Q&A {Part II}

Today is day two of our Q&A series.  Yesterday we discussed the changes to our market ratings back in March.  Today we will go over what prompted us to make those changes. 

Let's circle back to one thing from yesterday.  Do your market changes imply that equities will decline?

No that is not what I am saying.  As I noted yesterday if you took our changes as some sort of timing service than you would have lost out on a pretty good move in March.  I have no idea where stocks will be a month, six months or even a year from now.  Nobody else does either.  If they say they do then they are lying.  I use an approach that weighs all the evidence we see and then assigns a probability value to a certain event or series of events.   First let's define what I mean by probability.  There are books written on probability theory and financial analysis but here we will simply define probability as the chance that something will happen. We take these probable outcomes and apply it to our client's investment strategies.

Every investor should have a long term investment strategy. For my clients this comes by understanding their unique risk/reward criteria and then incorporating that into one of our different investment disciplines. Each of these strategies is based on something I call the playbook. The playbook is situational analysis based on historical market results. We study money flows along with the disciplines of fundamental and valuation analysis to see how markets have responded to similar historical events. The playbook gives us different scenarios regarding current market activity and it comes from understanding probabilities in the following disciplines.

Fundamental analysis:  Here I balance out various factors such as economic growth, government policy, corporate and sector analysis to derive where we are in the investment cycle.  Currently I think we need to weigh an economy that is definitely improving with some of the fiscal drags that are still weighing it down.  The housing crisis, European debt issues and high unemployment are three issues that come to mind.  Currently I still believe that the economy has the potential to grow between 2-3% this year.  It is unclear to me at this time how much of this is now factored into the move we've seen this year which leads to the 2nd leg of our analysis....

Valuation:  In our 1st Quarter letter to clients I discussed a valuation analysis that put year end 2012 valuation potential for the markets between 1350 and 1450 on the S&P 500.  I believe that economic growth in the 2-3% range this year supports that range and I will discuss sometime next week why I think markets have the potential to trade higher than that by the end of the year.  But I am also aware that the S&P 500 ended the 1st quarter within 1% of our midpoint analysis and is about 3 percentage points below our 1450 range.  On top of that I have to factor in the 25% rally we've seen since last fall and you begin to get the feeling that maybe we've come to far to fast.

Money Flows:  All of our indicators in all of our time frames are flashing overbought and have done so for months.  Some of the other indicators such as percentage of stocks trading over their 40 and 200 day moving averages are at levels that have historically signalled overbought levels.  When I add all of this up it simply signals that more caution is advised.  Put it this way.  Last summer when we were gingerly sticking a toe back in the markets we encountered a lot of disbelief about that stance. In the short run {meaning in a few weeks to a few months} those who may have questioned that stance were correct.  However it is some of these positions that we have been scaling out of the markets in the past few months, many of these sales are for nice profits.  The fact that there is the same ambivalence now to selling as there was then to buying is to me a tell on investor sentiment which I think now is perhaps leaning too bullish.   When I add all these factors together, I get a market where the weight of the evidence says more caution is advised.

So are you saying the market is overvalued and headed for a correction?

Not necessarily.  As I said before I think stocks still have the potential to move higher later in the year but I also think we are in a period now where stocks will have to prove themselves and are now entering a "show me" phase.  We're likely to get a clue on where we may be going in the next few months by what kind of earnings reports and guidance that corporations start to give as they report their first quarter earnings.  Also remember that stocks can correct by price {a market decline}, time {a churning phase where neither the buyers or sellers seem to have the advantage until price discovery catches up with economic and corporate realities} or both.

If there is a correction how deep could it be?

Well that's a question to which nobody can actually know an answer.  Sometimes corrections feed on themselves and markets overshoot to the downside.  However, probability and historical evidence suggest that stocks could be vulnerable to a 4-7% correction.  If that would occur then from their most recent highs stocks look to be vulnerable down to between 1320-1360 on the S&P 500.  Now I am not saying that is going to occur.  For one thing there has been a persistent bid under the markets for months.  I think there's the possibility that all these trillions of dollars sitting in money market accounts earning nothing just might be enticed to come even a little bit back into the markets if we would get some kind of correction.  So while I think it is possible to trade down to those levels it also might not happen.  There is also short term support at both the 1360 and 1320 levels by our work.     

One final note, we are closed tomorrow in observance of Good Friday.  

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