Anatomy of a Stock Market "Meltup"
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. What is a Meltup?
2. Retail Investors Poised for a Pullback
3. Will the Meltup Continue in 2010?
4. What’s An Investor to Do?
As an Investment Advisor, I would be less than honest if I didn’t admit that the stock market sometimes causes us to scratch our heads, wondering what in the world it’s up to. As the current market rally continues unabated, this is definitely one of those times. In 2009, the S&P 500 Index soared 65% since its lowest closing value in March and ended the year up over 23%.
Typically, the stock markets are driven by fundamentals regarding economic growth and corporate profits. However, I have previously noted in this E-Letter how some analysts say that the stock market is currently factoring in a 5% GDP growth for 2010, which few economists expect to happen. So much for fundamentals.
In addition, this market has seemed to defy gravity in that it has not experienced so much as a 10% correction since the March lows, which is rare for such rallies following major bear markets. Add to that double-digit unemployment, a potential commercial real estate bust and a new emphasis on saving rather than consuming and you get what should be bad news for the market. Reams have been written about why the market shouldn’t be doing what it’s doing, but it’s obvious that the market doesn’t subscribe to those publications.
Considering the market’s continued upward trend, I recently came across a surprising revelation as I reviewed the Investment Company Institute (ICI) statistics for mutual fund investments. The ICI data show that domestic equity mutual funds have recently had consistent net outflows of money (more withdrawals than new investments), meaning that retail mutual fund investors have been heading for the exits in favor of cash or other asset classes.
So, how can it be that the market goes up even though investor sentiment for domestic equities is still decidedly bearish? The answer may lie in an obscure market phenomenon known as a “meltup,” which is a momentum-based rally that usually bears little relation to the underlying market fundamentals.
But if retail investors are actually withdrawing money from domestic equity funds, then who is behind a momentum-based meltup? This week, I’ll provide some possible answers to this question, and the answers just might surprise you. I’ll also provide some additional thoughts about the current market rally and what it might mean for your investments.
What is a Market Meltup?
I’m sure we all know what a “meltdown” is in relation to the stock market. It’s when the values of stocks simply seem to melt away (plunge) over a relatively short period of time. However, the term “meltup” is not usually as familiar to investors, even those who have been participating in the market for a long time.
In general, a market meltup is just the opposite of a meltdown, in that it describes a sudden increase in stock prices, often without the support of market fundamentals. In most cases, market meltups are fueled by investor momentum rather than improving economic conditions and can be viewed as a kind of investment “herd mentality.”
In some cases, this rush to buy equity investments is based on a realization by market participants that they have missed out on significant gains, so they feel they must invest to participate in any remaining upward market momentum. If enough market participants react the same way, the meltup can actually become a self-fulfilling prophecy as money moving into the market drives up prices far beyond where the fundamentals say they should be.
This, in my opinion, is exactly what we saw in 2009. The market meltdown that occurred in 2008 and early 2009 drove stock prices too low, and this paved the way for a market meltup, which we now know began in early March of last year. As noted above, the S&P 500 Index soared apprx. 65% from the March low to December 31.
The question is, will the meltup continue in 2010, or are we now in a post-meltup environment, which could mean we’re in for anything from a severe correction to a long-term range-bound market? Obviously, no one knows for sure. What we do know is that some very interesting things are happening in the current market meltup.
Retail Investors Still Dumping Stocks
While the domestic stock markets have continued to rally in recent months, it’s clear to see that retail investors are not the reason for the meltup we’ve already had. That’s because domestic stock mutual funds have actually experienced net outflows of apprx. $40 billion over the past five months, not something you’d expect in an upward trending market like we’ve had since March.
A recent BusinessWeek article noted that retail investors are only slightly less bearish now than they were back in March when the market hit a 12½–year low. Therefore, it’s no surprise to learn that statistics compiled by the Investment Company Institute (ICI) show domestic equity mutual funds have experienced net outflows since August of last year. Additional detailed information for net new cash flows into equity and bond mutual funds is shown below, with the domestic equity fund statistics highlighted in yellow:
Weekly mutual fund money flow figures for December show that the domestic equity outflow trend continued into the last month of 2009, albeit at a bit slower pace. Individual investors are obviously nervous about the price level of the US stock market and are moving their money to other investments, primarily bonds and foreign stock mutual funds.
