Are Stocks Cheap? {Part IV-Market Volatility}

Today I'm going to continue the series I started back in December regarding the markets and valuation. If you remember back then we started discussing market valuation. We started off discussing our basic philosophy regarding valuation. From there we gave an update on our outlook for 2011. We also introduced in that post an S&P 500 target price of 1,375 for 2011. In part III we discussed the positive effects of the 3rd year "Presidential Cycle" on equities and why I think an inevitable rise in interest rates this year may be ultimately construed as a good thing.

Today and in the next few days I want to step back and take a look at the risks in the market. Investors need to balance out both positives and negatives in the investment matrix and risk {to the extent it is known} needs to be factored into the market analysis.

Today though I want to separate market risk with market volatility. Market volatility can be defined as the relative rate in which a security moves up or down. Now if I had more time and you were more interested we could go off into a tangent about standard deviations and regressions to the mean. Instead I'll keep it brief and tell you how I view market volatility.

Much of how markets move on a day by day basis is random with short term players looking to make money using a variety of strategies that can place markets in very short term over bought or over sold levels. There are strategies that can be used to take advantage of this but frankly most investors don't have the time, inclination or mental discipline for it. However there are seasonal variations or patterns that come into play in most years that investors should know about and use to their advantage. Understanding the seasonal aspects of stocks is one of the principal tenants of our money flow analysis.

The study of these bullish and bearish phases means that I accept as a given that stocks at some point this year will experience a sell off between 8-20%. This is simply the normal course of how markets behave in most years. It is part of the seasonal variation of how in a normal investment year stocks will cycle between bullish and bearish phases as measured by money flows.

Typically what happens is that at some point stocks become over bought enough that the supply of buyers is exhausted. Stocks fall under their own weight when that happens. This is true in bull markets as well as bearish trading periods. Statistically stocks are most prone to sell offs in between March and October of the year. The chart we've shown below is a daily chart of the S&P 500 for 2010. It shows what I like to think of as a typical trading pattern for markets. Of course this can vary and it does not occur every year in such a neat pattern. But if you study market patterns from 1900 to today as I have you will notice that these same tendencies occur again and again.

In 2010 stocks began the year advancing and building on what was perceived as decent economic prospects, especially in the US. Stocks stalled in late April as data began to call into question whether the economy would indeed recover and as investors tried to price in the negative aspects of policies coming out of Washington such as the healthcare bill. A crisis over European debt prompted a sell off in May exacerbated by the one day flash crash.

Stocks spent the next four months building a base and began to rally later in the year. They were helped by the fact that the European problem seemed contained and that economic growth was indeed better than originally feared. The kindling that really stoked the flame was the Republican landslide in November and the prospects of more pro-business and pro-growth economic policies from the capital. This lead to the astounding better than 5% rise of the markets between Thanksgiving and the end of the year.

It is important to note that while the events of last spring are used to explain why stocks were so weak at that time, it is likely that some other event would have prompted a sell off if these things had not occurred. The markets had reached a point both in terms of valuation and in terms of money flows that meant we needed a perfect scenario for them to keep advancing at that point. Disappointment was met with sellers stampeding towards the exits.

Stocks are currently headed or are already over bought by many of the systems we use to measure such things. In the jargon of the business stocks are acting "tired". That is why I think probability indicates stocks could rest here. I'll repeat what I said on Monday that if we look for what market action would cause the most pain then I think a market that does nothing for awhile would fit the bill. Seems to be to many people talking rather loud about how stocks are going to correct big or go up big.

That is not to say that I think stocks won't rally at some point. If the normal year pattern holds {and it of course may not} than stocks should experience some sort of advance before finding a level of resistance/valuation that forces the buyers to pull back. I think the more serious pullback for the year is likely to occur later in the spring as that is the seasonal norm. As always we'll let our indicators be our guide in watching how money flows in the markets. We will react accordingly to that.

Stocks can correct by time {churning around and doing nothing}, by price {that is by declining} or by a bit of both but correct they will. It is part of the normal course of events and ultimately is healthy for stocks in that it keeps markets from becoming overheated.

In the next post of this series I'll look at events this year that could possibly derail the rosy forecasts that Wall Street has put in place.

*Long ETFs related to the S&P 500 in client accounts.