Four Reasons

The following financial market commentary was written by Matt Malick and Ben Atwater of Atwater Malick LLC. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers. You can learn more about them at www.atwatermalick.com .

Last week, the S&P 500 saw its third consecutive weekly drop and has tumbled 7 percent since reaching a 15-month high on January 19^th. The index is down 3.5 percent year-to-date, having suffered its first monthly decline since October and the biggest since it plunged 11 percent in February 2009. According to the Stock Trader’s Almanac, the performance of the S&P 500 in January is a reliable predictor of how it will fare during the full calendar year. Before last year, when the index dropped 8.6 percent in January and then rose 23 percent for the year, the so-called January barometer made only five erroneous predictions since 1950. However, below are four reasons we believe that the recent selloff is part of a temporary correction amid a rally that began in March 2009 and will eventually reconstitute itself and lead to a multi-year bull market:

1. One gauge of investor sentiment, the Chicago Board Options Exchange Volatility Index (VIX), also known as the fear index, rises when buyers are speculating that equities will retreat, because the gauge, according to Bloomberg News, moves in the opposite direction of the S&P 500 more than 80% of the time. The VIX opened Wednesday the 20^th, the first day of the selloff, at 18.51 and it ended this week at 24.56, a 33% increase. In its 19-year history, the average reading on the VIX, also according to Bloomberg News, has been 20.28. Clearly, the fear index reflected relatively little investor nervousness coming into the sell-off, a potential warning of the correction we are now experiencing. Overall, this explosion in the VIX indicates to us that investors have moved from complacency to panic too fast, often a contrarian indicator.
   
2. According to Michael Santoli, writing in the Monday, January 25, 2010 edition of Barron’s, “Citigroup strategist Tobias Levkovich points out that inflows into bond mutual funds over the past six months are three standard deviations above their 10-year average, an extreme level of change that has typically had nasty implications for the asset class in question.” In other words, the extreme favoritism individual investors are showing toward bond funds is converse to the disrespect they are showing equity funds. According to TrimTabs Investment Research, December was the fifth month in a row in which mutual fund investors pulled more money out of domestic equity mutual funds than they contributed. December’s net outflow came to $7.2 billion, bringing the total since the beginning of March to $29 billion. If the market does not resume its bull market run, this will be one of the only times in anyone’s memory when mutual fund investors predicted the market’s subsequent move.
   
3. While professional investors have been better market timers than individual investors, they have also displayed an unimpressive track record. And although sentiment has improved significantly from its lows, financial market practitioners are still mostly negative. Bloomberg News reports that 43 percent of respondents in a quarterly global poll of market professionals who are subscribers to the Bloomberg Professional Service say the international economy is improving, up from 37 percent in October. Thirty-eight percent said their country’s benchmark stock index will rise in the next six months; 33 percent say it will vary little and 27 percent say it will fall. This subdued sentiment leads us to believe that professional money managers have not fully committed capital to equities, meaning there is still a great deal of money on the sidelines.
   
4. Earnings, which fundamentally should drive stock prices over the long-term, have been very strong so far this earnings season. For example, six of our companies announced earnings this week and, in five cases, these companies exceeded the average analyst estimates. More broadly speaking, Bloomberg News reports that “a record nine-quarter earnings slump for S&P 500 companies is projected to have ended in the fourth quarter with a 73 percent increase in profits.” Also according to Bloomberg, nearly 80% of the U.S. companies that have reported earnings since January 11^th have beaten analysts’ estimates (153 out of 192 companies).

Friday’s GDP report further evidenced a stronger recover than many have yet contemplated. Bloomberg reported, “The 5.7 percent increase in gross domestic product at an annual rate reported by the Commerce Department in Washington today exceeded the 4.8 percent median forecast of economists . . . Separate reports [on Friday also] showed consumer sentiment and a barometer of business activity rose more than forecast in January.

Overall, the market appears to be in the process of a natural correction following a huge rally. This correction most likely has some distance to travel. But, as far as we can tell, the recent pullback has no fundamental economic or earnings-based rational whatsoever. This means that the market is acting irrationally, based on pessimism and fear, no reason to abandon our long-term optimism.