Sell in May and go away

There is an old market expression which states: “Sell in May and go away.” In other words, traditionally the U.S. stock market tends to experience seasonal swoons.

Going back to 1900, studies indicate the two periods when stock prices tend to be weak are from April to June and again from September to October. So, the old expression of “sell in May and go away” has, on average, held true. However, we look at issues on a more fundamental basis, rather than relying solely on historical expressions.

Analyzing what is happening in Europe, in particular the issues with Greece, and the potential for contagion problems leads us to the conclusion that the probability of a downside shift in U.S. equities is real. We don’t believe this is the start of something big unless the Euro truly collapses and chaos takes over in the currency markets. Our international team is not looking for a collapse in the Euro, but would not be surprised at a certain amount of continuing weakness in relation to the U.S. dollar.

Earnings season is going well – and the market is embracing a 30-plus percent rebound in corporate profits. From the end of March through April 26, the S&P 500 Index had risen by 4.1 percent. Since the end of 2009, the market had increased by 9.2 percent, with total return (including dividends) coming close to 10 percent year-to-date.

At the beginning of this year, we had been looking for the market to generate roughly 10 percent returns for the year. We have been saying this return was probably going to be “front-end” loaded – in other words, most of the return occurring during the first portion of the year. This has occurred. Now, where do we go?

We would not be surprised in the least for the market to slow its ascent and perhaps experience an “intermediate” correction between 10-to-20 percent. However, we don’t sense the start of a new bear market – the economy is currently experiencing too many positive influences for this to be the start of a 20-plus percent decline.

Among these positive influences are:

 Friendly Fed policy – (Fed is not tightening – yet).  Extremely positive earnings momentum. It appears this quarter’s average gain in operating earnings for corporate America may exceed 30 percent. Remember, during normal times this number is in the seven percent range.

 Consumer final demand appears to be ramping to the upside.  Unemployment appears to have peaked. What are the negatives the market is currently facing?  Gravity. The S&P 500 Index is up more than 78 percent from the lows we witnessed in March of 2009. This move has been accomplished with little more than a 10 percent price correction. In other words, we are due for a slowdown.

  The real problems in Greece highlight a nation’s weak balance sheet. Investors are now beginning to focus on the problems we have been talking about for three years – the majority of the problems the world’s financial/political systems face is debt -many countries/individuals have been living beyond their means for years. This is proving unsustainable. The problems the markets faced a couple of years ago have not gone away – rather the market’s focus has shifted to the income statement side of the argument.

 China appears to be slowing. We don’t consider this to be a serious problem at this time but it bears watching.

  Debt. We can’t say it more simply.

Our politicians are attempting to recalibrate banking rules and regulations. In our opinion, this needs to be done. However, the focus should be squarely on debt and the amount of leverage allowed on balance sheets within the financial system. Lehman Brothers and Bear Stearns both had a huge amount of leverage on their balance sheet when they went out of business. Debt-to-equity ratios at Lehman eclipsed a 40x ratio.

In other words, for every $1 of equity on Lehman’s balance sheet, they were carrying $40 in debt. When the debt declined in value by a small amount, the firm’s equity base was wiped out. From a societal standpoint, the debt issue is still present, and probably will be for some time. We have said before that as long as the world’s investors are focused on the economy’s income statement (GDP, employment, productivity, inflation), the markets will probably continue to perform well.

However, as investor focus shifts towards balance sheet issues (Greece and debt in general), the markets will probably swoon. We believe the evidence is still in the camp of income statement focus. Consequently, we currently believe if a correction takes place in the equity market, it may certainly prove temporary in nature.

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