Q&A {Part III}

Today is part III of our Q and A. 

You place a lot of emphasis on market seasonality.  Why is that?

We have touched on this in past client letters here   here  and here.  Basically  there  are seasonal variations or patterns that come into play in most years. 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.  While market declines can come at any time, statistically stocks are most prone to major sell offs in between the months of March and October.

As I've said in the past {see link above} one of the reasons I think this pattern works is the philosophy behind how most of what we refer to as institutional money is invested. Institutional money is a generic term for large institutions such as pension plans and large asset managers such as mutual funds. It is managed on a relative basis usually tied to a specific benchmark and is also managed so as to not give up the assets. By relative basis I mean as an example in a market that loses ten percent, institutional accounts that go down only 8% are said to have outperformed their peer group. That influences how their portfolios are set up. Institutions generally start a year with similar economic and valuation expectations for stocks.

Institutions have a very strong incentive to be heavily invested in the early months of a new year. They are afraid to fall too far behind their benchmarks. Their thinking is similar to that of a baseball manager at the beginning of a long season. The manager knows you don't win a pennant in April but you can lose one during that time. As the year progresses and in particular if stocks have advanced in the first few months, equities begin to look less attractive on year end expectations. Stocks will either need unexpected positive news {i.e. better than expected earnings news or higher economic forecasts for example} or prices will begin to stall out.  One of my concerns right now is that the markets have had such a strong move that much of the economic expectations are already priced into stocks.  If companies don't excessively move the needle higher on earnings and sales going forward than investors, especially those with a shorter term horizon,  may begin to lock in their profits.  

Stocks will fall of their own weight unless there are marginal new bidders for their shares. Summer is typically a down period for Wall Street as the news flow often dries up {unless it’s bad news. It is amazing how many international crises begin in the late spring/summer period. Both World Wars, the Korean War, 9/11, the First Gulf War and the 2008 banking crisis are examples of this.}

Summer is also when analysts begin to fine tune their expectations for stock prices as clarity begins to enter the picture about year-end economic activity. Stocks will also begin to discount any lower revisions or negative economic news during this period of seasonal weakness. Once this discounting process is completed stocks will usually then begin to rally sometime in autumn. The cynical amongst us also know that the only print that matters for most money managers is the one shown when the market closes on December 31st. To put it simply Wall Street wants to get paid. So there is a strong incentive to boost share prices during the 4th quarter of the year.

So where are we in this yearly investment cycle? 

We are on the verge of entering this more seasonally weak period.  Again I would stress that there has been this strong underlying bid for financial assets all year.  It could be that the seasonal pattern this year looks similar to 2009 when there was never really an opportunity to use pull backs to your advantage.  Stocks that summer I think never saw more than a 4% pull back.  2009 also saw markets recovering from the worst of the 2007-08 bear market and they were  more undervalued then than they are now.  It is also possible that economic growth will be better than most economists are expecting.  That has been the case so far this year.  As an example of perhaps a better economy, take autos.  Car sales are a pretty good barometer for how the consumer is feeling as they represent a large discretionary purchase that can be usually be put off for a significant period of time.  Car companies are seeing very strong US sales.  People are less likely buy cars when they are worried about their own personal finances.  

We see a lot of headlines about the high price of gasoline.  Your thoughts?

The price of gasoline has experienced a large runup this year.  But domestic consumption is actually declining to the point where we are actually net exporters of gas.  I think this has a lot to do with cars that are getting better gas mileage and the fact that people, particularly those that live in large urban areas may be driving less.  Also the mild winter may take some of the sting out of these increases.  I went almost two weeks in March where the heat never ran in my house.  March is usually the fourth highest month of natural gas useage for me.  My heating bill was nearly $150 dollars less in March than last year.  That pays for a lot of that gas increase.  Also this may be on the verge of stabilizing.  To that regard I'd note that energy stocks have not really participated in the rally this year.  We discussed this back in mid-March.