So, how do you have a domestic equity meltup when retail equity mutual fund investors are heading for the exits in droves? Many sources point to large institutional investors as the reason for the current momentum-driven rise in equity prices. Institutional investors include mutual funds, hedge funds, large pension plans, etc. that tend to buy individual stocks rather than equity mutual funds, so their purchases wouldn’t be reflected in the above ICI data.
Institutional investors are often judged based on how they performed in relation to one or more market indexes. Some analysts speculate that institutional investors that were on the sidelines in early 2009 began to feel pressure to move back into the market as prices continued to move higher. The result has been a game of “catch-up” as institutional money managers sought to make up for lost time. This buying, in turn, buoyed the markets even higher.
It seems clear that we have seen massive buying of domestic stocks by institutional investors at the same time that retail mutual fund investors have been moving in the opposite direction on balance. The question now becomes how both institutional and retail investors will behave in the near future, and how these actions may affect the stock markets.
What Might 2010 Hold?
In last week’s E-Letter, I wrote that I did not expect to see a continuation of the 2009 market rally in 2010 based on the fundamentals. However, as I noted above, a meltup typically disregards fundamentals and causes the market to rise based on other criteria. One such factor could be emotional trading based on the fear of missing out on continued gains.
As I noted above, individual retail investors have actually been moving away from the domestic equity market over recent months. However, some analysts believe that this may change come January as investors get their brokerage and 401(k) statements and compare them to the major market indexes.
Some predict a major shift of individual investors back into the domestic stock market if the major indexes remain strong through the beginning of 2010. Using a similar logic, the same could be true for any institutional investors who have remained on the fence during 2009.
As institutional and retail investors compare near-zero returns on cash and low bond returns to double-digit 2009 gains in the stock market, a new herd mentality might occur. The fear of missing out on equity returns may prove to be irresistible, especially for those who have been in cash since late 2008/early 2009. And this rush of money into the market could continue to reinforce the rally that is currently under way. In fact, the most recent ICI weekly report shows that flows into domestic equity funds actually turned slightly positive as of the week ending December 23. While the month of December still shows a net outflow of funds in domestic equity funds overall, this latest weekly report could be signaling a trend reversal that may extend into 2010.
The question then becomes how much money investors have on the sidelines that might flow into the market. According to the ICI, money market assets came close to hitting $4 trillion in March of last year, and are still close to $3.3 trillion as this is written. Two-thirds of this money is held by institutional investors and the remainder by retail investors. All told, there’s certainly enough money to fuel a continued rally in domestic stocks if it all decides to come into the market over a relatively short period of time.
I also think that we should look to bond mutual fund assets as a potential source of future equity investment. According to the ICI table above, investors poured over $340 billion into bond mutual funds in 2009 through the end of November. Yet, bonds are paying historically low rates of interest thanks to the credit crunch and the Fed’s easy money policy. At the first hint of tightening, investors could exit bonds and bond mutual funds in droves, which could provide additional fuel for a continued stock market rally in 2010. (Yes, I realize that increasing interest rates are also historically bad for stocks, but remember that meltups typically don’t pay attention to such fundamentals.)
As I noted above, some analysts say that the stock market is currently priced for 5% growth in GDP in 2010, something most economists do not expect to happen. However, if we get momentum buying by retail investors in early 2010, this could lead to a self-fulfilling prophecy where money rushing into the market pushes up prices which, in turn, bring in more money from the sidelines.
Of course, the further away from fundamentals the market gets, the bigger the eventual correction will be when the bubble finally bursts. Meltups rarely end well for the individual investor, and I wouldn’t expect this one to be any different.
Now that I have made a case for the possibility of a 2010 meltup, let me throw a little cold water on the idea. There are plenty of arguments against the possibility of a continued meltup in 2010, even though there is a huge amount of money sitting on the sidelines in money market funds and bond funds. For example, if retail investors begin crowding back into the market, this may be taken as a contrarian indicator by institutional investors, especially if the market continues to ignore basic economic fundamentals. If so, the big money that helped create the current meltup could suddenly disappear, leaving retail investors holding the bag (again!).
Another reason a meltup might not be in the cards for 2010 is that many investors on the sidelines have been burned by two major bear markets within a decade. In some cases, what sits in cash now is what’s left of a previously much larger retirement portfolio. I don’t know that the desire to chase returns will overcome the fear of losing more of their nest eggs, as has been the case many times in the past.
