Market Volume a Concern

Looking at stock market volume statistics over the last few weeks has not given me much confidence in a resumption of the bull market. In a healthy bull market we would like to see strong volume on up days and/or weak volume on down days. This general pattern is regarded by technicians to be a confirmation for bull markets, and the opposite pattern to be a confirmation for bear markets. Of course this is not always the case, and more analysis should be considered before calling bear markets, but it’s not a good sign.

Below is a chart of the S&P 500 SPDR ETF, ticker SPY (I have used the SPY as a general proxy for the trend in volume although there might be slight differences to actual exchange volume). The top section of the chart is the SPY price movement and the bottom of the chart is the SPY volume. When the market is down the volume bar is red, and when the market is up the volume bar is green. During the up-trend in March and April you will notice red volume bars spiking higher than the green bars indicating that volume was much stronger on down days then it was on up days. This volume pattern would seem to question the bull market as more investors were eager to sell on down days than buy on up days. Or put another way, volume did not confirm the trend.

After the April 23rd high, you can see that the red volume bars at the bottom still stick out higher than the green bars, with significant peaks during the May 6th “flash crash.” At this point volume is now confirming the short-term trend as volume increases on down days and decreases on up days. This is only one look at the market but I would like to see the volume pattern change, and provide some rocket fuel for what may be the last leg of this cyclical bull. Until then I would remain skeptical of the rallies.

Correlation Breakdown

Over time, the price of gold typically has a fairly strong inverse correlation with the value of the U.S. dollar, meaning that they tend to move in opposite directions. But lately the dollar and gold have been moving higher in lockstep as the long-term inverse correlation has broken down (see chart below). There are a number of plausible reasons for the breakdown in the normal relationship between these two asset classes.

Start with gold. We are currently engulfed in the middle of a perfect storm of uncertainty: fears of eventual currency debasement in developed economies, worries about the long term viability of the Euro-zone, geopolitical tensions in Korea and Thailand, new signs of stress in the banking system, and even the recently attempted terrorist attack in New York City. That is one hearty list of unstable conditions, which has been supporting the gold trade recently.

As for the dollar, the trade-weighted dollar index, which is based on our largest trading partners, is made up of approximately 58% Euro. So, movements in that index are largely driven by movements in the Euro/dollar relationship. As the Euro has plummeted in recent weeks, this has been a huge driver of dollar gains. Other fundamentals such as purchasing power parity, real interest differentials, and future growth rates are no doubt operating beneath the surface. But quite simply, recently it seems like the Euro’s pain has been the dollars gain.

The traditional inverse correlation between dollar and gold appears to have recently decoupled. However, if the history of gold and the dollar remains a decent guide, then the longer-term relationship is likely to reassert itself at some point, implying that one of these asset classes is going to be wrong. The key will be in figuring out which one that is.

Bouncing, but for How Long?

The market finally bounced yesterday from a very oversold short-term condition, turning what was a 33 point loss on the S&P 500 Index at its worst point into a very slight gain for the day. So far today, it seems to be continuing, with the S&P up again as I’m writing this. The big question, of course, is how long this can potentially continue. Is this just a brief respite before we get a 2008-like plunge, or will the bull market of the past year resume from here?

It’s probably too early to tell at this point, but there will be some key things we’ll be watching to help us make that determination. First of all, the decline of the past few weeks has taken the market below some significant technical levels, so how it behaves as it now approaches these levels from below will be important. Second, to the extent this bounce is able to extend all the way back towards the April highs, we’ll be watching market internals for any notable divergences. Back in 2007, for instance, the S&P fell 9% in July and August before rallying back and making its ultimate high in October. But, there were some glaring divergences in measures like the advance/decline line, which failed to make a new high, giving a big clue that an important market top was forming.

