Correction Is Here, Finally

After more than four years of steady climb, the markets finally experienced a correction — all major indices are now 10% or more below their peak.  On average, market corrections occur every 18 month, so this particular one was long overdue.  In a way, it is a good thing to have that correction box checked — investors who were sidelined waiting for the correction will now how have one less reason not to be in the market.

The market drop over the last few days was, for all intents and purposes, made in China.  Fears of slowdown in Chinese economy and its market crash of over 40% caused worldwide equity rout.  Whether the extent of the drop was warranted is hard to say.  Note that the Chinese economy slowed from 7% yearly growth to probably around 5% – a number that is still much higher than the growth of any developed country.  Also, Chinese stock market had a huge rally earlier this year, and even after that 40% crash, it is still at the level of the beginning of 2015.

What happens now is anyone’s guess.  Often, and especially in situations like these, daily fluctuations of the markets are not driven by economic fundamentals, but by hordes of traders unable to control their emotions.  Historically, once the markets decline by 10%, there is a 50% chance that they will continue to decline further into bear market — that is, a drop of 20% or more from the peak.  That’s the bad news.  The good news is that there is 86% chance that the markets would be at least 50% higher in 5 years.  These are pretty good odds!

What is happening in the markets now is completely normal.  That is what markets do, once in a while.  It is the nature of the beast. The last few days were not fun, and the roller coaster ride will probably continue.  But days like these are the reason why equity investors in the long term are paid more, a lot more, than any other kind of investor.

The financial media thrives when markets are volatile.  You are going to hear all kinds of experts predicting the future, and stories of high-profile investors and entrepreneurs in the likes of Bill Gates or Mark Zuckerberg who lost billions of dollars in a few days.  But after the dust settles and the markets continue their inevitable climb to new highs, it will be clear that they didn’t lose anything.  Because, chances are, they didn’t sell.  And neither should you.

Know When to Sell

Most investors would agree that a decision to buy a stock is much easier than a decision to sell.  Watch the video below to see when it is a good time to sell and when it is not.

Investing and Emotions Don’t Mix

For many people, investing can be very emotional.  In declining markets, fear takes over and the natural reaction is to sell to prevent further losses.  In advancing markets, greed is in control and produces a desire to buy more.  These emotions are extremely dangerous to the health of your portfolio and if followed through, will inevitably lead to regrets later.  Emotions do not belong at all in investing, only hard logic and reasoning does. For Star Trek fans, you should always be Mr. Spock as far as your portfolio is concerned.  Live long and prosper!

A Common Misconception of Index Funds

It is now a well known fact that 80% to 90% (depending on the study) of actively managed funds underperform S&P 500 index funds.  The reason for that is two-fold.  First, active fund managers charge higher fees.  Second, they tend to trade often which results in commission costs, unfavorable capital gains tax treatment, and most importantly, underperformance due to continued attempts to time the market  stemming from frequent trading.  Index funds, on the other hand, change composition very rarely and thus almost never trade.

As a result, there is a flow of cash from actively managed funds to index funds.  Many prominent investors, including Warren Buffett, advocate to consider only index funds for individuals.

However, many investors don’t understand exactly how index funds are structured.  Most indices, including S&P 500 index, are not equal weighted, but instead market capitalization weighted.  This means that dollar amount of each fund holding is proportional to its market cap.  So if you invest $1,000 into S&P 500 index fund, you will not put $2 into each of 500 companies.  Instead, you will own approximately $50 worth of Apple, $30 each of Microsoft, Google and ExxonMobil, etc. — because these are highest market cap companies in the index.  And you will invest only $10 combined into hundreds of mid-cap and smaller companies with less than $5 billion market cap.

While market capitalization is appropriate to measure performance of the overall market, no reasonable investor will construct his or hers individual portfolio in the above manner.  The best way is to select high quality companies with excellent management teams and own these companies for a long time, selling only if business fundamentals deteriorate.  That way, you can have your own properly constructed “index fund”, and without market timing, it will have a good chance of beating the venerable S&P 500.  This is exactly the strategy I use for my clients’ and my personal portfolios.

Market Timing Doesn’t Work

Since 2011, investors have been waiting for a correction, which has not yet materialized.  Meanwhile, the market has been climbing steadily and hitting new highs.  I am sure a correction will happen sooner or later, but trying to time the market this way never works.  Watch this one minute video for details.

