October’s reputation for danger is well known in the investment community. Nonetheless, this year for a good part of this historically perilous month, stock prices confounded the multi-decade averages and rose. Nearly all major equity indexes reached highs for the current rally in the middle of the month. The back half of the month proved less fruitful, however. The indexes declined slowly in the initial days of the correction, picking up speed as October came to a close. Wednesday and Friday (today) saw aggressive declines on rising volume. Most market indexes declined between 2% and 3% for the month as a whole.
So far, declines from the intra-month highs are approximately 6%. The S&P 500 has given back just about 65 of the 435 points it gained from its March low. Still less than 20% of the rally’s gain, that is well within the range of what would be considered a normal correction in an ongoing bull market. Market behavior over the next several weeks will determine whether, in fact, this is simply a correction or whether it has more ominous implications.
We have stated in a number of recent commentaries that market prices have run far beyond levels warranted by business fundamentals. As a result, deep discount value managers like ourselves have seen very few stocks meet our historically-based selection criteria. In fact, we have used this powerful rally to our advantage and have rid our portfolios of all unwanted equity positions. As we indicated in our recently issued quarterly commentary, we would be vulnerable in the short run if the market should disregard fundamentals and continue its rally through the end of the year.
We recognize that markets can ignore fundamentals far longer than most people believe. In light of our own sub-normal equity position, we added a 10% position in the S&P 500 exchange traded fund (SPY) this week when that index declined to the low 1050’s. This purchase was an acknowledgement that technicians and momentum players have been in control of market behavior over the past few months. Our entry point was just above the extended trendline connecting the March and July price lows of the current rally–a logical point at which bullish technicians might come in to buy. Our added stock position still left us in an extremely conservative asset allocation posture.
Wednesday’s strong decline saw prices penetrate the trendline and decline further on rising volume. At the very least, this was an indication that the bulls were getting tired and that the market needed a correction. While that trendline break increased the probability that prices would ultimately move somewhat lower, many technical factors were short-term oversold. We anticipated that some rally would likely occur to relieve the oversold conditions. It happened faster than we expected with a 200 Dow point rally yesterday. Despite that impressive point gain, market internals, especially volume, were far less impressive. Since our reason for buying the incremental stock position no longer existed, we chose to use the rally as an opportunity to exit the position with a minimal profit in this morning’s first half hour. Those exit prices proved to be near the best of the day, as the Dow subsequently dropped by 250 points.
We manage our portfolios almost entirely on a fundamental basis steeped in market history. Occasionally, as in this instance, we will attempt to take advantage of technical market conditions that appear to offer a low risk supplemental profit opportunity. This week we were willing to accept a small risk to capital in an attempt to increase this year’s total return. We were quick to recognize that the market did not follow the pattern we were anticipating and were able to close the position with a small profit
We remain ready to add equities to our portfolios as individual stocks decline to price levels that meet our historically based valuation criteria. In the meantime we are comfortable not carrying any appreciable equity risk at current levels.
Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.