In addition to market technicals, obviously we also need to keep a close watch on economic fundamentals to see if the recovery is still intact. Seemingly lost in all the concerns about the European debt crisis, rising geopolitical tensions around the globe, the oil spill, etc. is that recent economic reports have been largely positive. Yesterday, consumer confidence rose more than expected, while today both durable goods orders and new home sales surpassed expectations. Of course, there are plenty of things to be worried about and the market clearly seems to be focusing on those lately, but if the economy can withstand all of the current concerns and continue making progress, then maybe this will turn out to be just a nasty correction in a bull market.

A Special, Special Report?

This morning the investment team looked at 102 PowerPoint slides broken down into the categories of Spending and Wages (17 slides), Credit and Liquidity (34 slides), Employment (9 slides), Housing (9 slides), Leading Indicators (19 slides), Inflation (7 slides), and Commodity/Currency (7 slides). Not to bore you, but we then looked at another 20-plus technical slides showing market fear, mean regression, and a bunch of other technical indicators. Our goal was to see what, if anything, had changed in our outlook considering that we just wrote a Special Report to Pinnacle clients saying that we thought the recent European Union bailout plan for Greece might be the catalyst needed for the next, and possibly last, phase of the current bull market. Here is what we concluded:

Things have changed since we wrote our last report as the level of fear in financial markets has increased to levels not seen since the Lehman collapse. It is possible that investor fears about a Greek debt default have now morphed into investor fears that the entire European Union could unravel. This shock to growth has investors reconsidering risks to economic growth that were already well discounted in stock prices prior to the European crisis. Pinnacle is no exception, and this morning we reconsidered several well-known but relevant data points that could have an impact on our bullish view of economic growth going forward. Specifically we focused on 1) real wages remain soft and transfer payments are at historic highs relative to income, 2) small businesses cannot access credit and are pessimistic about future economic prospects, 3) mortgage delinquencies continue to be very high, 4) short-term views of risk spreads are elevated to levels that deserve our attention, 5) copper and oil, two of our leading economic data points, have sold off sharply over the past few weeks signaling something…or nothing.

Items 1 – 3 are not new but deserve a second look in light of recent events. Items 4 and 5 are new data that go into our economic forecast. The bottom line is that economic and credit risks are higher than they were and we are at an inflection point where we may pull some risk assets back off the table. We know that selling into elevated fear indexes is the “wrong” thing to do, and we would prefer to either hold what we have, or sell into a rally. At this point it is way too early to know if the global economic recovery is over and the financial markets are forecasting a double dip, or if global stock markets are simply having a well anticipated correction in a bull market. I would prefer it if the markets would find a bottom sometime soon so that we will not to have to provide our clients with a Special, Special Report about hedging portfolio risks. It is good to note that our portfolios continue to perform as expected on a relative and absolute return basis. Stay tuned…

Kicking the Can down the Road

I recall that as a kid I had great sport occasionally kicking a rock down the road. There were often rocks to be found along whatever route I was traveling and kicking the rock was a fun and relaxing way to pass the time, although I don’t have any idea why I would have been tense as a child, but that’s another matter altogether. I don’t recall often having the ability to actually kick a can down the road because in all probability there just weren’t that many cans lying around the road to be kicked. It seems to me that nowadays hardly anyone kicks cans down the road, mostly because we are all driving cars now and if you are a kid you are probably playing a video game on some handheld device while walking to wherever your destination happens to be.

“Kicking the can down the road” is especially relevant today because it is the newest overused term in the investment business. Occasionally the investment world gets fixated on a description of current events that spreads like wildfire and you hear it so many times that you just can’t stand it anymore. The most recent is “kick the can down the road” and the one prior to that was “the new normal,” a term given to us by Paul McCulley at PIMCO to describe the slower pace of growth we can expect from the global economy going forward. The term “kick the can down the road” is used to describe governments that refuse to address fiscal imbalances that are presumed to cause financial and social chaos in the future. A recent research piece by Joe Kalish, Senior Macro Strategist for Ned Davis Research, titled “Where We Stand on the European Sovereign Debt Crisis” comments on the Greek debt situation by saying, “By not rescheduling or restructuring the Greek debt, the Europeans have bought some time and ‘kicked the can down the road.’”

