June 7, 2013

Market Outlook

Chloe Lutts Jensen

 The Next Correction is Imminent
(… and so is the next sunset)

“Unlike sunsets, however, corrections are not predictable in an ongoing bull market—especially one as strong as this one that has defied investors’ fears for four continuous years. It would be safe to say that every investor is either fearing, anticipating, expecting or hoping for a correction (which is the case for those who are underinvested). Even the seasonal ‘Sell in May’ crowd is dumbfounded by the 700+ point gain in the DJIA since May 1.

“The simple fact is that bull markets do whatever they can to confuse, confound and frustrate the majority of investors. We’re not sure which market sage said that first, however, it was a lesson well learned in our early years of InvesTech Research during the roaring 1980s. Corrections are a healthy part of every bull market.

“On average—based on 16 bull markets over the past 80 years—a 10% correction comes around every 25 months, and 5% corrections are far more frequent at seven months. Yet, historically, there is no predictable frequency between such corrections. This four-year bull market has already experienced ten corrections of 5% or more, with two of those exceeding 10%. The last correction was 7.7% from September-November 2012, so one might say we’re certainly due for another. Yet, remember that during the 1990s the bull market ran for almost seven years (83.5 months) without a single 10% correction. … The and fundamental data remain positive—supporting our current 89% invested allocation target. …

“Bear market warning flags that would warrant a more defensive stance are not evident at this time. There is no sign of divergences in market breadth or bellwethers and we are encouraged by the continued improvement in the Leading Economic Index and in consumer confidence.

“The overall invested allocation target must be based on this evidence, and not on the likelihood of a correction. It is not advisable to reduce investments simply based on the fact that we are in the midst of a six-month ‘correctionless’ bull market run. However, given the higher probability of a correction—and especially as we enter the seasonally soft summer time frame—we should review sector allocation to ensure portfolios are positioned to weather any downturn while still capturing further market appreciation.

“During previous corrections in this bull market, it is perhaps not surprising that the more defensive sectors held up better than the market (see table). This bull market, which began in March 2009, has experienced ten corrections of 5% or more thus far. In each of those ten corrections, the Consumer Staples and Health Care sectors outperformed the S&P 500. This means they have a perfect 100% batting average (i.e., they beat the Index in 10 out of 10 corrections).

“Sector seasonality studies also suggest a defensive sector focus may be prudent. It is well known that the market experiences seasonal tendencies with the majority of gains being realized in the winter period (November-April) as opposed to the summer months (May-October). This phenomenon is often referred to as ‘Sell in May and go away.’ While we don’t subscribe to the ‘Sell in May’ investment strategy because summers still generally show a gain, it does make sense to be more defensively positioned during the typically softer summer months.

“Just as the market experiences seasonality, so do the underlying sectors. Top performance in the more favorable winter months is dominated by cyclical sectors (see table below). Leaders include Consumer Discretionary, Materials and Industrials, each gaining nearly 10% or more vs. a 7.2% increase for the S&P 500. Technology, Energy and Financials also perform better than the market on average in the winter, but by a smaller margin. The most defensive sectors, Health Care, Consumer Staples, Utilities and Telecom have been the worst performing areas in the November-April time frame.

“However, sector leadership has historically experienced a dramatic shift in the summer months. The defensive Consumer Staples and Health Care sectors—which underperformed in the winter—move to the top of the list in the summer, with gains exceeding 4% on average compared to slightly less than 1% for the S&P 500. And the leading cyclical sectors in the winter—Consumer Discretionary, Industrials and Materials—become the laggards in the summer. In fact, these are the only three sectors to average a decline in either the summer or winter months. Energy and Technology show less seasonal tendencies, slightly besting the market during both periods. Given this seasonality trend, coupled with the data shown above for sector performance during corrections, it appears the safety-first decision is to overweight defensive areas of the market at this time.”

James Stack, InvesTech Research, www.investech.com, 800-955-8500, 5/31/13