As I write, the Dow Jones Industrial Average is down over 500 points. I have a one-word response to the drop today. That word is, “FINALLY!”
The market just finished producing the best performing January since 1987. Some weakness (we are not done with the selloff yet) is natural, expected, and healthy for this market. Here is a little perspective. At the current level of decline (-536pts), the Dow Jones Industrial Average has dropped to the level where it closed on January 16. Less than 3 weeks ago!
We have been encouraging clients to remain calm and collected as the market declined prior to the presidential election. We counseled clients to push back against fear that stocks would crash when the market rallied and notched record highs on an almost daily basis last year. All along the way, our view has been that the economy is simply too healthy and fear of a correction too high for stocks to suffer any meaningful correction. We also suggested that tax reform would likely fuel further gains and would pass before the end of the year.
Our enthusiasm for stocks spilled over into January and, FOR NOW, remains intact. A correction in stocks that is worth trying to avoid is coming. However, this is not that correction, nor is it the beginning of the correction we expect to come. Why? Well, for many reasons. Let me hit on a couple.
First of all, more investors need to buy in to stocks and the amount of “cash” on the sidelines needs to diminish in size. While many investors have been plowing money into stocks as the rally has continued, there is still a sizeable amount of cash that remains uninvested. The Financial Crisis might seem like a lifetime ago to a 30-year old portfolio manager. But, for most of us, it seems like yesterday. This is important as it takes a while before investors who have experienced such a crash to regain enough confidence to be fully invested again.
Many investors who have been sitting on the sidelines with uninvested cash have been waiting for the market to take a “breather” so they can get in. I expect we will see buyers come in over the next week or two and prevent the market from really cratering. In fact, for most of our managed accounts, we came into February with over 10% in cash after selling off a few positions in January. We, too, expect to use the weakness to buy stocks we think have been unduly punished. We may even trim some of the stocks that have performed very well of late to free up cash to buy those which we believe have more room to run.
Another reason for our sanguine mood is that strong January’s usually portend strength through the rest of the year. A tone is set in January that many times will follow through to the rest of the year. This January saw the S&P 500® Index rise more than 5%. A strong start indeed.
LPL Financial published a study which is worth noting here. In it they show that since 1950 the S&P 500® Index has finished higher by 5% or more 12 times. In every case, the index finished in positive territory by the end of the year. The average gain for the rest of those 12 years was 15.8%. The average return for the entire year in those 12 was 24.8%. Of course, this in no way guarantees the same will hold true for 2018 but when a long-term study returns a 100% result, I take notice.
There are reasons to be concerned. This may come as a bit of a surprise but the main concern I have for the market is the strength of economic activity that is being reported. Unemployment is at extremely low levels. Wages are beginning to rise in a meaningful way. Profitability has been expanding for several quarters. Optimism about the future of the economy on the heels tax reform is overshadowing any negative sentiment.
Do not get me wrong. These are very good things for the country and individuals alike. However, the stock market is a discounting mechanism. This means much of the good news hitting the headlines right now explains why the market has been so strong since the election. A “breather” in the economic expansion is coming. This respite will come after the market sniffs it out. Will this mean the economy is going to slow enough to go into recession? Maybe but we feel this is unlikely. None the less, we expect a slowdown is coming and stocks will let us know ahead of time.
The market tends to move in the direction that causes the greatest pain to the largest group of people. As the economy continues to improve and average investors grow confident that it will continue, they will invest. Eventually, “everyone” who wants to invest will be invested. This leaves little cash to propel stock prices higher. In a perverted kind of way, the stock market will likely show weakness at precisely the time when most people think the economy is great.
We expect this peak in enthusiasm will occur later this year. We expect to lighten up on stocks in our managed accounts ahead of the third quarter (if stocks continue to rise beyond February). That said, we believe stocks are in a long-term uptrend that will not be derailed by any weakness experienced this year. Just because we believe stocks will rise significantly over the next decade does not mean we will simply “buy and hold”. If you want to be able to take advantage of lower stock prices, it requires you to sell ahead of such a decline in prices.
In summary, this decline will likely run for a couple of weeks. If it does and there is no ominous economic data that comes out, we expect to use the weakness to buy stocks we think will perform well during the recovery. We may adopt the old market axiom of “Sell in May and go away.” If so, we may lighten up on stocks as summer approaches and just sit patiently through the summer months. The mid-term election may bring out the sellers and take the market down again. If so, we will likely see this as tremendous buying opportunity and act accordingly.
Kessler Investment Group, LLC