Meltups are notoriously unpredictable, so it’s difficult to say what might happen in the months and years to come. While there are good reasons for the prospects of more money flowing into the market in 2010, there are equally compelling reasons for it to stay where it is. It may come down to a contest between fear of getting back in at the wrong time and greed that would cause investors to chase returns. All I can say is that 2010 is lining up to be a very interesting year.
What’s An Investor to Do?
The current market meltup may be out of gas, or it may have another strong leg to go. So, what should you do with your investments? The answer to this question really depends upon where you were invested in 2009 and your current financial situation, among other things.
As I have discussed above, there is no clear indication of what direction the market may take in 2010, so there’s risk in virtually any investment decision you might make. Therefore, you have to balance the market risks against your financial needs in order to determine the best course of action. I’ll discuss several situations and options below, but keep in mind that all of these alternatives are not personal recommendations and are dependent upon your personal investment situation.
Currently Invested in Stocks: If you have been fully invested over the past nine months or so, you have had quite a run. If you were smart (or lucky) enough to move from cash to stocks or mutual funds in March or April of 2009, then you are sitting on quite a gain. Or, if you have been in a buy-and-hold strategy that caused you to ride out the entire bear market, then you’ve recovered some lost territory.
In either case, I think that the continued rally has provided an excellent opportunity to take some profits. I’m not saying to cash in all of your investments, but since the future is uncertain, you might want to take some money off the table. This is exactly the opposite of what buy-and-hold investment gurus will tell you to do, but the last thing you need is for your entire portfolio to be exposed to a major market correction.
Currently In Cash: If you have been in cash or cash equivalents throughout 2009, yours is perhaps the hardest decision to make. A huge market rally has passed you by and you are now faced with a decision to either jump into the market now or continue to wait for the major correction that many analysts predict.
Failing to jump into the market would mean that you would miss out on any additional gains should the market continue a meltup in 2010 as discussed above. However, should you get into the market just as it suffers the major correction that many analysts feel is overdue, you could lose a substantial portion of your principal.
The answer to this question really depends upon where you are in your investment life cycle and your risk tolerance. If you are at or near retirement, then moving into the market on your own at this time may not be the best choice. Younger individuals with a longer time horizon may be better able to survive a market setback. Either way, I believe there is a lot of risk in the markets, especially with them being priced based on 5% GDP growth in 2010.
That being the case, if you want to invest on your own and want to re-enter the market, I suggest that you do so using a dollar-cost-averaging strategy. I have written about this method of investing several times in the past, and it involves buying back into the market over time rather than investing all of your funds at once. The time intervals between investments and the percentage of your portfolio you invest each time are up to you, but should be whatever you’re comfortable with.
I’ll also go ahead and tell you that, if you invest through a broker or financial planner, they are likely to tell you that some studies show that there is no advantage to dollar-cost-averaging over investing an entire lump sum. While such studies do exist, they certainly weren’t written within the context of the current market environment, so I still encourage the dollar-cost-averaging method. Plus, it’s important to remember that brokers earn commissions on what you invest now, not what you may invest in the future.
Currently in Bonds: Interest rates are at historic lows, so if your assets are primarily invested in bonds, you are likely getting a low return. That being the case, there’s nowhere for interest rates to go but up and when that happens, bond prices will fall. Treasuries and other government bonds (Treasuries, agency debt, etc.) will likely be the hardest hit, since they are considered to be among the safest of investments and contain little risk premium. The primary thing to remember about bonds is that if you are investing for the coupon rate of return and you don’t mind fluctuations in value, then they can be a great asset class to own.
However, if you invest in bonds or bond mutual funds for potential capital gains, 2010 may not be the best environment for you. If you plan to draw upon your principal to fund retirement, a college education or other financial goal, even the threat of rising interest rates could affect the value you can access for these expenses. This is especially true if you are investing through a bond mutual fund, since such funds have no set maturity date at which you can redeem your principal investment.
One way that I have used to gain an exposure to bonds is through a managed account. If you have $200,000 or more to invest in a bond strategy, the Wellesley Investment Advisors Convertible Bond Program may be just what you’re looking for. Convertible bonds have unique characteristics that combine the advantages of both bond and equity securities. Plus, many convertible bonds have “put” options that allow them to be redeemed prior to the maturity date.
