Market Correction... Or IN-Correction?

Includes: DIA, QQQ, SPY
by: Todd Kenyon, CFA

Anyone else feel like they are in the 10th round of a heavyweight bout - and losing? If you are long stocks, the answer is almost definitely yes. That's how it feels during a correction. As the screaming media won't let us forget today, yesterday we crossed the magical "down 10% from the highs" point that officially means we are in a correction. Funny thing is, by definition, if it is a correction, it must be correct - right?

Personally, I feel like it's an IN-correction, and I know I'm not alone. Sure certain sectors of the market are/were due for a smack-down. The irony is that in corrections like we are currently experiencing, the wrong stuff goes down. The cheap companies get even cheaper, and whatever has been working gets even more expensive. The psychological phenomena at work are known as recency bias and/or extrapolation. People tend to put too much emphasis on recent data points, and tend to extrapolate recent trends into the future. Nobody wants to touch the cheap stuff - it's the old "don't catch a falling knife" syndrome. This all works fine until it doesn't. For now, if you're piling into what's going up, you are doing better short-term, than those of us looking long-term and trying to pick up good companies on the cheap. As David Merkel said:

Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

The market is big-time scared right now. Look at treasuries. My officemate trades treasuries for a living and he cannot believe the fear and related "flight to quality" he is seeing. The market is buying treasuries no matter how expensive they become, and fleeing the stuff that is really cheap (financials, retail, etc). The 10-year has hit its lowest yield in more than three years, around 3.9%. The 2-yr's discount to Fed-funds is the greatest it's been since 2000.

Other factors are at work too. Many big Wall Street firms end their years this month, and bonuses are on the line. Hence you can bet that they are dumping losers for tax losses and window-dressing as well by buying winners to try and eke out some last minute performance.

We already know that US equity mutual funds have seen large asset outflows as investors tire of taking the pain and either flee to safety (cash, treasuries) or reinvest in overseas funds. Now, we get the news that big pension funds are dumping US equities and moving into international funds too. We are talking about institutions that collectively control more than $500 Billion of assets! For example, Calpers, at $250B, recently decided at a board meeting that they could enhance returns by moving assets into international funds, decreasing US weighting from 40% to 24%, its lowest weighting in more than 20 years. Other big funds are following suit.

Here's some news for you: Pension funds are not the "smart money", even if they are the big money. Just ask Mr. Buffett (how could I write something without quoting him?). In December 2001 in Fortune he wrote the following (I have tried to limit how much I reprint here, so please read the article for more):

In 1971--this was Nifty Fifty time--pension managers, feeling great about the market, put more than 90% of their net cash flow into stocks, a record commitment at the time. And then, in a couple of years, the roof fell in and stocks got way cheaper. So what did the pension fund managers do? They quit buying because stocks got cheaper!

That sort of behavior is especially puzzling when engaged in by pension fund managers, who by all rights should have the longest time horizon of any investors...Yet they behave just like rank amateurs (getting paid, though, as if they had special expertise).

In 1979, when I felt stocks were a screaming buy, I wrote in an article, "Pension fund managers continue to make investment decisions with their eyes firmly fixed on the rear-view mirror. This generals-fighting-the-last -war approach has proved costly in the past and will likely prove equally costly this time around.

I continue to believe that there are many excellent companies out there selling for bargain prices, and I continue to add holdings in retail, financial and other beaten down areas as my subscribers can see. In the near term this has largely been an exercise in masochism. Remember I am trading my own money here as well as my clients'. Yet, amazingly, I am not yet kicking the dog or gazing expectantly at the open (3rd story) window behind my desk. It's not the first time I've been through this, and I have conviction in my investment process and my holdings.

For those fellow Investment Directors whose Vestopia performance records start near the all-time high for the market in October like mine, things may look grim even if we are outperforming the market. Let me say right here that although the daily performance calculation is a necessary evil, never will I do something to try and window-dress my short-term results at the expense of the long-term.

Quoting Legg Mason's thoughtful Investment Strategist, Michael Mauboussin:

We argue that there is an approach that distances the best performers in all probabilistic fields from the average participant...

1. A focus on process vs. outcome

2. A constant search for favorable odds, including a recognition of risk.

3. An understanding of the role of time.

...the ability to stick with these elements in the face of the market's vicissitudes and the crowd's tugs is very difficult - and ultimately all about temperament.