I saw several clients last week with my planning associate David Kauffman, who reminded clients in three separate meetings that we are “kicking the can down the road.” And many analysts who look at the deferred funding for the recent healthcare legislation feel that we are kicking the can down the road. Current U.S. debt to GDP ratios also imply some serious can-kicking. In fact, governments around the world are engaged in can-kicking most everywhere you look. If you happen to be out walking and see a can, give it a good kick. It will remind you of the simpler days of your childhood, or it will depress you as you consider our collective inability to live within our means. I find myself wondering whether democratic political systems can resolve can-kicking dilemmas without a serious financial crisis. Voters need to vote for a serious reduction in their standard of living and politicians need to try to get elected by offering a serious standard of living reduction to the voters. I’m skeptical that this will happen, to say the least. Ultimately the financial markets will riot and drastic measures will be enacted as we are seeing in Greece today. Until then, I guess we will just “kick the can down the road.”

Fear Factor or Fundamental Change?

The market adjustment since late April has accelerated recently, taking the S&P 500 and other major equity market indices into negative territory for the year. One thing that’s obvious is that the mood of investors has made a sharp turn from complacency to outright fear. That can be seen in measures such as the VIX Index of implied options volatility as well as put/call ratios that are now jumping off the charts. From a sentiment standpoint, the kind of fear we are seeing now is typically a good sign as it indicates that weak hands are being shaken out of the market. I say typical, because if a debt contagion occurs in Europe then we might be headed for a replay of the crisis of 2008, where the exception becomes the rule. But outside of outright contagion, the return of fear should be compelling for seasoned investors to consider adding risk right here for at least a shorter term rebound, while suppressing the urge to join the rest of the sellers.

Unfortunately, those same indicators don’t really tell us much about whether the fundamentals of the world economy are changing or not. For that we go back to a long laundry list of economic data that we follow. On that front, the latest developments have been mixed. On the downside, some of the leading indices are taking a hit. Extremely economically sensitive commodities such as copper and oil are declining precipitously, measures of money supply have waned, and recently the Conference Board’s Index of Leading Economic Indicators fell from March to April, after twelve straight monthly gains.

However, there are other important data points that we follow that continue to look encouraging. Job growth has returned, where four consecutive months of gains provides hope for stronger wages and a new spending cycle. In addition, there’s renewed stimulus due to the Euro-zone bailout, lower bond yields in the U.S., lower energy prices, and a U.S. Federal Reserve that will likely stay on hold longer than previously anticipated. These forces, when taken together, are not trivial and will likely be discounted by markets as the fear subsides.

Events are moving quickly, markets are being adjusted at light speed, and one can easily be overwhelmed by the negativity of the moment. Our job is both simple yet intensely complex – to be able to separate the noise, evaluate the meaningful signals, and determine whether this market sell-off is based more on fear or a fundamental change in the landscape. Rest assured that is what we will be wrestling with in the days ahead.

Another Misguided Ban

You might recall during the height of fear in September 2008, the Securities Exchange Commission halted short selling of financial stocks in an attempt to protect investors and markets. They felt that the integrity of the markets was being questioned and this move would restore equilibrium to markets. You might also recall that financial stocks (as measured by the XLF – financial sector ETF) fell from $18.50 to $6 per share (a 67% decline) from September 2008 to March 2009. It is certainly evident in hindsight that excessive shorting was not the enemy of financial positions. But it’s nice to place blame elsewhere!

Now, it seems that Europe may be heading down the same path. Today, Germany’s financial markets regulator announced that it would ban naked short selling and naked credit default swaps on euro-zone debt, and ban short selling in 10 financial/insurance stocks through March 31, 2011. The reason given for the new rules, as you may have guessed, is that massive short selling has led to excessive price movements which could crash the entire financial system. And apparently they fear that crash could occur in one night, since the ban goes into effect at midnight local time.

