Will Q4 Be Strong Yet Again?

Fourth quarters in recent years have been strong periods for the equity market, but I wanted to put some hard numbers behind my recollections. I went back all the way to 1990 and calculated the S&P 500’s performance for each of the last sixteen fourth quarters. The results, shown below, were even stronger than I had remembered.

As you can see, fourteen of the last sixteen years have produced positive S&P 500 returns in Q4. The mean return for the period since 1990 has been 6.5%. The average gain in the positive years is 8.0%, while the average loss in the negative years is only 4.5%.

Does this mean investors should be 100% equities going into October? Surely some will do just that based on these statistics, but I am being more cautious. The market has had a very, very strong third quarter and I want to protect some of those gains.

Stocks simply feel overbought currently. With the average fourth quarter producing a 6.5% gain since 1990, I am going to have to take “the under” and say this year will be less impressive than average. On the bright side, I’ll be thrilled if I’m wrong!

Market Struggling to Break Out

The 1,280 level on the S&P 500 seems to be a very difficult area for the market to break through. The fizzling of yesterday’s early rally didn’t feel very reassuring and again today we have an early morning rally that puts the S&P right around 1,280. If we get more sellers in the afternoon and lose a 100 point advance again, the bears will use it as fuel to remain unimpressed with recent market action.

As for ways to make money in this trading range environment, Sears Holdings (SHLD) reports earnings on Thursday. I would expect a bottom line that exceeds expectations. Whether or not it results in a huge stock price move or not, I don’t know. However, the shares are trading $20 per share below the highs made after their last quarterly report. Retail earnings from Target, Kohl’s, Federated, and Dillard’s have been strong, much to the surprise of those warning of impending consumer doom. This bodes well for the Sears report.

Today’s Unimpressive Action

The market started out great today, opening up nearly 1% on a weaker-than-expected jobs report, but all of those gains have evaporated. Despite a bet that the NFP data will ensure a Fed pause on Tuesday (I still think the odds they raise are higher than the futures markets are implying), stocks feel like they are topping out again here in the high 1200’s on the S&P.

Honestly, we really should not be all that surprised that a Fed pause is already priced into equities. I mean, how many times have we had a huge “Fed is Done!” rally in recent weeks? On at least a couple of occasions we saw big triple digits gains on the Dow following dovish Bernanke comments or economic data. The real story isn’t what Bernanke does on Tuesday, but rather, what is next for the U.S. economy? The market doesn’t like uncertainty.

Without much confidence about what the next catalyst could be to get us back over S&P 1,300 and toward the old highs, stocks likely continue in their 1,225-1,280 trading range. Essentially, we need a lot of things to go right for the rally to gain steam. After the Fed pauses we need inflation to stabilize and GDP to remain in the 2-3% range, avoiding a recession.

Since rising costs are leading to company price hikes as a method of expense pass-through (which causes core inflation rates to rise), we also need commodity prices to stabilize or perhaps drop a bit. A slowing international economy would certainly curtail demand, and therefore allow for cost input prices to come down, but we would be walking a fine line between a global recession and merely more tepid growth. Until we see evidence that most of this scenario could play out, a “soft landing” so-to-speak, I can’t get excited about near-term stock market returns.

Getting the Froth Out

Over the last year or so the markets have done well despite the rally being very narrowly focused. Consider what was working up until May. International, energy, gold, copper, industrials. The investment banks did great too as M&A activity hit record levels. What about other areas? Healthcare, technology, telecom, media, banks, retail. Not a lot of performance in those areas, even though they make up a huge portion of the U.S. market.

The result of such a narrow market was that everybody began chasing what was working and shunning everything else. The copper move from $3 to $4 a pound was probably solely due to hedge funds piling in. The moves were parabolic, especially in commodities and international stocks. Finally we have reached a point where people are getting nervous, nervous enough to reduce risk. This is leading to extreme selling in the areas that have done best. Basically, we are getting the froth out of the market.

It is this explanation, and not anything fundamentally wrong with the companies, that is causing the massive sell-off. Goldman Sachs (GS) reported a great quarter this morning. The stock is down 6 points. GS is still doing well. In fact, they advised on the Maverick Tube (MVK) buyout announced this morning. The market action has been violent, but prices are getting a little out of whack with reality at these levels, unless the world really is headed for horrible times. Not impossible, but it’s tough to make that case at this point.

Uptrend Intact, For Now

If you look at the last month or so, you might want to quit the market entirely. However, it’s always a good idea to put things in perspective. An easy way to do that is to take a longer term view and see where we’ve come from in order to gauge how bad a pullback really has been.

Here is a three-year chart of the S&P 500. As you can see, the uptrend has not yet been broken, even though we are pretty darn close. I don’t know if we’ll hold and make a bottom around this level or not (by me putting this chart up, it could jinx that scenario a little bit), but it is an interesting chart, especially for any of you that like technical analysis.

