You and me been over this ground,
Over this ground before.
I can’t explain, I can’t explain
I can’t explain anymore.
Oh, it’s hard to watch you go.
I’m down but it won’t last long.
I’m down but it won’t last long.
Don’t let me down, don’t let me down
Don’t let me down like this.
It’s not the same.
Over and over, over and over again.
-Tom Petty, Won’t Last Long
Amidst overwhelming evidence for the contrary, last week saw equities move higher.
The economy has slowed to stall speed. Unemployment mired at 9.1 percent. Manufacturing is weak. Europe remains in crisis. The Greeks missed their deficit reduction goals. The middle east is in flames. And a generation’s Edison, Mr. Steve Jobs, died of pancreatic cancer at 56.
Despite all of this, the S&P 500 temporarily dipped below the Mendoza Line of 1100 before rocketing upwards to nearly 1190.
Surprising? Hardly, if you consider three facts.
1) What is the long-term trajectory of the market? Up.
2) Where will the market be next week? Next month? Next year? Anybody’s guess.
3) What does the market do most consistently? Frustrates the largest number of investors.
Whenever a consensus opinion on the markets begins to take shape, be it a call to rise of fall, the smart money will consistently take the opposite side of the trade. Everyone says the market’s going to rise? Get out. Everyone says the market’s going to plummet? Get in.
Long term, equity markets are pretty predictable. Short term, they read like differential calculus.
There are numerous reasons the market can fly when the world seems to anticipate the next big drop. Large fund managers looking to bolster end-of-year performance. Speculation on the strength of third-quarter earnings. Oversold conditions amidst a negative economic backdrop. Double-bottom head and shoulder patterns portend a technical rally.
“Ever wonder why fund managers can’t beat the S&P 500? ‘Cause they’re sheep, and sheep get slaughtered,” Gordon Gekko relates to Bud Fox in the movie Wall Street.
His point? If you’re just another blade of grass, eventually you get mowed.
So, how does a falling market, facing numerous economic headwinds, turn on a dime and soar?
First, technical analysts have been pointing out that, despite all the negative sentiment, the market was oversold. Some recently pointed out that the recent extremes of investor negativity often portend a quick rebound. Further, they explained that short-term positives could serve as catalysts for a market markets rebound.
European bank recaps. U.S. unemployment data (not worse than expected, just bad). 3Q earnings expectations. CEOs saying that they do not see the economy tipping into recession (thought they’re often the last to know).
It is pretty typical of the markets to elevate at year end. According to Bespoke Investment Group, the S&P 500 has historically fared quite well in the fourth quarter:
-The S&P 500 has averaged a 2.44 percent 4Q gain since 1928.
-The S&P 500 has averaged a 4.57 percent 4Q gain the last 20 years.
-The S&P 500 has advanced in 24 of 30 fourth quarters over the last 30 years, with an average return of better than 7 percent.
For more rational as to a prospective rise into January, consider this: institutional money managers lost their shirts in 2008. Then, in a risk management frenzy, many of these same managers held too much cash amidst a rising market in 2009. Last year, many expected the market to take back some of the ‘09 appreciation, and again they held too much cash. This year, as these managers dipped their toes, the market dropped.
Now, with many of these money managers facing a fourth consecutive year of poor returns, they will be emboldened to push the market upwards. They face “career risk,” as they’re job performance is based simply on their abilities to deliver returns. When confronted with another failure to deliver, they will resort to any tactic.
So, from a performance perspective, the fourth quarter has an opportunity to amount to something positive.
True, Europe remains bleak. The U.S. deficit issues are vast. Volatility in the middle east (and energy prices) will remain much as they are now for the foreseeable future. Yet, history, and some performance-hungry money managers, remain on your side.
The answer can be boiled down to three words: third-quarter earnings.
If they’re solid? Markets are cheap and rise. If they’re poor? The market is richly priced and drops.
Regardless of what transpires these next few months, we continue to expect a pullback at some point. The economic situation remains poor. Greece still levitates just slightly above the abyss. Italy, Portugal and Spain are not far behind.
And so the levers to take advantage of such a pullback remain before us. When the time comes, we will act accordingly. Till then, we will take whatever the market gives.