It has been pointed out that this is merely a symbolic move by the German regulator because most naked short selling occurs in London which is outside their jurisdiction. However, it highlights the inability of European nations to face the real problem. In 2008 financial stocks were sold due to toxic assets littering their balance sheets, and now Euro bonds are being sold due to fiscal problems and excessive debt loads. And just as the financial stocks in the U.S. continued to fall after the short selling ban in 2008, the market will probably find a way to tell the European leaders that this type of action does not correct the underlying problem of fiscal mismanagement. The euro was down over 1.5% today so I think that message is already coming through.

Lies, Damn Lies, and Statistics

Today the major guru of a research firm that we routinely follow was making the point that the momentum of the market is important, but the quality of the momentum is also important. He then went on to look at several underlying data points to make the case that it was prudent to be cautious about the current cyclical bull market. One of the data points he shared was to compare the percentage gain and the length in days of the current bull market to past cyclical bull markets that occurred during secular bears. For those who are wondering, secular market cycles are very long-term market moves and cyclical moves are the shorter-term bull and bear markets that occur within the secular time frame. Most cyclical bull and bear markets are measured in terms of years rather than months. During the current secular bear market, which began in March of 2000, there have been four cyclical market moves. The first was March of 2000 to either October of 2002 or March of 2003 (depending on your preferences for measuring this kind of thing). The second was the bull market that lasted from the 2002-2003 market troughs and lasted through October of 2007. The third was the cyclical bear from October of 2007 to March of 2009. And the fourth is the current bull market that began in March of 2009 and has lasted to the current date.

If you look at the list of S&P 500 Index cyclical bull markets that occur within secular bears going back to the 1930s, you find that there are 16 different cyclical bull markets during secular bear markets. The percentage gain for these bull markets ranged from 21.2% to 123.3% and the number of days from bottom to top ranged from 61 to 1,826 (the latter was the cyclical bull from 10/09/2002 – 10/09/2007). Our guru points out that the percentage gain for the current bull market is 79.2%, which is greater than the mean and median percentage gains from prior periods, which were 62.3% and 51.2%, respectively. Similarly, the 413 days of the current bull is lower than the mean and higher than the median durations of prior cyclical bulls in secular bears, which were 465 days and 337 days, respectively. Today’s message was that the current bull market has gained more than the average cyclical bull (79% versus 62% mean or 51% median) and lasted longer than the median but less than the mean (413 days versus 465 mean and 337 median). In short, this bull has gained enough and lasted long enough to be cautious.

However, just a few weeks ago another analyst at the same company used similar data to reach the opposite conclusion. Using data for the Dow Jones Industrials (as opposed to the S&P 500 Index), he found that the statistics show that the DJIA’s gain of 71% ranks only 8 among the 16 cyclical bulls that have taken place within secular bears. The longevity ranks ninth. In short, just looking at the rankings as opposed to comparing to the means and medians of previous data leads to a completely different conclusion about the percentage gain and duration of the current cyclical bull. The rankings suggest that this bull market has a long way to go in comparison with bull markets within secular bears in the past. It’s another good reminder to think carefully about the data as it is presented to be certain that you understand the “spin” in the message.

What Could Change Our Stance?

Lately our communications have focused on the fact that we are still bullish over the intermediate term, and are using current volatility in the markets to augment risk assets in our portfolios. With that in mind, it is important to note that we are not complacent here, and realize that if conditions continue to deteriorate, there is a possibility that the dislocation in Europe could infect growth across the globe. As investors learned during the last downturn, countries are more interlinked than ever these days, and I certainly don’t think that any country can decouple should a major economic power begin to falter.

So I’m sure readers are wondering what sorts of data points we are watching that might factor into a change in stance. To make a change in our cyclical market view (as opposed to forecasting a correction within a bull market) it usually takes a wide cross section of data points (macro economic, technical, value, change in independent analyst views, etc). However, there are certain data points that we are focusing on very intently given current market conditions. The table below is a brief scratch list of some of the more important things that the team is watching closely right now.

