4 Days in May Wipe 4 Months Away

Includes: DIA, QQQ, SPY
by: Alan Brochstein, CFA
  • 12/31/09: 1115.70
  • 05/07/10: 1110.88

How about that for a round-trip on the S&P 500? If you include dividends, stocks are up 0.26%. It beats cash perhaps, but not by much. Most stocks, though, are doing better than that, as the equal-weighted index for the S&P 500 has returned 3.3% and the Russell 2000 index is up a healthier 4.8%.

I am sure that most pundits are out in full force writing about how they saw this coming. I am not. I will highlight, though, two articles that shared my views for 2010, while I admit my total shock at how powerful this decline this week was. First, I stated in January that we are still in a bear market unless the S&P 500 takes out 1229. Whoops - it stopped at 1220. Second, I said that this won't be a year for beta but rather alpha (stock picking). So, even with all of this great foresight, I had no clue!

What now? First, the fact that we are back to where we were four months ago needs to be put into perspective. Most people thought that the market was priced stupidly high after the massive rally in 2009. In that case, it must still be stupidly high. On the other hand, anyone who bought the dip in January/February is still quite happy. The only really sad people are the shorts who covered or the guys with cash who threw in the towel in April. I am happy to say that at least that wasn't me!

Many folks don't realize it, but 10% corrections are quite normal. We never got one in the last bull market - no, I have checked. So, while the plunge this week may not feel like a bull market move but rather a reminder of the plunges we had in the bear market, these types of shake-outs tend to happen more in bull markets. Bear markets have their days, but they tend to be death by a thousand cuts. So, I still define this as a transitional market - not a bear, not a bull.

My best guess, though, is that we will break out later this year. Yes, the world is still a horrible place, as many seem to dwell upon, but I have sensed that the economy is getting on more solid footing. No, we won't get strong growth for several years - the almighty consumer is still tapped out. But the 80 or 90% of us, depending on how you count, who still have jobs will continue to loosen the purse strings a bit, and we will be joined by some of the unfortunate 10-20% who will find work. More importantly, the industrial economy is downright booming.

In any event, I continue to think that those who take the time to do some basic fundamental, technical and valuation analysis can continue to do better than the overall market. This is perhaps self-serving, as this is how I make my living, but I was smart enough to know in 2008 and 2009 that the most important decision was "in" or "out". In the Top 20 Model Portfolio, which is all about alpha since it is fully invested all the time, we have done well by getting more conservative as the market rallied. I detailed some of my strategies a couple of weeks ago, but I note that they allowed us to hold up a lot better than the overall market. Despite the massacre, we still maintain a double-digit return in 2010. Yes, chasing alpha seems to be working.

So, while I won't tell you that I am extremely confident that we are at or near the end of this correction, I will say this: Bargains abound. You can find them in large-caps or small-caps and across various sectors. As far as the Top 20 model portfolio goes, we are very underweighted Consumer Discretionary and Financials, but we do have a few names from those sectors. Where I see the greatest number of opportunities is in Healthcare and small-cap Industrials. Unlike the beginning of the year, when we had no exposure to Technology, we have added a few names that have declined this year. I even added Utilities in Q1, not a sector I typically favor but that looks incredibly cheap to REITS.

It's easy to get caught up in the volatility and concerned about the market direction. I don't profess to have the answer about how far or long this correction goes. From my perspective, holding the lows from February would be nice (call it 1050), but I sure would like to see 1073 hold. That's a spot I see on the chart, but it would also represent a little over a 25% retracement off the lows. If we are in a bull market (which is probably the case), we need to see the first Fibonacci retracement (38.2%) hold: 1008. That would be a pretty big correction - 17.5%. I suppose if we break that level, I will have to reconsider my views that this is just a correction. On the other hand, taking out 1150 to the upside will look like the "all's clear" signal.

Disclosure: No stocks mentioned