Trust, illusion, values and the death of "common sense"

The S&P 500 rallied 73.2% from the March 9th, 2008 low through the recent peak and declined 6.9% since January 19th.  This is a normal correction and similar to the 7% decline we saw last June 15th-July 10th.  If the correction extended to a 10% decline, we would not be surprised.  We would not sell stocks at this time as we expect positive returns in the S&P 500 by year end.  No, we're not going to try to trade around the short-term fall and rally. 

We're encouraged by corporate earnings, which show an astonishing rebound (up 148% compared to Q4 2008) after last year's wipeout.  US GDP growth turned in the best performance in 6 years with a year over year gain of 5.7%.  The US employment situation improved -job losses flattened and the unemployment rate fell slightly.  By no means is the US economy, or the world economy for that matter, free and clear. 

We have often described the economy as an automobile engine in which the production of goods and services are the pistons, cylinders and drive-shaft; designers, engineers and marketers are the gasoline, and the finance sector is the 5 quarts of oil that keep everything moving.  The financial crisis last year was like losing most of that oil, at which point the moving parts overheat, jam and crack.  We're back to 4 quarts in the pan with a raggedly running engine, and we don't yet know the extent of permanent damage.

On balance, we remain cautiously optimistic.  However, the average investor remains deeply pessimistic.  Investors moved money out of stock funds and stock ETF's every month from August through December last year and were net sellers of stocks despite the monster run up.  The last time investors were so pessimistic was in the years following the 1973-4 bear market, during which time the S&P 500 declined 48.0%.  Economic fundamentals actually were far worse in that era - US support of Israel during the Yom Kippur war triggered an OPEC oil embargo, which tripled energy prices in a very short time frame and caused soaring inflation.  At the same time, the US was transitioning from a manufacturing to a service based economy with corresponding disruption and high unemployment.  Stock prices did not eclipse the 1972 high until 1982.  Investors who bought stocks in that era experienced returns of 2600% over the next two decades, but many more swore never to buy stocks again.

Read the entire commentary here.