Ramblings of a Portfolio Manager 1-11-2010

Fair is Foul and Foul is Fair
--Macbeth

The old saying on Wall Street is “as goes January so goes the year.” It’s a quaint little scrap of urban legend that suggests the first week of trading in the stock market—the Dow Jones Industrial Average—foreshadows the remainder of the year. Over the years stock traders, ever an impatient lot, have further distilled the adage into “as goes the first week of January, so goes January” thus avoiding the wait until the 31st to make their asset allocation decisions. Not to be outdone other, equally superstitious, traders have added the Super Bowl Indicator, which suggests a correlation between the winner of the big game and the performance of the equity markets (Dow) in that calendar year (old NFL team wins are good, former AFL team victories are bad). While both myths are good for a chuckle, there is a surprising correlation between them and Dow performance. The Superbowl Indicator has a better than 88% accuracy rate over its life while the so-called January Barometer has demonstrated predictive power 73% of the time when the indicator points up. It’s all spurious, of course, but it gives the tooth fairy believers among us in the markets something to which to look forward during the bleak winter weeks. But we digress.

The US equity markets got a good start to the new year last week. The Dow rose 1.82% while the S&P 500 gained 2.74% and the Russell 2000 Index of small cap stocks bested them all at +3.08%, giving believers in the January Barometer something to cheer. What was remarkable to some, however, is that these gains came amid the release of mixed to weak economic data: Construction Spending kicked off the week coming in slightly worse than expected, down 0.6%, followed by the ISM Index, which was slightly better at 1.1% vs. a forecast of 0.5%. Pending Home Sales were a disaster, down 16% vs. a +2.0% forecast but the 800 lb. gorilla broke the scales on Friday when Nonfarm Payrolls were reported at -85,000 vs. a forecast of flat and some market expectations of a rise. While most of the market gains occurred on Monday, the first trading day of the year, the markets failed to give it back during the rest of the week and actually tacked on slight gains over the remaining trading days even in the face of the weak economic news, especially on Friday. To the market skeptics this behavior was absurd; to us it was predictable.

Market bears have decried the rally since it began on March 9th and they’ve thrown every known investment cliché at it—from “too far too fast” to “not supported by fundamentals” to a cornucopia of chart-speak we don’t understand so will not quote here. Having failed to receive their expected revisit of the Dow to the 6000 region, these same skeptics are now calling for the end to come when the Federal Reserve begins to withdraw liquidity and hike rates, which was expected to occur later this year. Here we cannot disagree with them. While we believe much of the markets’ rise since March has been the result of them doing their job as discounting mechanisms, anticipating the economic rebound we are now seeing, much still has been liquidity-driven. An effective short-term interest rate of zero has made the equity markets look “cheap” in many investment models--not to mention what that implied yield curve has done to bank earnings--and the result has been as remarkable as it has been predictable. Anyone who doubts the rate effect on the markets need only look at the inverse correlation between the dollar and markets over the last year or, more recently, the sideways action of equities amid the increasing belief that the Fed will begin to raise rates sometime in mid-2010. In fact, we were prepared, earlier this week, to call this piece “Sell in May and Go Away,” suggesting that if most market participants expected a June-July rate hike, then the time to get out of equities would be months earlier. Friday changed all that. The weak jobs numbers, we believe, have pushed out market expectations of a rate rise to later in the year. Before the report PIMCO’s Bill Gross was calling for no rate hike at all this year and few believed him—now, many do.

So what do we expect now, as we head into earnings season? Perversely, we believe that for individual equities, bad news will continue be seen as negative and good news good, while for the equity markets as a whole, bad news—in the form of weak economic data--will be positive overall as it will push further out the expected date the Fed will have to take back the proverbial “punch bowl.” Add on top the cynical optimists (like us) who believe that continued weak jobs data will spur the White House into releasing more Fiscal stimulus programs ahead of the mid-term elections and you have a recipe for continued market gains amid lackluster economic reports. Last week we poked fun at investment managers who call each year for a “market of stocks” versus a “stock market” but for the upcoming quarter, at least, that just might be what we will see.