For now, we continue to invest a bullish view based largely on continued economic expansion. But views can and do change, and we will continue to keep an open mind based on how the evidence builds in the many data points we follow. After a monster rally off the lows, and hitting the lower end of our target range, it is no time to be entrenched in any one view at this time.

What’s So “Golden” About the Current Market Environment?

Gold recently traded to a new closing high, at $1,238 an ounce. In the process, it took out prior technical resistance, and was accompanied by decent trading volume. That prompted a discussion here about the yellow metal this past Wednesday. We’ve held gold in our portfolios for some time as both insurance for a wide array of negative scenarios (hyper inflation, systemic crises, terrorism, currency debasement, etc), as well as the potential for a mania to develop in this asset class over time. Gold hasn’t always worked for us against our benchmark, due to its low correlation to equities, which can make relative performance versus equities very fickle at times (one of the things we like from a diversification and hedging point of view, but hate when it costs us versus our benchmarks).

In our Wednesday meeting we took a few minutes to talk about what was driving gold’s impressive performance of late. In other words, is this a breakout or a fake-out that we are witnessing in the gold market, and what does it mean to us? Should we sell into the rally, pile into the momentum trade, or do nothing at all?

The chart below gives a glimpse into a number of the key issues we discussed at the meeting. At the end of the discussion we decided to leave our positions in place and take no action at this time. If you are a client in Pinnacle portfolios, while we ended up not making a change to our allocations, rest assured that it wasn’t because we weren’t watching or talking about the potentially golden opportunities that moving markets create for our clients.

Euro At A Critical Spot

In the wake of the massive, $1 trillion bailout package concocted by the European Union, IMF, and European Central Bank last weekend, conventional wisdom was that the euro would get a big boost. After all, it had fallen by more than 16% percent since the news of Greece’s budget problems first surfaced late last year. However, after a brief reprieve during the trading day on Monday, the euro has rolled over and fallen back down near the lows from last Thursday (currently trading at $1.26 - see chart below).

The lows around $1.23 - $1.25 from late 2008 and early 2009 are critically important. If the euro breaks lower than that, bearish investors may pile in more than they already have, driving the currency even lower, perhaps back towards parity with the U.S. dollar. That would be a crushing defeat for European leaders, since the recent bailout package was designed as a “shock & awe” attempt to save the currency and remove growing doubts about the ultimate survival of the European Monetary Union. A fresh drop in the currency would reignite fears of contagion and de-stabilization, likely leading to another bout of volatility in the financial markets.

Mr. Miyagi and Trading Corrections in Cyclical Markets

My wife is usually in charge of the gardening at our house this time of year, but for some reason I thought I would pitch in this spring and help plant the annuals. I thought that gardening would be like Mr. Miyagi in the movie Karate Kid, where Pat Morita’s character studiously and artistically trims his ornamental bushes in a way that has Zen Master written all over it. I thought of great men like Winston Churchill puttering with their plants in the shade in between tea times and creating art. And so it was for me…at first. I cherished each of the annuals that I planted and took the time to consider each of them as individuals, a blessing of nature, a soother of souls. But then my wife explained that we needed to move the rest of the lariope (a plant that spreads all over the place) that was taking over our flower bed. All of the sudden gardening turned into back breaking work. It was hot. The lariope have a maddening network of roots that is impossible to dig out. I’m sure Mr. Miyagi would have paid to have someone else pull his lariope if he had any.