As far as what could help us in the quest for a near-term bottom, I really think it is in the hands of Bernanke at the upcoming Fed meeting. My thesis for why the market made new highs in April, despite many apparent headwinds (soaring commodity prices and rising interest rates), was that equities were pricing in an end to the rate rising cycle.

As soon as it became clear that 5% might not be the top in Fed Funds, we lost nearly 100 points on the S&P 500. As you know, the market hates uncertainty, which is what we have right now. Some are predicting a Fed pause in late June, whereas others are calling for 5.5% or even 6% Fed Funds this year.

If Bernanke would just quit it already, we could very well hold the trend line in the above chart and make our way back to where we were the last time investors thought rates were finished going up. Conversely, if we get another rate increase and more uncertain talk from the Fed in a couple of weeks, it’s unlikely we’ll see better times on Wall Street anytime soon.

Yesterday’s Capitulation

If a market is oversold you always want to see signs of capitulation as a tell that a short term bottom has been made. Yesterday’s action surely looked at lot like people throwing in the towel to me. After dropping more than 170 points, the Dow actually finished the day higher by 8 points. It looked like a good example of a selling climax.Where did that sell-off put us in terms of the market correction? The S&P 500 hit 1235, which is 7% below it’s 2006 highs. Other indices such as the Russell 2000, which have led the latest bull run, are down far more than that. Yesterday that index of small cap stocks traded at 685, nearly 13% from it’s all-time high.

The overall market action has been interesting lately, to say the least. That said, and despite the fact that I have talked about it a lot recently, I am still not taking much action here. As I’ve said before, I am a long term investor, so most of my time is used monitoring companies and their specific business fundamentals, not market technicals. These companies are still doing well, even though most of their share prices have been flat-to-down since reporting Q1 earnings in April.

I only mentioned the overbought nature of the market a few weeks back to explain why I was raising cash levels in the portfolios I manage and to prepare my clients for a rather sharp sell-off. After all, they haven’t seen one since early 2003, and many seem to forget how ugly they can get. I have put some of that cash to work in recent days, but still have slightly above-normal cash levels.

Where do we go from here? Hopefully we have put in a short term bottom. I would still welcome a 10% correction on the S&P 500 to under 1200, and I think the odds are still good that we get that in coming weeks and months. However, yesterday’s trading action indicates we could get a bounce here before we head to that level.

How Low Do We Go?

Lots of emails coming in saying “good call on the correction.” Perhaps, but there’s nothing “good” about it if you are long stocks, that’s for sure. No matter how many times you’ve experienced nasty pullbacks in the market, and no matter how well you understand that we need to see this kind of action every once in a while, it still isn’t fun to sit through.

When will it stop? I don’t know, nobody does. I do think, though, if you had to pin me down, that we will continue to go lower. In fact, I almost prefer to get the whole 10% correction thing out of the way (we are halfway there so far). Let’s just take the pullback that we know is coming at some point, and move on to brighter skies.

Three and a half years is a long time to go without a 10% drop. Sure, we went 7 years in the mid 1990’s without an official correction, but that ended badly. Heading into 2006, Peridot was up 72% over the prior 3 years. That’s a lot. I’m more than willing to concede a pullback, and then we can run again.

As far as how to play this market, I’m not doing anything dramatically different. I did raise cash when I sensed we were setting up for a drop and posted such on this blog, but since I’m a long term investor and not a trader, I’m still very much net long. An above-average cash position for me is between 10 and 20 percent, since despite a near term bearish call, I still like the stocks I own looking out 2 or 3 years, and my investing time horizon is even longer than that.

I have sold my metals stocks (gold and copper) while holding tight on energy because of the upcoming summer driving and hurricane seasons. Economically sensitive areas will get hurt most as GDP growth slows, so try to focus on stocks that have secular trends behind them. Aside from that, relatively cheap (below-market multiples) stocks with solid longer term growth outlooks are the kinds of positions that you should feel okay holding through the correction and for the months and years ahead.

Is The Correction Finally Here?

Here I sit with the Dow down 130 points, oil up more than $1, and gold jumping $16 an ounce. It has been more than three years since we have had a 10% correction in the market. Is this the start of it? Nobody knows for sure, but it could be.

If you think about it, the 6% rise we have seen in less than 5 months of 2006 defies traditional investment logic. Consider the current economic environment. Interest rates are rising, commodities are soaring with gold at 26 year highs and oil at record highs. Investor sentiment is very bullish. We are a country at war. And yet, the stock market has rallied strongly.

Given that official corrections (10%+) in the market occur about once a year, you would not expect three years to have passed since the last meaningful drop, given what the country is facing and what economic indicators are showing. For some reason stocks have ignored this backdrop. It is a combination of things; strong corporate profits, balance sheets flush with cash boosting M&A and buybacks, many hope that the Fed will stop hiking rates and prevent a recession.

Whatever the reason, it is hard to argue that we are not overdue for a pullback. Our economy is unlikely to withstand all of these pressures forever. Who knows if today is a sign of more things to come in the short term, but I would not surprised if it is, and investors should be on the lookout. There is no need to panic, just be prepared.