It’s about Sector, Not Economic, Weakness

Posted by on Apr 14, 2014

Hard to believe that just a little over a week ago, we set all-time high marks in both the S&P500 and Dow Industrials. File that under “how quickly they forget” because in just the few sessions since, newsreaders are now talking of the “risks of a correction” (a), as if corrections are to be feared and, (b) the inference is that we’re about to go back to 2008 again. Many investors see it that way and that’s making them more than just a little nervous.

Their anxiety got a boost when investor Marc Faber said the market is “setting up for a decline more painful than the sudden crash in 1987.” (I couldn’t find any reference as to when he said this would occur or its causes. I guess these details would be made known to you if you were to subscribe to his (aptly named) Gloom, Boom and Doom Report…)

Let’s look at what may have caused this swing in perceptions – especially with consumer sentiment having just been reported at its best point in nine months (1), initial unemployment claims at their lowest level in seven years (2) and job openings being reported at a six-year high (3).

Valuations

It seems very clear to me that the selling of the past few sessions, while made to seem dramatic, was really pretty straightforward. The sectors that have been under the most pressure have primarily been the biotechs, Internet service and social network companies. As a group, these are what are known as momentum, or story stocks. In other words, they have a great story that “should” work out great. They all have a bunch of revenue and a high profile. However…one part of the story this group hasn’t quite seemed to have figured out just yet is the bottom line.

Case in point, as brought up by Eddy Elfenbein writing in his Crossing Wall Street blog, is Twitter. According to his data, the company is expected to make a total annual profit of…one cent per share. And, their, forgive the use of the term, profit margin in the 4thquarter was minus 210%! While I don’t know if any others in the sectors, such as either Netflix or Tesla, are in such straits, I think the point is that all of them have – for now anyway – extended themselves beyond what their valuations justify. As a result, profits are being taken within them.

More to the point, what’s been going on is what’s referred to as an internal rotation. Further, it’s not been anything close to across-the-board selling. Finally, it isn’t about weakness in our economy.

Those high-valuation companies have been getting sold and the proceeds then being rolled into many of the cyclical, economically sensitive, and yet still much lower priced, companies – to include many of the “old tech” names like IBM and Microsoft. To demonstrate this lack of widespread weakness, a quick check of the Morgan Stanley Cyclical Index will show that it’s continued to hold up very nicely over the past few weeks. That would very likely not to have been the case if we had major challenges in the economy coming.

Emotion check

I bring this up in light of the current confusion in the markets and because this past week I saw a chart in the most recent JPMorgan quarterly chart book that reminded me of the painful error so many investors make. In short, it’s letting news / peers / the phases of the moon – whatever, affect your emotions and cause you to make bad investment decisions. Here’s the proof of that.

The folks at JPM identified 7 investment sectors, plus the rate of inflation, for the period from 1993 through and including 2012. In terms of annualized returns over the entire 20 year period, the top performer provided 11.2% per year. The lowest had a return of 2.3%, with inflation at an annual rate of 2.5%.

The top return, not surprising given the time period, was real estate investment trusts. The S&P500 and gold had an average annual return of 8.2% and 8.4%, respectively. Bonds had a 6.3% return and residential real estate (owned home) was in at 2.7%. So, who had the 2.3% and couldn’t even beat inflation over that whole period? The average investor took home that trophy. The reasons? They include no form of risk management in place, no overall investment strategy and, it would seem, little to no discipline.

This is why you need to work on the “invest and ignore” mindset. Create a strategy and stay with it so you can just laugh at the goofy people trying to make sense out of the daily confluence of random, noisy motion that is the markets.

The terrible trio

I’m referring to those three emotions that have ruled markets of all types ever since there were markets for anything. They are, fear, hope and greed. One or more of those basic emotions are always around the markets at any time. By understanding and acknowledging them, you’re that much ahead.

One of the easiest ways to set up a personal defense against being part of that 2.3% group – I have it on good authority that your brother-in-law is one of them – is to have a properly allocated asset investment plan. That there’s always a bull market in something is a truism on Wall Street. By you not trying to be a fortune teller and winding up over-committed into one or two investment sectors, you can vastly improve your chances to meet your goals. And, if done properly, you can also reduce the amount of overall risk you need to take to make that happen.

If you would like to talk about creating such a personalized allocation or would like a second opinion on what you’ve been doing – each without cost or obligation – please email at [email protected]or call me at 509-747-3323. We’ll set up a time to meet and I’ll even buy the coffee…

Summary

What’s going on now seems to be selling that’s primarily driven by sentiment changes; it’s the selling of last year’s market leaders. It’s not as a result of anything fundamentally being wrong or risky in either the markets or economy. We sure haven’t seen market over-valuation or speculative craziness.

Still a coin toss between the skeptics and the rest of us as to who has the “correct” market outlook. Economic indicators, here and in rest of the developed world, still point to strong growth. Barring the proverbial unforeseen events, I’m of the opinion that we’re in the still relatively early stages of a secular bull market that can continue to expand higher.

Don’t be concerned if or when we do have a correction. Just because we haven’t had one for over a year does not mean one is either imminent or that it will be “bad.” Plus, think of such an event as simply being a way to get the high quality stuff you’ve been wanting marked down…buying low is a good thing.

Cheers!

Mike

509-747-3323

(1) Department of Commerce, 11 Apr 2014

(2) Department of Labor, 10 Apr 2014

(3) Department of Labor, 8 Apr 2014

To get an overview of economic conditions, use this link. It’s updated monthly. http://www.russell.com/Helping-Advisors/Markets/EconomicIndicatorsDashboard.aspx

Past performance is not indicative of future returns.  Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment.  Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.