Often we forget this and it is sometimes helpful to ask ourselves: Who is likely to be on the other side of the trade that I am about to make, and why might they hold the view that they do?
sometimes they may want to hold the stock, but are forced to do sell:
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More on Economic Focus...
Froehlich: Bull Market Will Return
by Robert J. Froehlich
Vice Chairman, Kemper Funds Group
Special to CNBC.com
In order to figure out where our markets are going, you first have to
figure out where we are today and why. After all, the first three
months of the year it seemed like the markets could go nowhere but
up. Now it seems like stocks will never go up again.
We got to this point thanks to the confluence of three unrelated
events that together caused this major market sell-off ? margin
calls, capital gains tax lock and tax day.
Margin Calls
Don?t be mislead by the pundits, day trading is a great business
so long as the market goes up. Think about it, you buy stock with
other people?s money on margin, continue to leverage your stock
position and so long as the market cooperates by moving
upward, you can become a wealthy individual using other
people?s money.
This dream job, however, becomes a nightmare when the market
makes a dramatic movement downward for a few consecutive
sessions. All of a sudden you face a margin call for cash that you
don?t have, so you are forced to sell your stock in a falling market.
Once this process begins, it has a spiraling effect. Which is
exactly what happened in early April. The explosion in margin
calls was one of the three factors that led to our markets major
correction.
Capital Gains Tax Lock
The second unrelated event was that investors rushed to lock in
their capital gains in April. It is unprecedented and unheard of to
lock in your gains as early as April. To figure out why, we have to
look backward.
Remember in 1999 the Nasdaq gained an unbelievable 86
percent. I can remember a time when, if you generated an
86-percent return in your lifetime, you were considered a savvy
investor. Now we do that in one year.
Thus, with the 86-percent gain in 1999 as a backdrop, Nasdaq
investors watched as that market dropped 10, 20 then 30 percent
in early April until they finally screamed, "Enough! I?m locking in
my capital gains now." Thus, with the market up 86 percent last
year, even with a 30-percent free-fall from the top, it was still up
more than 30 percent, and investors decided to lock in those
capital gains and take some money off the table.
Now, it is unprecedented to lock in your capital gains in April! In a
normal Nasdaq year this never would have happened. Now
remember in a normal Nasdaq year, the market would have been
up only 30 to 35 percent. (It?s still hard for me to write that 30 to 35
percent is a normal return. The old-school habits are hard to
break.)
But think about it for a minute, if the NASDAQ were up 35 percent
in 1999 and then in early 2000 all of a sudden it?s down 10, 20
even 30 percent, no one would be rushing to lock in anything.
Instead, investors would be saying this technology revolution is for
real and Nasdaq is coming back.
Not this time. Investors got greedy and focused solely on the
short-term by locking in their capital gains.
Tax Day
Now the final unrelated event that caused our market sell-off was
that tax day was fast approaching. It was as little as five years
ago when tax day was irrelevant to our market. You see, five
years ago investors would typically figure out their taxes in late
January or early February, write a check and then hold onto it until
April 15. It?s a tradition here in America that no one is going to
pay Uncle Sam one day early.
Well, there has been a shift over the past two years in how
investors pay their taxes. They still figure them out in January and
early February, and instead of writing a check and letting it sit in a
checking account or money market account, investors plowed the
money into the stock market. You see, they found out that this
so-called January effect in which the market goes up every
January is now a January, February, March effect.
Over the past few years if you weren?t in the market in those three
months, you missed the bulk of the markets move. Thus investors
(a.k.a. taxpayers) decided that instead of letting their tax
payments sit idol in their checking accounts, they would put them
in the stock market and let Wall Street pay part of their tax bills to
Uncle Sam.
This is a great strategy so long as the market goes up. This year,
it went down. Thus investors not only had to liquidate their
investments to pay taxes, they had to liquidate even more
because their initial investment could no longer cover their tax bill.
Thus it was the combination of these three unrelated events that
fueled our major market sell-off.
An Economy-Driven Correction?
Again, to figure out where we are going, we must make sure we
know how we got here. There are only three types of corrections ?
the first type being an economic correction. In an economy-driven
correction, economic growth is flat or declining, inflation is
soaring, unemployment is high, consumer confidence is low and
consumer spending is nil.
Well we certainly didn?t have an economically driven correction.
Our economy just put together the strongest consecutive three
quarters of economic growth in the past 15 years. Inflation
remains nonexistent. Unemployment is at 30-year lows, consumer
confidence is at all-time highs and consumer spending is on a
tear.
Teenagers are driving spending ? just ask my high-school-age
daughter about her weekly mall excursions. Young adults are also
fueling consumption, as witnessed by my oldest daughter, who is
finishing her freshman year in college where she has become a
more cost-conscious shopper, but make no mistake about it, she
is a shopper. And last but not least, my dear wife continues to
help fuel the economy (there is no doubt in my mind that my
daughters came about their talent naturally).
Earnings Driven Correction
The second type of correction is an earnings-driven correction. In
an earnings-driven correction you find numerous earnings
surprises that are negative across all industries. Well, we are
having earnings surprises, but the surprises are positive. So far
89 percent of the S&P 500 companies that have reported
earnings have met or exceeded earnings expectations. In
addition, earnings are up a whopping 25 percent on a
year-over-year basis. Well this certainly wasn?t an earnings-driven
correction.
Market Driven Correction
The third and final category is a market-driven correction. And if it
wasn?t an economy- or earnings-driven correction, it has to be a
market-driven correction. We should be getting good at this,
because we seem to have these market-driven corrections
almost annually. First it was the Asia-led currency crisis, then the
Long-Term Capital Management bailout, followed by the Russian
bond default.
Remember, in an economically driven correction it takes about a
year for the market to rebound. After all, if economic growth is flat,
inflation high, unemployment high with no consumer confidence, it
will take almost a year for the economic numbers to convince
investors it?s time to get back in the market.
In an earnings-driven correction, it only takes half the time to
rebound -- about six months. You see, earnings are issued
quarterly, so even if you can turn earnings around in one quarter,
investors will not be back in the market. They are skeptical that
the accountants "cooked the books" to make earnings happen
this quarter. Thus investors want proof. Give them back-to-back
quarters of positive earnings (six months) and they will be back in
the market in a big way.
So it takes a year to recover from an economic correction and six
months to recover from an earnings correction ? and it takes
about six minutes to recover from a market-driven correction!
There is no timeline for a market-driven correction. Because no
economic or earnings fundamental brought the market down, it
doesn?t need any economic or earnings fundamentals to bring it
back up.
Remember, the market rebounded every bit as fast as it fell after
the past few market-driven corrections. This will be no exception.
If you blink, you just might miss the market rebound.
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Best regards
Paul |
