US Stocks Make 31 Record Highs in 2014, But Investors Panic During 3% Selloff


US stocks as defined by the S&P 500 made 31 record highs in 2014, most recently on July 24th.  Through Friday afternoon, stocks declined 3.3%, which is to say less than the decline of 4.2% we saw in April of this year, and decline of 5.6% in January.  We know that FOX and CNBC declared an apocalypse because of an increase in phone calls and e-mails from our clients.  One of our long term clients wrote to say that he was upset we had not protected him from a $44K paper loss.  In conversation, we learned that he was not talking about YTD (actually he's up $117K for year on a portfolio worth about $2 million) but from the high of a week ago.  We gently reminded him that the only guarantee we offer is that "portfolios will fluctuate over time."  We also gently pointed out that he and wife continued to get their monthly draw regardless of how crazy markets get, an unbroken streak since he retired 14 years ago (right at the start of the "decade of suck!")

The CNN Money Fear and Greed Index swung to "Extreme Fear" from last month's "Extreme Greed."  No doubt the investors who finally started buying stocks this earlier year aggressively sold on Friday.  This is why we have a thriving business - 98% of average investors "Buy High/Sell Low."  To actually "Buy Low/Sell High" obliges us to ignore "crowd think" and rely on the analytical processes that have aided successful investors for decades.  There's nothing brilliant about what we're doing other than executing a good plan with diligence and discipline.

The DALBAR Quantitative Analysis of Investor Behavior (20th edition for 2014) lays out in depressing detail how badly investors do by chasing short term returns.

The DALBAR report notes that average investors churn funds, holding for an average of only three years.  The net of that churning is that over the last 20 years, investors received annual returns 4.2% LESS than the average return of the S&P 500 of 9.22%.  Gurus love to make fun of the "buy and hold" strategy, but the hard evidence is that "buy and hold" works, and that market timing significantly reduces returns while increasing taxes.  The counter argument is that there are a handful of mutual funds that have consistently outperformed.  In a universe of 10,000 funds, random chance would throw out a couple of exceptions.  If you have 10,000 people flipping coins, random chance dictates that a couple will flip heads 10 times in a row.  Our lizard brain would predict that their next coin toss will be heads, but actually the odds are still 50/50.

The other counter argument is that certain hedge funds have delivered outsize returns.  On further analysis, we see that these funds aggressively leverage their investments, which often dictate 4 or 5 stellar years, followed by a complete wipeout.  We have available data for the Bloomberg Aggregate Hedge Fund index since January 2005 through June 2014.  The total return of the average hedge fund over that time frame was 31.2%, which averages 2.9%/year.  The S&P 500 gained 102.2% over the same time frame, or 7.8% annualized.  The Barclays Aggregate Bond Index gained 55.4% or 4.7% annualized.  The hedge funds beat the S&P 500 only once in the last decade - 2008, when the funds declined 19% versus 37% in the S&P 500.  High fees and high taxes, no transparency, lockups and poor returns - why do people clamor to invest with these firms?  Oh yes, the glamour...

Certain funds also "cheat" by making active use of non-public information.  Now that 20 or so managers have gone to jail in recent years after failing to beat insider trading charges, the returns of the remaining managers have curiously softened.

In conclusion, DALBAR wrote, "Attempts to correct irrational investor behavior through education have proved to be futile.  The belief that investors will make prudent decisions after education and disclosure has been totally discredited."  We would be happy to forward a complimentary copy of DALBAR's 20th Annual Quantitative Analysis of Investor Behavior 2014, which explains DALBAR's methodologies and expands on their research.  Please e-mail Samantha Gorelick in our office.

What are we thinking about?

First off, we never make a decision based on a single data point.  We look at about 30,000 data points over the trailing 6 months, while simultaneously estimating what data we'll see over the next 6 months.  Like 30,000 tiles in a mosaic, patterns evolve out of discreet elements.  In brief, we see that S&P 500 earnings and revenues are rebounding after a slow patch in Q4 2013 and Q1 2014.  That earnings expansion supported continued gains in the stock market and lifting it to slightly over-valued for the last year - Yellow.

The US Dollar remains in tight range against the weighted basket of industrial currencies since January 2012 - Yellow. 

Commodities spiked briefly with energy prices as fighting broke out in the Gaza Strip, now settling back to lower levels.   The commodity index is 38% below the high set July 2008 but more likely to move higher than lower given continued and increasing worldwide demand  - Yellow.

Economic reports - US employment continues to gain, adding 1.2 million jobs over the last 6 months.  The unemployment rate is 6.2% - near the lowest level since September 2008.  Housing prices rose steadily over the last three years.  Prices remain a long way from the peak of June 2006, but at least have returned to levels where most people have positive equity in their homes.  The most recent GDP report was a solid 4.2%.  Inflation remains contained at 2.1%.  Industrial Capacity Utilization is 79.1%, right around the long term of 80.1%.  All in - Yellow flashing Green.

Federal Reserve Policy - the Fed knows that rates must go higher, but does not want to crush the still fragile recovery.  With inflation around 2%, the Fed can gently bring quantitative easing to an end in 2014, think about raising the Fed Funds rate in 2015 or later - Yellow.

The Bond Market remains super skittish, falling sharply last July as tightening Fed Policy was first discussed, rallying early this year given the measured pace of change in policy.  We know rates have to be higher in a "normal" economy - Yellow flashing Red.

Politics - If there was ever a case for term limits, this Congress made it!  Our national infrastructure is failing apart from lack of funds for maintenance, corporations skip out of the country daily to avoid paying their fair share of taxes, we spend billions to protect ourselves from terrorists overseas, but can't lift a finger to protect average Americans from domestic terrorists (your estranged spouse, white supremacists, the neighbor's disaffected teenage boy) with sensible gun control.  Say whatever you want about Obamacare - 8 million families no longer play Russian Roulette with their family finances.  Yet, the Republican House of Representatives voted 54 times since 2009 to repeal this bill, and 34 Red state governors have worked to block the expansion of healthcare in their own states.  This weekend, Congress headed off to "recess" leaving scores of important issues unresolved.  RED!

Technical factors, which include overall valuations, money flows, market breadth are neutral - Yellow, though flashing Green after the recent pullback.

All together, we rate the stock market Yellow, flashing Green.  This means you won't make outrageous amounts of money compared to buying stocks in April 2009, but you will make a return that will support your long term financial goals.