Mid-Year Letter To Clients {Conclusion}

Today we will conclude our mid-year letter to clients, originally published July 23, 2012:

We are particularly mindful of the impact that market seasonality can have this time of year. Basically there are seasonal variations or patterns that come into play in most years. The study of these bullish and bearish phases means that we accept that stocks at some point will experience a sell off between 8-20%. This is simply the normal course of how markets behave in most years 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.

One of the reasons we believe this pattern works is the philosophy behind how institutional money is invested. Institutional money is a generic term for organizations 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. 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. 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 dries up {unless it’s bad news. It is amazing how many international crises begin in the late summer. 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 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. 

Stocks have ample reason to trend listlessly and perhaps decline a bit from here into the fall.  We are mindful of the problems that are out there and have our defensive strategies ready just in case they come to realization.  But stocks are cheap on a valuation basis based on what we know today.  While mindful of the fact that they could become cheaper still, the potential for earnings clarity as the year progresses, better than looked for economic growth and any resolution to the European situation have the potential to set stocks up for better returns later in the year.

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