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 July 2006 Trendless Summer
The old adage, "Sell in May and go away," was fairly prescient this year -- especially for those who sold before the market's high on May 10th. The threat of additional rate increases, increased inflation, and ongoing geopolitical tensions sent stocks tumbling in late May and early June. At that point it would have been nice to have already "gone away". But what do you make of the developments since May 10th? Is it the long-awaited turn in the market or is it instead the pause before the next leg up in the bull market? Has a new trend been established?
Everyone's looking for trends because they want to be out ahead of them. If large cap growth stocks are ready to regain leadership (as analysts have predicted for three years running), they want to already be there. If dividends will again be sought after, they want to be there first. When bonds hit their low point and yields crest, investors want to be positioned to lock in those near-term high rates as well as whatever capital appreciation potential remains. The trick is to be one of the first to identify and benefit from emerging trends. That's easier said than done, especially in the summer when thin markets give off a lot of false signals.
Not a Bear, Not Even a Correction
But worries about interest rates and the fate of the economy sent stocks sliding. In the week of June 5, central banks in the European Union, India, South Korea, South Africa, and Turkey all raised their equivalent of the U.S. Federal Funds rate. Investors began to agree with our prediction that rising global rates would pressure domestic rates to continue rising even after the Fed stepped aside. Diminished liquidity would not only threaten U.S. growth, but the global economy as well. After the spring's run-up, stocks were already overvalued. When the selling started on May 11th, it built on itself, sending stocks down well into mid-June. Even when the heaviest selling abated, there wasn't much of a relief rally. Shares' best outing occurred on June 15th when Fed Chairman Ben Bernanke said inflation expectations have "fallen back somewhat" in the past month. After a month of declines, it was difficult to keep what had happened in perspective. TV's talking heads threw out terms like "correction" and even "bear market", but both were really overstatements.
At their lowest points, the Dow was only 8.0% and the S&P 7.5% below their May 10th highs. Corrections are generally defined as a 10% decline. The Nasdaq (-10.7%) and the Russell 2000 (-12.0) did meet the definition, but even they failed to qualify for a bear market which is generally considered a 20% fall from the high. Perhaps the magnitude seemed greater than it actually was due to its length of the selloff. Yet even though the upward trend was broken, a bear market was certainly not established. Another trend that hasn't come about centers on market leadership. For three years pundits have been calling for small caps to cede leadership to large caps. Small caps did fall harder than their large counterparts, but they also recovered to a greater extent, too. At the end of June, small stocks were still the year-to-date leaders. Typically when investors are fleeing stocks, other investments pick up the slack. For example, when inflation is perceived to be a problem, gold is often one of the few safe refuges. Not this time, however, as gold fell from peak of $730.65/oz. on May 12th, to $562.30/oz. on June 14th. The prior day, it lost $44.50, its greatest one-day decline in 26 years. It's safe to say the usual flight to hard assets as a hedge against inflation wasn't materializing this time. Clearly investors were selling everything. It wasn't a matter of what to buy or hold, it was just a matter of selling. This isn't a trend that can persist for a prolonged period of time. In fact, it didn't. By late June, the market had stabilized, returning to day-to-day event driven volatility. The trading week ending June 9th -- almost exactly one month after the selloff began -- marked the low point. On June 5th, the Dow Industrials fell 1.8% and the Nasdaq gave up 2.2%. The small stocks of the Russell 2000 fared even worse, dropping 3.2%. This may have been the capitulation blow-off that many market watchers thought would mark the end of the correction. Now the question becomes, "What's next?" If the selling is over -- at least temporarily -- where should investors be placing their money? When and where will a new trend emerge?
More of the Same
Looking back over the past three decades, there's been a rotation in domestic equity leadership. Each time there was a bear market or severe correction, a new leader emerged. The 1970s were was a difficult period most noted for the "nifty 50" group of large cap stocks that were the last to capitulate to the bear market. Shares began to recover in the latter part of the decade when Energy stocks led the way. In the late '80s and early '90s Consumer Staples stocks took the lead. They passed the torch to Technology shares at the end of the 1990s only to see them fall from grace when the internet bubble burst. More recently, small caps and lower quality stocks have led the recovery from the 2000 - 2002 bear market. Small stocks have dominated larger issues for six years running while across all capitalizations, lower quality shares have attracted investors' dollars. Even riskier emerging market stocks have outperformed those of developed countries. The recent selloff may mark another turning point. Given that the riskiest stocks fell the hardest, investors are certainly reassessing their appetite for risk. Pundits who have been calling for a return to "safer" large caps may finally be right. Money markets, CDs, and at some point even bonds are also more attractive not only for their safety, but for their higher yields as well. Of course the market isn't acting in a vacuum. There are still outside influences such as inflation, the threat of recession, and geopolitical concerns. These issues really haven't changed and that's why market conditions may be slow to change, too. After all, it was uncertainty about inflation and recession following the Fed's May meeting that ignited the May-June selloff. Although the Fed's June statement was perceived to be a little more accommodative, it still acknowledged, "some inflation risks remain." citing the threat from "the high levels of resource utilization and of the prices of energy and other commodities."
Truth be told, aside from lower stock prices, little has changed form May 10th. Further monetary tightening isn't completely off the table. Instead, the Fed says, "The extent and timing of any additional firming that may be needed to address these risks will depend to the evolution of the outlook for both inflation and economic growth as implied by incoming information." In other words, the Fed is still just as "data dependent" now as they were back in May. If investors had a reason to worry then, they still do now. This suggests that for at least the short-term, we can expect more of the same. The tug of war between inflation and recession is a no-win battle. Any report hinting inflation is on the rise will tip off concerns about more rate increases and potentially stalled growth. On the other hand, any suggesting that the economy is still growing smartly will bring inflation fears back to the fore. Just as before, this is one of those situations where there's no happy medium. Given that, it won't take long for investors to turn their focus to the next Fed meeting in early August. Until then, market activity will turn on the economic or political report du jour. In other words, it's highly likely the only trend will be a lack of a real trend. And speaking of political developments, this pattern could extend well into the autumn as the mid-term Congressional elections begin to dominate the news. Uncertainty about them and their implications for the market will likely weigh on investors. As a result, no true trend may be in the offing until well into the fourth quarter. At that point, not only will the mid-term elections be a thing of the past, the Fed may well be through with rates for a while. Previous increases will be filtering through the economy and it will be possible to get a better feel for their effects. Analysts will be turning their sights to 2007 and mutual fund tax-loss selling will be drawing to a close. Perhaps then the next trend and market leaders will emerge. So don't be surprised if the next few weeks or even months simply bring more of the same. Uncertainty will never completely leave the market, but some of it should diminish as we move towards the end of the year. Hopefully by then, the inflation/recession debate will have run its course. Just having that issue removed as well as a neutral if not accommodative Fed, will be a positive sign for the economy and domestic stocks. In the meantime, brace yourself for a trendless summer. Search this site! Just enter you key word or words:
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UMMER IS TRADITIONALLY ONE of the slowest periods of the year for the market. Many traders are away from their desks and investors' thoughts turn to vacations rather than buying and selling stocks. Low volume tends to increase volatility yet stocks make little sustained headway until October.