Investing a correction in a cyclical bull market is much like moving the lariope. You might think that the decision to take profits is made where analysts armed with the facts easily discern the right trade to make and the right timing for the trade. The trade gets executed, the markets react right on cue, the analysts look knowingly at each other having once again outwitted the consensus of investors, and all is right in the world. But timing a correction in a cyclical bull market is often like pulling the lariope from the garden. Oh brother it’s hard work. The facts are maddeningly confusing, the risks look similar on both sides of a trade, and the market proceeds to do something you had discussed the day before but decided not to invest. When the market corrections are less than 10% from top to bottom, resulting is rather small portfolio losses, you work twice as hard as you do otherwise and it often doesn’t result in any transactions in the portfolio. You just grind it out. When the markets get like this you have the usual research to read, more than the usual number of team meetings, as well as a river of special reports on topical subjects. As you might guess, just about everyone has something to say about the recent troubles in Greece. I can’t wait to start reading about oil spills…I know it’s coming soon.

So the lariope have been transplanted and the beds are ready for more annuals. Linda (wife) tells me that this is the work that has to get done before you can really enjoy the beauty of the annuals that you plant now for the enjoyment of your summer. Last week’s market turbulence resulted in some seemingly well-timed selling of our U.S. Treasury Bond positions and buying of an Industrial sector ETF. In the very short run our work has been rewarded. Beyond that, I believe that the work we are doing in the investment team today will result in significant outperformance as the year progresses. Then I will stand back, like Mr. Miyagi, and admire our handiwork. Ahh, Daniel-san…..Hiyaahhhh!

Technical Damage Contained So Far

Prior to the recent sell-off, we’d repeatedly referenced how strong the underlying technical condition of the market was. We regularly monitor a variety of these different price-based measures, and prior to yesterday, we didn’t see any of the classic divergences that have preceded significant market declines in the past.

While yesterday’s rout was certainly nerve-wracking, it appears that technical damage was relatively contained on most measures. At one point, the S&P 500 broke below its longer-term 200-day moving average. However, it managed to finish above that level by the end of the day. Other measures like advance/decline lines and new 52-week lows were moderately worse on the day, but don't appear to be flashing alarming warning signals at this point.

There were a couple of measures that suggest that there may have been too much fear in the market yesterday – total volume on the NYSE reached 11.4 billion shares, very close to the levels hit in the fall of 2008, just after the collapse of Lehman Brothers, and about a year into a bear market that had already seen a 20%+ decline in stocks! In addition, the VIX Index, which measures the volatility of options prices and is widely viewed as a “fear” indicator, rose to 41, which was the highest level since last May, almost exactly a year ago.

In short, while there may be more volatility ahead as the Greek crisis continues to capture headlines, we believe yesterday’s sell-off may have been overdone, and are staying the course for now.

Chart: NYSE Total Composite Volume

Chance Favors the Prepared

Recently our investment team has been discussing the possibiity for a cyclical bull market correction, and preparing ourselves for the waters to get temporarily choppy. The thought was that sentiment had gotten frothy and that many positions were way extended over the 200 day moving average. Heck we’d only had two major corrections during this huge run in the market, and they were about 7-8% in magnitude. In our models we created different strategies we might pursue if the correction unfolded. For our very aggressive clients we were preemptive and pulled about 10% of equity positions out of the portfolio on April 29th. For models with less risk, we planned sales of treasuries and potential equity buys to augment exposure on a dip.

The 200 day moving average seemed to represent a good target for the correction we were looking for, since it’s the long term moving average and should represent major support. Coming into today we were still 6% off that mark and eyeing up the possibility that we might start to nibble as we approached the long term moving average. What we didn’t realize was that the market was about to fall right through the 200 day moving average in one day.

The markets started down on riots in Greece, oil spill angst, and a surprise that the ECB has not yet considered quantitative easing. Things looked orderly through midday, but at about 2:00 things began to accelerate as computer selling kicked in. Then, at about 2:45, the market simply imploded, as the S&P 500 dropped by about 50 points in 5 minutes, and was down by about 100 points on the day (below the 200 day moving average at that point)!!

