Accumulation is the New Strategy

The stock market has confused and confounded a great many investors so far in 2012. While the macro negatives are seemingly monumental and there are no easy answers available, the S&P 500 index is up +7.5% so far in 2012, +12.1% from the December 19th low, +16.7% from the November 25th low, and nearly +23% from the October 3rd low. This action has the bears crying foul and has left lots of folks scratching their heads.

Given that I have a call with some investors later this morning and I know I’ll be asked to explain why the market doesn’t seem to make sense, I decided I’d best put together my explanation for this seemingly counter-intuitive action. So, while I’m sure I’ll get some hoots and hollers from the bear camp regarding the remainder of this morning’s missive, here’s my view on why stocks are doing their best Energizer Bunny imitation right now.

First, in order for stocks to rally to the degree that they have and to do so in the manner they have this year (meaning there have been virtually no pullbacks and nearly every intraday dip has been met with buying), you’ve got to have demand. So, if you look around the room at the various players in the stock market game it becomes obvious that there is one contingent with the cash available to buy stocks. No, it’s not the mutual funds as the cash-to-assets ratio amongst equity funds sits near an all-time low. It isn’t likely the pension fund managers, who have more liabilities than assets coming in. And it definitely isn’t the public as Mom and Pop were blown out of this market a long time ago.

However, it has been well documented that Hedge Funds had gotten uber-defensive in the latter stages of 2011 as the macro picture appeared to be getting uglier and uglier by the day. Thus, the fast-money crowd was likely caught flat-footed as the current rally began. And since a great many of the hedgie crowd subscribe to the church of what’s working now, it isn’t surprising to see stocks being chased higher on a daily basis.

The bears will argue that this type of demand is suspect as these managers can and will turn on a dime. Therefore our furry friends tell us that today’s rally is likely to soon morph into tomorrow’s nightmare. However, it is worth noting that there might just be something besides performance anxiety happening here.

Let’s take a step back from the blinking screens for a moment. And just for fun, let’s x-out the period from June through October on the charts. And to make the point really clear, let’s also erase all the fear about what could or should happen in Europe for a moment. So, what are we left with?

For starters, we have an economy that is growing – slowly, yes – but growing all the same. And to hear Mr. Bernanke tell it, we have no signs of a recession and a GDP growth rate somewhere north of 2.5%. Now mix in low inflation and ultra low interest rates and what do you have? Yep, that’s right, a pretty decent backdrop for stocks.

This is especially true when you look at earnings and valuations. In short, with EPS on the S&P 500 up 14.6% in 2011 (according to Ned Davis Research estimates) and another 8% – 11% of growth expected in 2012, valuations remain no worse than average. In fact, the S&P would need to rise about 34% from here in order to become overvalued from an historical perspective (I’m defining overvalued as +1 standard deviation from the median P/E over the past 48 years). And then if one looks at valuations from 1990 forward (when the public really got involved in the game via 401(k)’s), it is interesting to note that there have only been two other periods where valuations have been lower in the past 22 years (1990 and 2008).

Then there is the issue of competition for stocks. If we can remove the big-bad-event risk from the stock market (I did say “if”), it becomes clear that stocks are a better bargain than bonds right now. How can I say that, you ask? Easy – bonds are overvalued and stocks are no worse than fairly valued. And since the Fed has turned cash into trash, stocks look like a decent alternative.

I am fully aware that there is a “yea, but” to the very simple arguments I’ve presented. But I’m not talking about what is going to happen next, I’m merely trying to understand/explain why the environment did a quick 180 in mid-December. And in short, I think it’s all about a little thing called accumulation.

The question, of course, is whether or not this sideways-is-the-new-down, buy-the-dip (every dip) environment can continue. Since I don’t have a functioning crystal ball, I will say that in my experience, these types of moves go and go and go, until they don’t. So, as long as the big boys and girls want to continue to accumulate positions, buying the dips (especially if we can get a 3-5% move down somewhere) would seem to be the appropriate strategy to employ.

Turning to this morning… Conflicting data has futures moving a bit below breakeven after the disappointing Retail Sales numbers from the U.S. However, the overnight action was dominated by the Moody’s downgrade of European countries, the strong German ZEW Confidence Indices, and the weaker than expected Eurozone Industrial Production report.

On the Economic front… The Commerce Department reported that Retail Sales were up +0.4% in the month of January, which was well below the consensus for +0.9%. When you strip out the sales of autos, sales were up +0.7%, which was above the consensus for a reading of +0.6% as well as last month’s revised -0.5%.

Next up, The government reported that Import Prices for the month of January rose by +0.3%, which was in line with the consensus for an increase of +0.3%. Export prices rose by +0.2%, which was above last month’s level of -0.5%.

We also got reports on the NFIB Small Business Optimism Index, which increased by +0.1 in January to its highest reading since December 2007.

David Moenning
Editor:  Short-Term Market Manager