By Charles Rotblut, CFA | 3 September 2010
A 'bubble' may be forming in bearish indicators. A sign of just how much attention pessimistic prognosticators are getting occurred last week when my mother asked me about the 'Hindenburg Omen'. This is an arcane indicator that uses technical analysis criteria to try to predict a forthcoming market crash.
Like many forecasting tools, the accuracy of the Hindenburg Omen is questionable. Market timing is far more difficult than it seems. A combination of luck and historical trends can translate into one or two correct market calls and make a market timing system seem better than it actually is. This could be the case over the next few weeks if September lives up to its reputation.
As I mentioned last week, September has historically been the worst-performing month of the year. Since 1971, the average September monthly returns for the S&P 500 and the Russell 2000 have been -1.0% and -0.6%, respectively (according to Jeffrey Hirsch of the Stock Trader's Almanac). This is not a recent pattern: Sam Stovall of Standard & Poor's states the month's comparatively lousy performance dates back to 1928.
Mid-term election years make September's reputation for performance even worse. Stovall says September was down "five of five times ahead of the mid-term election during a Democrat's first term in office" with an average return of -3.8% for the S&P 500. Thus, as you can see, calling for stocks to fall in September is not exactly a sign of predictive prowess— just an awareness of market history.
Historical trends only hold until they do not, however, and September could end up pleasantly surprising us. Since 1971, Hirsch counts 16 occurrences when the S&P 500 has posted gains, or four out of 10 times. What could cause this September to buck the trend? Better-than-forecasted economic data would be the most likely catalyst. Action by Congress on 2011 taxes (I know, I'm a dreamer) and a lack of third-quarter earnings declines could also help.
Beyond guessing about what may or may not happen, there is the issue of what to do with your portfolio right now. Though I recommend maintaining a focus on your long-term goals and asset allocation strategies, I realize that some of you are nervous and want a short-term action plan. While no financial plan is one size fits all, here are some broad steps for dealing with the ongoing uncertainty and market volatility.
- Review all of your holdings to see if the reasons you bought each investment still apply. Pay particular attention to stocks that would violate your sell rules under normal market conditions. One thing that helps is if you wrote down the reasons you would sell a stock when you first bought it. If you have never done this, now is the time to start.
- Review your asset allocation relative to your financial objectives and risk tolerance. If your allocation to bonds is too high, create a shopping list of stocks you would buy if the price were right. An often overlooked part of asset allocation is that 'rebalancing' can help you to sell high and buy low.
- Assess how much downside risk you really think there is. As of Monday's close, the S&P 500 was trading at 13.2x projected 2010 earnings of $79.50 per share. Even if we assume the forecast is too optimistic, it does leave a margin for error. Furthermore, if September lives up to its reputation, ask yourself whether a 3% or 4% drop in stock prices is large enough to justify tearing apart your portfolio and risking the chance that you won't get back into the market fast enough to take advantage of any rebound. After all, Hirsch found that during mid-term election years, the best three performing months were October, November and December.
- Take a more defensive stance with your stock holdings. Dividend-paying stocks from industries that are less impacted by economic trends may incur less volatility— although they are not immune from the broad market's fluctuations. Inverse ETFs and put options can pay off if stock prices do fall, but there are downsides to both. The actual performance of an inverse ETF may be worse than you expect because of tracking error. Put options can expire worthless and cost you all of the money you invested in them.
Keep in mind that there are transaction fees and potential tax costs with any of these strategies. Plus, if you have traditionally done a good job of managing your portfolio and maintaining proper allocations, the best move may be the one that you don't make.
The Week Ahead
The U.S. financial markets will be closed on Monday in observance of Labor Day. Rosh Hashanah starts on Wednesday night and could cause volume to be light on Thursday. I wish all of our Jewish members l'shanah tovah ("a good year"). The only S&P 500 member company scheduled to report is National Semiconductor Corp. (NSM), which will announce its results on Thursday.
There is not much on the economic calendar. The Federal Reserve's Beige Book and July consumer credit will be published on Wednesday, July trade deficit data will be released on Thursday, and July wholesale trade numbers will be issued on Friday. Otherwise, it will just be the weekly reports such as mortgage applications (Wednesday), initial jobless claims (Thursday) and oil inventories (Thursday).
The Treasury Department will auction three-year notes on Tuesday, 10-year notes on Wednesday, and 30-year bonds on Thursday.
Charles Rotblut, CFA is a Vice President with AAII and editor of the AAII Journal.
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