Market Update

We are well into the first quarter earnings season, and the results are not quite as robust as they used to be.  Many prominent mega-cap multinational corporations, like Caterpillar, Dupont, ExxonMobil, Pfizer, etc. either missed earnings estimates or provided cautious guidance going forward.  There is nothing wrong with these businesses — the reason is our strong currency which reduced dollar-denominated sales overseas.  This affects all companies with significant business abroad.  Thus, we may witness a shift in market leadership toward domestic companies, which tend to be smaller.  It is about time — large cap stocks outperformed smaller companies last year.

Meanwhile, in addition to never-ending “Grexit” concerns, deflation is a new market bogeyman.  Indeed, deflation would be bad news for worldwide economies, and in order to prevent it, several European countries now sport negative interest rates (which causes weakness in Euro and other currencies and leads to dollar strength — see paragraph above).  With no inflation in sight, I don’t think Fed will raise interest rates anytime soon — doing so will only strengthen the dollar even more.

As a result of this very low interest rates environment, S&P 500 dividend yield is now higher than 10 year U.S. Treasury rate.  There is always a possibility that one or several multinational companies chooses to cut its dividend, and that may well trigger that long-awaited correction.  However, at this time, equities remain essentially the only game in town for investors expecting a reasonable return.

Third Time a Charm?

Investment pundits have been complaining for quite some time about something lacking in this market.  Namely, a correction.  Indeed, corrections, or drops of 10% or more from a top, are fairly common events and usually occur once a year or so.  The last one happened during summer of 2011, more than three years ago.  So yes, we are overdue.

Note that for the last few months, the market really tried to, well, correct itself.  In October, everyone was worried about Ebola and economic weakness in Europe, and stock prices came within a percentage point of “official” correction territory, only to come roaring back to new highs.  In December, everyone was worried about falling oil prices, falling ruble and again weakness in Europe.  That time, the market managed only 5% or so decline before bouncing back.  2015 started quite volatile, but with prices down only about 4% from the peak we are not close to the coveted mark.  The worry this time – even lower oil prices and yes, weakness in Europe yet again.

If we have to worry about something, I think that falling oil prices would be a great choice!  Lower oil prices act similarly to a huge tax cut and are generally a boon to overall economy (oil companies excepted).  Consumers who have extra cash from saving at the pump will most likely deploy it elsewhere.  Indeed, looking at the most recent 5 drops in oil prices of 50% or more since 1985, stock prices were higher 12 months later on all occasions.  They were also higher during the periods of the oil price drops themselves, in 4 out of 5 occasions.  The only exception is the period of global financial crisis of 2008 that crushed demand worldwide.  Now, however, with U.S. output rising significantly due to fracking, we simply produce more oil than we need – by 1 to 2 million barrels per day on 30 million barrels daily output.  Eventually we will reach an equilibrium — OPEC may well succeed in driving some U.S. shale operators out of business.  But the argument that low oil prices are a symptom of weak demand, rather than oversupply, is faulty.

Struggling economies in Europe is a valid concern — and it was valid for all 6 years of this bull market.  Weak Euro (and conversely, strong dollar) will hurt profits of U.S. based international companies in the short term.  However, there is a definite historic correlation between a strong dollar and strong U.S. equities performance.  In any event, I would not read too much into currency fluctuations.

As for the correction, I am sure that it will happen sooner or later.  Some even argue that it would be good for the market, since investors who have been waiting for it will finally put their money to work after it happens.  Well, they have been waiting a really long time and have missed out on an 80% rise since that last correction in 2011.  That is why trying to time the market in any way is a sure way to under-perform the said market.  Instead, as I have been advocating for quite some time, ignore macroeconomic headlines like the ones above and instead concentrate on the companies your own.

Proper Investing Mindset

In the first quarter of 2014, last year best performing stocks, such as Netflix, Baidu, LinkedIn, etc. experienced fairly significant corrections.  Some of these stocks declined by 10-20% or more.  That’s really not too surprising given last year gains — it is only natural for high-flyers to be more volatile than the overall market.  Note that the market itself is still sitting near all-time highs.  If and when a general market correction comes, these stocks could suffer further declines.  On the other hand, they can just as easily rebound as they have consistently done over the last year.  There is no way to know.

