidelity Magellan fund through some of its most successful years. I have read all of his books and enjoy his writing. The most important thing I like about his writing is his simple way of understanding the futility of trying to time the market. His philosophy is to buy good companies and the market will take care of itself. One of the most famous quotes relates to his position that you cannot predict the economy, interest rates, and the stock market. As Peter Lynch said, " If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes." I also enjoy the following because it is so true - “It’s only three dollars a share, what can I lose?” to which Peter Lynch replies, “Three dollars for every share you buy.”

While it gives me great pleasure in writing the words that my blog of October 15th was correct, I do not find joy in seeing my clients make moves that are not beneficial to their investment future. I wish I would have kept track of how many clients called indicating their concerns that the market was headed for a major correction. Despite very few of them actually making any moves after speaking with us about the markets, it still bothers me that clients are not evaluating true economic data, and choose instead to give weight to some of the ridiculous proclamations of so-called knowledgeable people in the financial press. If you are ever having a hard time evaluating data, please give us a call as we certainly would love to discuss it with you.

While writing this, I am reviewing the financial and economic issues in the US today. Clearly, there is no indication of a weakening economy when you read that the durable manufacturing is up 6.42% over the last one year, and capacity utilization borders on a full capacity 80% with a reading of 79.3% for September of 2015. Manufacturing is extraordinarily strong and that is a positive. Also, exports increased 4.5% over the last one year, even in face of a dollar that is strengthening dramatically due to the strong US economy. We hear so much about employment and the employment participation rate that it obscures the actual facts. While it is clear that there are way too many people living off government subsidies, employment has dramatically improved over last year.

Over the last two-year period, we have added almost 4 million new jobs. This is a significant number since this is 4 million people that can now contribute to the economy by buying goods and services, which improves gross domestic product. Virtually every aspect of employment has improved over the last year, although I don’t believe the unemployment rate is truly 5.8%, as the government reports. While certainly better, who knows exactly how good it is at the current time. But what I do know is that these previously unemployed 4 million Americans will now be contributing to improve the economy.

It is amazing to see consumer confidence up 30.52% over the last 12-month period. Standing at a percentage in October at 94.5% tells you that most people feel good about the economic future. Also, the index of leading indicators is up a robust 7.3% over the last 12-month period. Anyone reading the almost rosy economic statistics at the current time could tell it is highly unlikely a major negative economic swing could be occurring.

Earnings for the third quarter of 2014 were up almost 10% over the identical quarter in 2013 and interest rates continue to be zero or lower and as illustrated above, the economy continues to be strong. It is interesting to note the rate of inflation was recently announced at an annualized 1.7%. However, many of the people reading this posting today have funds in money market accounts earning zero and CDs earning less than 1%; having money in cash today means that every single day you are losing money to inflation as the cost of living grows.

I have indicated in multiple postings that the market will reverse when one or more of the indicators of interest rates, earnings, and the economy change. Currently, all three are positive and are increasing. When I wrote the blog “Conundrum” in mid-October, I had absolute confidence whatever was happening would not affect the stock market in a dramatic way. You may rest assured though that I have no pretense about predicting market crashes. No one can, no one will, and it is unlikely that I will even try.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

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