Thursday, May 20, 2010

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.