The market volatility continues over these summer months with triple digit moves both up and down being the norm. The S&P 500 Index, a useful gauge for the markets as a whole, has moved back to near breakeven for the year which is at the mid-point of its 2010 range. In late April the S&P 500 had been up as much as 9.15% but had given back all of its gains and was down by as much as 8.34% in early July. A wild ride in just over eight weeks time! (It is worth noting that the S&P 500 Index (excluding dividends) currently stands exactly where it was in March of 1998.)
Most major market indexes have experienced a similar path in 2010, including large cap value, large cap growth, emerging markets, commodity-based equities, and high yield bonds.
Markets are made up of tens of millions of individual participants each with a voice in the direction any particular market will take. Buyers of individual companies or packaged investments (such as ETFs) cause prices to rise; sellers of these same investments push prices down. It really is that simple. As such, the markets reflect the voices of these millions of participants, each expressing an opinion about what something should truly be worth. The larger the investor, the more weight the voice is given. Right now there is a significant disagreement among the market’s many participants about what the future value of whole economies really should be, most especially the economies of The United States and the collective economies of the Eurozone. Until an agreement (or at least a consensus) is reached by the crowd of investors, I would expect the choppy, directionless market to continue.
The Appleton Group Composites™
The discipline we employ is best described as a “trend following” strategy. In its most basic form, trend following uses the prices of any investment (such as real estate, equities, etc.) to identify both rising and falling price trends. Investors are best served by participating as much as possible in rising price trends and they are served best by minimizing (or eliminating) participation in falling price trends. In other words, investors should buy securities during the early stages of an emerging rising price trend (on the assumption that the trend will continue to rise) and investors should sell securities during the early stages of an emerging falling price trend (with the assumption that the price trend will continue to fall). So what happens when the emerging price trend fails to continue as expected? We usually experience a brief period of underperformance.
This simple outcome has been the most trying aspect of our trend following strategy since its inception more than ten years ago. Over this period of time the market has occasionally experienced the kind of unpredictable, choppy and frenetic market that we are stuck with right now. Looking back at the past 10 ½ years of S&P 500 data, the market has experienced “trendless” environments only ten times, together lasting approximately 21 months. This represents approximately 17% of the time, with the remaining 83% experiencing clear sustainable trends (either up or down). I can say from experience that these trendless choppy periods of time have never been fun, and I know how emotionally difficult that uncertainty can be.
And this has always been true. Over the last decade these kinds of trendless and choppy markets can and do often create a period of brief underperformance. Markets begin to trend lower, we adjust and the market reverses itself. The market advance triggers another adjustment to avoid being on the wrong side of the market for too long, and the advance we have just responded to fails to materialize. Such is the nature of a disagreement – in fact, that’s exactly what trendless markets are. The crowd of investors simply fight to push the markets in a direction (up or down) until one side wins out. Often, it doesn’t take too long for the crowd to get itself organized and for the herd to move in a specific direction. But given the presence of both extreme economic uncertainty and massive government stimulus right now, it’s no surprise that there is a real battle going on that will ultimately be resolved – one way or another.
I also know from experience that when a sustainable trend does emerge it can be a powerful force. Once the markets do start to move this period of relative underperformance can quickly change. As the summer draws to a close I would expect to see a clearer picture emerge heading into the fall and into the upcoming elections.
Almost eighteen months ago it became evident that the Federal Reserve would do everything possible to fulfill its mandate to produce price stability. Chairman Bernanke knew then that the way to avoid a cycle of falling prices for housing and wages and businesses was to enact monetary policy that would keep the system flush with cash. It began as a simple injection of dollars into the banking system. It then escalated into a purchase program for troubled assets. It than morphed into a strategy to specifically buy mortgage securities, and now is targeting 3-10 year U.S. Treasuries in an effort to keep interest rates low. Figuratively speaking, the Fed has thrown everything at the economy except the proverbial kitchen sink. My assessment of the Fed’s impact has remained intact for the past year or so: either they will be wildly successful (and generate inflation much higher than expected) or fail miserably (and cause a protracted environment of sharply falling prices).
The battle currently being waged by the markets reflects the reality that the end result could still go either way. It has often been said that the market hates uncertainty, but for foreseeable future that’s all we can reasonably expect. While corporate profits have been good, it is difficult to say how much of that is reflective of genuine demand as opposed to artificial stimulus. If it is a result of the stimulus, that medicine is certainly wearing off and because another dose seems unlikely corporate profits may begin to turn downward. Unemployment remains stubbornly high but may reflect the transition away from an economy based on artificial growth to one based on true need.
No President wants to be the one who presides over a contracting economy and high unemployment – a double dose of bad news come election time. There is always the possibility that additional job creation measures may be enacted between now and November; however, time is running short and with a significant push from the right additional stimulus appears highly unlikely.