Friday, July 5, 2013

What the Hell is Going on With the Market?

Although the end of the first half of the year now behind us, the volatility in the financial markets in recent weeks warrants an immediate comment.

I continue to believe that, now more than ever, it makes sense for investors to own outstanding American companies for long-term growth.  For several years now my accounts have been fully invested in reasonably-priced quality companies and every quarter my client letter has said the same thing.  “We are seeing a bubble in gold and bonds that will at some point burst in an ugly way and stocks will emerge as the most attractive investment of choice.” 

It had to happen—the only question was when.  For many years, there were net inflows into bond and gold funds which were falsely labeled as “safe havens.”  Most of the money that fueled those bubbles came out of stock funds which suffered two full years of monthly outflows even as the market averages doubled. 

The media ads promoting gold flooded the airwaves and the pitchmen were often the same conservative “news” reporters who had been predicting economic catastrophe as a result of our government’s policies.  Their status as wise people gave them even more credibility with their audience and the ease with which investors could participate in gold and silver through Exchange Traded Funds helped inflate the bubble even more. 

Last month, Federal Reserve chairman Bernanke stated the obvious—that the U.S. economy was steadily improving and if that continued the Fed could and should taper the size of its bond purchases in the open market.  That innocuous announcement served as a wake-up call to investors.  When Bernanke repeated the obvious again last Wednesday, it was apparently the needle that popped the bubble.

During the ten trading sessions since then, 10-year interest rates have soared to over 2.70 percent—up from their lows of 1.60 percent just weeks ago.  Gold has plummeted to its lowest level in years.  Massive mutual fund redemptions are causing the rout to feed on itself.

These developments should have been great news for stocks.  The economy is getting better.  One would think that much of the money suddenly flooding out of bond and gold funds would be reallocated to equities.  Most stocks are trading at valuations that seem quite reasonable by historical standards.  So why are stock averages down by more than 7 percent in recent weeks?  If those of us who have favored stocks have been so right about the fundamentals, why is the stock market going down when it should be going up?

Here are a couple of thoughts. 

First, we are in an environment where the majority of trading in all markets is dominated by huge hedge funds and high frequency traders which has added to short-term volatility.  As a result, in this interconnected world, nothing happens in a vacuum.

For example, one large hedge fund manager reportedly saw his gold holdings drop by almost $200 million in value last Thursday when gold fell by almost $100 an ounce.  When huge leveraged funds suffer big losses, they don’t just sell off their gold—they sell whatever they can to raise the cash to meet margin calls and rebalance their models.

In addition, even as the U.S. markets have held up reasonably well in recent months and are still well ahead for the year, overseas and emerging markets have fared much worse.  The Dow is still up by almost 10 percent for the year while the MSCI Emerging Market Fund (EEM) is down by almost 20 percent.  The Chinese market in particular has been quite weak and fell by 5.6 percent today alone. 

Second, our media have become addicted to crises and do their best to scare investors whenever possible.  It is bad for the country but good for ratings.  By any reasonable measure, the downturn of the last week does not yet qualify as a crisis or a major turning point in the market.  What we have right now is a 7 percent correction in an ongoing bull market.  Last year, the market suffered two 10 percent corrections in what turned out to be a very good year.  This could just be part of the normal volatility that goes along with being a long-term investor in stocks.

The other media mantra is that stock prices have gotten way ahead of themselves and investors are way too exuberant.  But the fact of the matter is that a smaller percentage of Americans own stocks today than ever before in recent history.  On top of that, a recent CNN poll showed that 87 percent of Americans believe this is a bad time to be in the stock market.

During my 33-year career I have learned what a market top looks like.  In 1999, investors were firing their brokers for “only” producing 20 percent annual returns and were losing sleep at night because they didn’t own enough internet stocks and were missing out on the rally.  That is what a top looks and feels like.  It is almost the exact opposite of the sentiment among investors today.

So on balance, we live in a dynamic world where no reasonable person could say that “nothing has changed.”  A lot has changed and more is changing every day.

But our investment outlook remains the same.  Now more than ever, we believe that owning quality, well-run, reasonably priced American companies will prove very rewarding for investors with a medium to long-term investment horizon.

















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