Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: The S&P 500 gapped up higher on Monday, largely due to encouraging discussions regarding the fiscal cliff, and has held up relatively well on Tuesday despite the news from Hewlett Packard (HPQ). What are your thoughts on the market’s resiliency this week?
Stovall: It’s still early, but the market was pretty much in an oversold condition as of the week ending on November 16, and was just likely due for a snap back. The real question is whether this ends up simply being a rally that investors will be selling into, or whether it is something that has the sustainability to then become an end-of-year rally. I still think it’s a little early yet to say that the market is ready to move in a linear fashion upward between now and the year end since we still have the debt ceiling we have to deal with. We also have a resolution of some sort for the fiscal cliff, either it being a postponement of falling off the cliff or an actual resolution. So there are still an awful lot of things that could undermine this rally.
EQ: It seems that investor sentiment toward a fiscal cliff resolution is becoming a bit more positive as compared to previous weeks. Could that optimism serve as a catalyst as we go forward even if Congress just decides to push the deadline further out?
Stovall: If it is indeed consumer optimism, and not consumer apathy, then I would tend to agree with you. Optimism would push prices higher even if we just get a postponement. That would be helpful in my opinion because it would give investors the opportunity to say that Congress needs a lot of time to hammer out a meaningful revamping of the U.S. tax code, and we wouldn’t want to do something too quickly in the remaining weeks of 2012. So in that sense, a delay of some sort would be helpful to consumers. However, I think there has been so much talk about the fiscal cliff that consumers and investors are just tired of hearing about it, and as a result, maybe they’re just tuning it out. So we have to wait and see if it’s true optimism or if it’s apathy.
EQ: In this week’s Sector Watch report, you discuss the rolling 10-month moving average for the S&P 500 and the dangers of trigger happy investing based on technical signals. Can you tell us more about that?
Stovall: I find that for investors, myself included, the one thing that can get in the way of successful long-term performance is emotion. So if you can embrace some sort of a rules-based investment approach, that can help you stay in the market longer and not get out at the first sign of weakness. Let’s face it, declines of zero to 5 percent happen all the time. I simply call them noise. Declines of 5 percent to 10 percent basically happen almost once a year. So since that is a fact of investment life, my recommendation is to find something that will help you stay the course rather than to respond negatively at every sign of concern.
I’ve heard money managers talk about a rolling 10-month moving average, and I first read about it in a book called The Ivy Portfolio by Mebane Faber. I decided to do some work of my own, and what I found was investors would probably be wise to sit up and take notice when the market does fall below its 10-month or 43-week moving average, but don’t react right away. I believe that the best returns have come when investors have waited at least four weeks, and preferably 11 weeks, before responding to the sell signal that comes from the rolling 43-week moving average.
Right now, we are in week three and if by the day after Thanksgiving, we are still below this 10-week moving average, then one might say it’s worthwhile to lighten up a little bit. However, I would still tend to say it’s a bit early to react.
EQ: When investors are waiting during that four week to 11 week period after the initial sell signal, does that tend to incur more losses?
Stovall: The losses don’t seem to accelerate between the four- to 11-week periods. The four-week period has provided investors a compound rate of growth of 7.4 percent per year going back to December of 1969, versus 6.4 percent for the S&P 500 during that time. However, in terms of frequency, you’ve beaten the market only 61 percent of the time. If you wait for the indicator to fall below the average for 11 weeks, then the compound rate of growth climbs to 8 percent versus the 6.4 percent, and the frequency of outperformance becomes 71 percent. So it ends up delivering better returns with a higher frequency. I also have found that, in general, you do not end up adding significantly to your decline by waiting that much longer. So I have to tell people it does require a bit of discipline to sit on one’s hands when they’re dying to pull the trigger.
EQ: How can investors avoid knee-jerk reactions, which usually does more harm than good to their portfolios, but still use technical indicators effectively to manage their positions?
Stovall: What they can do is two-folds. First, use technical indicators as a guide. So in a sense, use it as an alarm to tell you when things are breaking down you know when you might want to sit up and take notice. Secondly, you can use it as a rules-based investment approach, essentially pretending that you are working for a Marine Corp drill instructor who says, “Don’t think, just do what I tell you.” In that case, based on back testing, I believe that it’s best not to react the first time around, but rather to wait a couple of weeks--in particular wait four weeks at a minimum and 11 weeks optimally--before reacting and lightening up on your equities exposure. Over the long haul history says, but does not guarantee, that you will outperform the market both on a percentage basis per year as well as on the frequency of outperformance.
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