Rising Bearish Sentiment Brings Some “Good News”

In wake of stock market sell-off of the past few days, there is increasing evidence that small investors are getting scared. The Associated Press this morning reports that “the number of small investors who say they feel bearish soared this past week” and “some stock funds have been hit with their biggest withdrawals since 2012”. Here is the link to the AP article:

http://money.msn.com/business-news/article.aspx?feed=AP&date=20140201&id=17312155

 

 It may sound illogical but it is actually a good sign. As we’ve noted previously, the stock market has not had more than a 10% correction since mid-2011. This is longer than the statistical norm for time intervals between “corrections” which, since 1945, have occurred on average about every 20 months and average about 13% decline. The fact that small investors are getting nervous and pulling out is positive in that it relieves some of the extreme positive sentiment that is associated with rising markets, particularly a rise like we saw in 2013 (which was up 30%, about 3x the long-term average annual return).

 

We think the underlying fundamentals for U.S. companies remain sound based on improving economic growth and higher earnings in 2014. At about 15x 2014 earnings, valuation is “neutral”, no longer “cheap” but not excessive either. In addition, as we’ve mentioned previously, the financial arbitrage that currently exists between the cost of debt and equity capital is also providing support for equity valuations.

 

This morning’s auto sales and factory order data were lower than expected, partly contributing to today’s sell off, but we note this data bounces around significantly and does not move in a linear fashion. We don’t read much into the softer data. There may also be some investor concern with Janet Yellen taking over as chief honcho at the Federal Reserve, however our expectation is she will maintain a gradualistic approach towards unwinding of the quantitative easing program of the last five years. Concerns over slowing growth in China are legitimate, however, with over $3.5 trillion in monetary reserves, we think China has the financial wherewithal to engineer a “soft landing” for its economy. We continue to believe the best opportunities remain in U.S. stocks, in which we remain overweighted.

 

Our strategy of diversification among multiple asset classes is an important way in which we aim to provide not only asset growth but also reduce portfolio volatility, an important aspect of achieving improved risk-adjusted returns. Corrections and market pullbacks are normal, and in many cases, necessary, as they relieve extended positive sentiment and allow the market to “recuperate” technically. We expect this correction will prove to be another normal mid-cycle correction in an ongoing secular bull market.