Stocktake: Hoping for a healthy market decline

Should investors wish for a US market decline in 2015? Yes, say money managers Barry Ritoltz and Ben Carlson.

Neither is bearish – rather, both feel it would be healthy for the market, after six years of stellar gains, to take a breather. Carlson is worried further gains will cause complacency, with risk management going “out the window” as investors assume every minor pullback will be met with V-shaped rallies.

As well they might. Markets pulled back five times in 2013; new highs occurred within three weeks on four occasions. Last year was similar.

October’s 9.8 per cent decline was the steepest in years, but new highs followed just 21 days later. Over the last two years, pullbacks averaged 5.1 per cent and lasted an average of just 20 days.

A 2015 decline would allow earnings to catch up with prices. Continued gains increase the risk of a market melt-up and another boom-and-bust cycle. Who wants that?

Duping with window-dressing
A record $36.5 billion recently made its way into US-based funds in a single week, according to Lipper data. All that money and more went into US stocks, which attracted $39 billion, with funds invested in non-US shares seeing $2.5 billion in outflows.

It suggests a "pure hatred of overseas stocks", says money manager and Reformed Broker blogger Josh Brown. "The degree to which people are willing to chase US stocks while forsaking the stocks from around the world is hitting a fever pitch."

However, this jars with Merrill Lynch’s December survey of fund managers. It found managers had cut their US weightings and planned further reductions, viewed the US as the most overvalued region and were most enthusiastic about Europe.

Lipper’s data also shows $17.9 billion being withdrawn from US funds the week before the record inflows.

The following week’s $36.5 billion splurge was likely an exercise in window-dressing, where underperforming fund managers rush into the year’s best-performing assets, pretending their portfolio was perfectly positioned all along. In the fund business, alas, appearance is as important as reality.

Do January falls bode ill?
Many say stocks' miserable start to the year – the first three days of January were the third worst since 1950, behind only 2008 and 2000, both of which ended up being disastrous years – augurs ill for 2015. Does it?

Not necessarily. Stocks tanked in early 1991 and 1982, but ultimately gained 30 and 19 per cent respectively. Since 1928, the S&P 500 has begun the year with three straight losses on eight occasions; stocks gained seven times.

However, James Mackintosh of the Financial Times notes that when the first day of January is a losing one, subsequent US and UK returns are much poorer than average. Similarly, MarketWatch's Mark Hulbert finds stocks' performance in the first two days of January to be a "surprisingly good" indicator of future underperformance. Since 1896, the Dow's annual gains have averaged just 2.8 per cent in such circumstances, compared to 10.9 per cent in other years.

It may be a fluke, but market historians won’t find the data comforting.

Dollar trade getting crowded
The dollar is on fire, the euro is tanking and it's easy to see why. The US economy is outperforming, the Federal Reserve is set to raise rates and further European easing is predicted. Little wonder the euro is at nine-year lows, with some strategists now predicting parity with the dollar in 2015 or 2016.

However, betting on dollar strength is the most crowded trade in the market, say recent fund manager surveys, and consensus positions are always inherently vulnerable. The US dollar index has soared 13 per cent over the last six months.

That’s happened 18 times over the last four decades, says US money manager Dana Lyons. Six months later, the dollar was higher on just three occasions. Median returns were much weaker in all timeframes, from one month to one year.

This time may be different; the logic for a long dollar/short euro position seems impeccable, after all.

However, crowded trades bring their own dangers – Lyons's data is a reminder of that.

Mr Market's mood changes
Many say stocks' miserable start to the year – the first three days of January were the third worst since 1950, behind only 2008 and 2000, both of which ended up being disastrous years – augurs ill for 2015. Does it?

Not necessarily. Stocks tanked in early 1991 and 1982, but ultimately gained 30 and 19 per cent respectively. Since 1928, the S&P 500 has begun the year with three straight losses on eight occasions; stocks gained seven times.

However, James Mackintosh of the Financial Times notes that when the first day of January is a losing one, subsequent US and UK returns are much poorer than average. Similarly, MarketWatch’s Mark Hulbert finds stocks’ performance in the first two days of January to be a “surprisingly good” indicator of future underperformance. Since 1896, the Dow’s annual gains have averaged just 2.8 per cent in such circumstances, compared to 10.9 per cent in other years.

It may be a fluke, but market historians won’t find the data comforting.