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Market Falls 2.32%

sp500-today

It was an ugly day in the market in spite of the fact that it looks like a less than 1% down day.

How can that be? The market started out its normal ramp higher on no fundamentals (but on plenty of Fed stimulus and talking heads on television telling us why the market can’t go down), peaking at 10:30 EST. Then, its being reported by Doug Kass on his blog, the machines took over when a sell program clicked in when the yield on the S&P 500 and the 10-year Treasury Note hit the exact same level:

div-and-int-yield

I am looking at this as a 2.32% drop because from the top today (1,687.18 on the index) to the bottom (1,648.86 on the index) the market fell 2.32% – and subsequently recovered 0.35% into the close.

The above graph, courtesy of the Zero Hedge blog, shows how the two yields have been trending in recent weeks – as the stock market has moved higher, the yield on the S&P 500 Index has moved lower.

At the same time, the upward trend in yield since last Summer (as we’ve noted here on this blog a few times) – and in particular the big run up in the past couple of weeks since Japan started its own high octane money printing – has taken one of the support legs out from under the stock market.

If you are one of the people that has started to buy stocks for the yield this year because your CD’s and government bonds just weren’t paying anything – you now have a dilemma: do you continue to accept the added risk of investing in the stock market in order to get a 2.03% average yield on the market or do you invest in a 10-year treasury note with no credit risk (and no risk to your principal if you intend to hold the note until maturity)?

What you might see here is that if you bought into the stock market this morning at a 2.03% yield and the market dropped 2.32% from its high to low today, you are actually in the red, losing more on the principal of your investment than you will earn in dividends over the course of the entire year.

Now, the stock market does not exist in a vaccuum and people who are buying stocks for dividends aren’t buying the S&P 500 index in most cases. They are buying something like the Dow Jones Select Dividend Index that yields 3.33%, or one of many individual stocks that is yielding over 4%, to get some sort of realistic cash flow to live on. But how many of them will get scared by this sort of drop in the market and begin to sell their stocks because they cannot stomach to see their investment fluctuate in value (particularly downward)?

It is hard to say exactly, but based upon the 30+ years I’ve been in this business, a significant number of them will be sellers if this sort of thing continues. It happens every time we see the market go up for an extended period of time – people who are not stock market investors, who have lost significant amounts of their wealth in past corrections/bear markets/crashes and vow “never again” get convinced that markets can only go up and they are missing an opportunity. When they get in, it is time for us to be sellers and raise cash.

This past experience is widely known and understood by professional investors, and it is why the computerized traders set the parameters in their automated sale programs to automatically liquidate stocks when the yield on the stock market fell to match the yield on the bond market.

The question is, will this be a one day event (if the past six months is any indication, it very well could be an isolated instance – and after hours, the market has recovered 0.18% which might give credence to that one day assessment) – or will this be a multiple day event that will allow us to move back toward the 200-day moving average, a healthy situation that could provide the basis for a move to even higher highs by year-end.

Earlier this year, I posted a graph I really like that is correlated such that it is a leading indicator of the S&P 500 Index: the Mortgage Finance Index.

mortgage-finance-index

You can see how it (the red/black line) turns up before market rallies and down before market pullbacks – and it is still pointing down which could very well mean that the one-day theory won’t play out.

Another indicator that has a good track record is the CNN Greed and Fear Indicator:

cnn-market-guage

This comes from the Market Authority newsletter, but the way it works is that anytime the indicator reads > 90, you have extreme Greed in markets and within a week the market pulls back. You can see that we are at 91 on the index as of earlier today. This is another indicator that would likely point to the one-day theory being wrong, particularly if those new to the stock market decide to minimize or cut their losses and not experience a large pull back similar to some experience in the past – which ultimately leads to a self-fulfilling prophecy.

The final thing that has me thinking that we can see more than one-day down this time is that the hedge fund momentum driven stocks that have been a big part of driving the stock market higher were crushed today (as reported by Doug Kass):

OpenTable (OPEN) -6.2%
Zillow (Z) -6.2%
Herbalife (HLF) -5.8%
Green Mountain Coffee Roasters (GMCR) -5.8%
LinkedIn (LNKD) -4.5%
SodaStream (SODA) -4.2%
Netflix (NFLX) -3.8%
lululemon athletica (LULU) -3.1%

Momentum investing is a strategy that aims to capitalize on the continuance of existing trends in the market. The momentum investor believes that large increases in the price of a security will be followed by additional gains. The strategy looks to capture gains by riding “hot” stocks and selling “cold” ones. To participate in momentum investing, a trader will buy an asset, which has shown an upward trending price, not based upon any fundamental aspect of the company other than its price is moving higher. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend.

Unfortunately, when a momentum trend breaks, it breaks in a significant way. A good recent example of this is Apple losing 40% since September. And, many of us know someone that quit their job in the late 90’s to become a day trader and their boasts of how easy it was to make money in the market – where are they now? Likely not day trading as a career.

I’ve written here that the fundamentals of the economy, corporate earnings, and valuation would eventually matter to equity investors. There is no way of knowing if we are at that point or if today’s pullback will be shrugged off and the liquidity driven market moves higher on the backs of these hedge fund darlings.

My view is that the risk continues to be to the downside for the market and having cash on hand is a smart move long-term, no matter how dumb you look for not gambling alongside everyone else (and absent fundamentals, this year’s liquidity driven P/E expansion is really just a bet that the market will continue to move higher – much like the momentum driven day traders bet their family savings, kids college funds, etc., in the 90’s).

I will happily invest the cash we have been accumulating into some very good companies 5%, 10% or 15% below current prices. Investors need to look at the market with a 20-year time horizon and not a 20-day or 20-week horizon. If you are a winner over 20 years because you focus on fundamentals like earnings, valuation, and risk management – even if you underperform for periodic 20-day or 20-week time frames – you make a lot more money by focusing on the long-term.

We began to buy some very good companies as they pulled back 10% to 15% over the past few weeks – if we can get a broad sell-off that takes the rest of the market down to reasonable valuation levels, we will put the rest of the cash to work we have on-hand. Otherwise, we will continue to be selective and focus on the fundamentals and so we can continue being long-term winners.


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Make your bets in Las Vegas, not the stock market.

Mark