Wellesley’s managed accounts are constructed using primarily individual convertible bonds rather than bond mutual funds. This allows Wellesley to tailor the portfolio to the needs of the individual investor. If you are currently in or thinking about moving into bonds, I urge you to look into this managed account strategy. Click on the following link to learn more about Wellesley’s Convertible Bond Program.
A Word About Gold: I’m sure you’ve seen or heard TV, radio and magazine ads about gold. It is the current “investment du joir” in the financial services industry. There are several reasons for this hype. First, there is a real fear that unfettered spending by the US government will lead to future inflation. It won’t happen in the short-term, but long-term inflation expectations are beginning to creep up. Gold is historically a hedge against inflation, so investors who see inflation on the horizon are currently loading up on the yellow metal.
A second reason for gold being so popular is that it is also a hedge against uncertainty. We are engaged in two wars, the outcomes of which are uncertain. Iran appears to be proceeding toward having nuclear arms and North Korea already has them. Neither is governed by what you would call stable leadership. Unemployment remains high, a commercial real estate bust is under way, and banks appear to be more intent upon paying bonuses then lending money. All of these situations and others add to the uncertainty of today’s world. Gold is deemed to be a store of value that retains its worth even in the presence of chaos, but its value can fall off a cliff when world events calm down.
Finally, gold is again being accumulated by foreign central banks after years of selling their gold reserves. Most analysts see this as a diversification strategy away from the dollar, and lots of investors feel that what’s good for foreign central banks is also good for them.
In the past, I have always been cautionary when talking about gold investments. Since we have not been able to find any source of active management for gold investments, I have been hesitant to recommend gold ownership since buying and selling physical gold can sometimes be a hassle and precious metals mutual funds often don’t track the price of gold very well.
Now, however, there are gold “exchange traded funds,” or ETFs for short, that are securities traded on the stock markets that accurately track the bullion price of gold. These ETF investments make it easy to have a portion of your portfolio allocated to gold without the hassles of storage and risk of theft. However, if you want to run your fingers through your gold investments, ETFs aren’t for you. You’ll still need to buy physical gold and keep it in a safe place.
A One-Stop Option: As I think about the options available to investors who are uncertain about the market’s future, I can’t help but come back to the actively managed investments offered through our AdvisorLink® Program. These investments are somewhat unique in that you can access almost all of the options I have given above in one place. Most of our AdvisorLink® money managers have the ability to move in and out of cash or hedge long positions as the market environment dictates, so there’s no need for you to decide when to move out of cash or whether or not to use dollar-cost-averaging.
Our money managers offer a variety of programs that include both equity and bond investments. In fact, some of our Advisors can invest in a combination of bond and stock mutual funds as well as other sector and specialty funds. Some even use leverage and long/short trades that have the potential to add value even in declining markets. There are no guarantees, of course.
While the steps I have outlined above can be done on your own or with the help of a broker, I would urge you to at least check out our AdvisorLink® money managers before making a decision. Just click on the following link if you’d like to learn more about the innovative money management strategies in our AdvisorLink® Program.
Unfortunately, no one knows whether the market will melt up, down or just stand still over the course of the coming months or years. Die-hard buy-and-hold investors see the recent meltup as confirmation that they should stay invested at all times. However, when you look at the S&P 500 Index, the 10-year rolling annualized return as of the end of December is still in negative territory. Not exactly a strategy that can help you meet your financial goals, is it?
2010 presents a challenge to investors, whether they are in the market in stocks and bonds or on the sidelines in cash. The meltup we saw in the last nine months of 2009 could continue in the first few months of 2010 as there are literally trillions of dollars on the sidelines that could rush back into the stock market. On the other hand, investors are still showing signs of fear and apprehension in regard to the stock market. As long as investors are more concerned about the return of their money than the return on their money, they are likely to remain on the sidelines.
I fear that many investors will stay on the sidelines too long and then jump into the market at just the wrong time – right before a major correction. The emotions associated with fear of loss and missing out on double-digit returns can lead to hasty and poorly timed investment decisions.
However, you don’t have to miss out on the potential for positive returns just because you are apprehensive about the market. You can turn to one of the active money managers available in our AdvisorLink® Program to put a professional money manager in your corner. To learn more, click on the link above or give one of our Investment Consultants a call at 800-348-3601. You can also e-mail us for more information at email@example.com.
Wishing you a prosperous 2010!
Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.