With a mini panic on, we quickly went into action, and Sean Dillon calmly executed some sales of bond positions that were rallying hard (5+% at one point in the TLT) on the fear present in the markets. We also had planned to begin buying back some high volatility positions in our most aggressive models, and were able to buy a high yield ETF that had plummeted 7% during the malaise. It turned out that the most precipitous part of the drop was due to a trader error and markets quickly rocketed back off the lows, eventually closing the day back over the 200 day moving average and 37 points down on the S&P 500.

Years ago Louis Pasteur said that chance favors the prepared. In this case, our forward thinking strategy and ability to execute in a nimble fashion prepared us to execute trades that dropped right into our lap.

Oil Slick or Economic Problem

Recently, one of our clients forwarded us a piece about the Gulf oil spill and its possible economic and financial ramifications. In the piece, written by well known analyst David Kotok of Cumberland Advisors (http://www.ritholtz.com/blog/2010/05/oil-slickonomics/), Kotok paints a picture that this oil spill will create a financial calamity for many businesses, making a double-dip recession more likely.

Personally, I hate this spill, and am sorry that wildlife and human life has to suffer due to the accident. But I think that turning this unfortunate accident into a higher probability for a double-dip may be a little too drastic at present.

Recent articles about the cumulative economic damage resulting from the spill brings me back to articles that circulated back when Hurricane Katrina rocked the Gulf region back in August of 2005. At the time, there were scary headlines about the ultimate impact of the hurricane on GDP growth and financial markets. Though there was some volatility in the S&P 500 around the time of the storm, patient investors who didn’t panic were well rewarded, as the market rebounded with a gain of about 24% off the October 2005 bottom.

There’s no guarantee that this spill won’t turn into a real problem for growth and financial markets. But for my money, I’d worry more about continued problems in the Euro-zone, falling money supply, depressed wages, and the winding down of the "grand experiment" of massive fiscal and monetary stimulus. In that regard, we’ll continue to diligently monitor macro fundamentals, technical analysis, and valuation, looking for cracks in the bull market.

At present, we still believe that the higher probability is that this is simply a temporary setback. It’s certainly scary, as market corrections always are. But rather than focus on what could go wrong, we are currently focusing on how we can use this bout of volatility to add value to our portfolios.

Shooting the Winners

Last week, the investment team met for several hours and one of the main topics of conversation was the extended condition of several sectors of the stock market. We have seen this before during the past thirteen months. The S&P 500 Index will get more than 10% above its long-term 200 day moving average and then correct about 8% over a period of several weeks, and then go on to make new highs. The most volatile (highest beta) cyclical sectors will correct closer to 20% during these brief episodes, and then reward patient investors by once again leading the market higher. There is no doubt that financials, consumer discretionary, industrials, and materials have been the market leaders in this raging bull market environment.

At our meeting, we specifically considered either trimming or selling outright the consumer discretionary sector, which has confounded analysts concerned about high unemployment and weak residential real estate prices, by having some of the strongest earnings gains of all S&P sectors. On one hand, it seems to make sense to sell the leaders after a strong run to buy a lagging sector, the idea being that the leaders will mean-revert to more average returns and the laggards will catch up. On the other hand, it is a well known rule in the investment world that one of the biggest mistakes that you can make is not to let your winners run. Lots of money has been left on the table by investors who took their profits too early. Confusing the situation even further is our basic outlook which calls for the market to continue to work its way higher during the year, although we are aware that we are entering the worst seasonal part of the year to invest (“Sell in May and go away).”

For me, the most important question is whether or not we should couple taking some profits from a winning security with the notion that we can defend against a market correction that is due to appear any day now. We are 1 for 2 during this bull market in timing these short-term dips in market value. Our conservative and moderate portfolios would only decline 3% to 5% if the S&P 500 retreats to its 200-day moving average. I’m not sure that is significant enough to worry about. As of today we decided not to take our winners out and shoot them, but we are continuing to look at this trade. Perhaps the Greek fiasco will be the catalyst for the next correction and we will shortly be discussing buying the dip, instead of shooting the winners.