In this kind of environment, what should an investor do?  My answer: most likely, nothing.  I believe the proper mindset is essential in making investment decisions, namely, a mindset of a business owner as opposed to that of a holder of a nameless ticker than can be traded at a push of a button.  Suppose you own a business, or an apartment complex, and you have a hyperactive broker who calls or emails you several times a day with a current market price for your business.  Would you sell if that price happens to differ 20% compared to a month ago?  Unless you were already planning to sell it, of course not — you would instead be concentrating on growing your business and will most likely fire that broker for providing useless distractions.  As investors, we are part owners of great businesses.   Granted, the ownership stake is very small and we don’t get to make any business decisions, but nevertheless the same principle applies.  We have the best business executives working for us.  Let them do their job.

Of course, there still could be valid reasons for selling.  Two most important ones are the deteriorating business fundamentals, and identifying a better place for the money.  But more often than not, doing nothing is actually the best way.  Being active does not translate to better performance, actually it is the other way around.

Stocks Hit All Time Highs – Time to Worry?

With Dow Jones and S&P 500 hitting new all time highs seemingly every day this year, one cannot help wondering – is the rally close to its end and is it time to lighten on stock holdings?  Indeed, S&P 500 is up nearly 16% this year alone and up astonishing 160% from the bear market bottom reached in March 2009.  Moreover, Wall Street saying “Sell in May and Go Away” was right on the money for the last 3 years, so should we get worried this May?

Short term, I am concerned.  I think that a correction is overdue and will in fact be quite healthy for the market.  Longer term, I am more optimistic. Despite the advances over the last 4 years, S&P 500 is up by only 8% from previous bull market top in 2000, hardly an inspiring gain over 13 years.  Although it may be difficult to believe given the market roller-coaster for more than a decade, achieving new highs is actually a normal state of the market.  As it should be – as population, economy and GDP expand, so does enterprise, and consequently, market valuation.  This is what happened during the previous bull market of 1982-2000 and the one before it, 1950-1970.

It is quite likely that 3 major inflection points in market trends are taking place right now or possibly have already occurred.  First, the secular bear market that started in 2000 most likely ended in 2009, and the current four year old market advance is more than just a bear market rally.  Second, with interest rates near zero, the 30 year old bond market rally is over or at least nearing its end.  And finally, as a consequence of the above, the so-called Great Rotation out of bonds into stocks is starting (or has already started).  Indeed, why own a blue chip bond which yield is lower than the dividend yield and does not offer a potential for stock appreciation?

Despite recent gains, overall market valuation remains quite reasonable, near average of its historical range.  However, given extremely accommodating fiscal policies, equities have little real competition.  And as in any market, one can always find great companies unfairly discounted by current investor sentiment.  Many investors are still very cautious and an there is no general euphoria over the recent highs.  Thus, equity markets remain an attractive place to be.

Is the Bull Market Over? Or Just Beginning?

As you know, both S&P 500 and Dow Jones (but not the Nasdaq) are within striking distance of all-time highs.  So a natural question arises: Is the 13-year-old secular bear market that started in 2000 coming to an end?  Or, rather, is this a precursor to a market collapse that happened in 2000 and 2007, when previous peaks were reached?

Of course, only the time will tell the answer, but there are reasons to be optimistic.  From a historical perspective, reaching a previous peak after years of sideways movement could be a precursor to reaching new highs.  In the previous secular bear market, after 1973, it took Dow almost 10 years to reach its previous peak of 1051 in 1982.  In the bull market that followed, Dow rose nearly 15-fold.  But history aside, there are actual economic reasons to be optimistic:

• Company earnings continue to rise.  Just this past quarter, earnings rose 7.3% compared to 1.9% that analysts expected.  Meanwhile, P/E ratios remain very reasonable.
• Investors remain cautious.  Major publications remain skeptical of the rally.
• Central banks around the world keep pumping liquidity into markets.
• International situation is showing signs of improvement, from Chinese recovery to apparent stabilization of European debt crisis.
• There is a good chance that U.S. will reach energy independence in the next several years.
• Housing market recovery appears to be real.

Unlike equities, the last decade has been great for bonds which have benefited from declining interest rates.  Investors contributed to this trend by taking cash out of stocks and injecting $1 trillion into bond funds.  For the first time in years, this trend reversed this January, when stock funds saw $35 billion inflow.  That is still a trickle compared to $1 trillion, but some argue that the Great Rotation out of bonds into stocks has begun.  If so, stocks do have a long way to run.  History will tell.