Cautious on the Current Market Rally

This is our first newsletter of the New Year and we wanted to take some time to recap our performance for 2012 and outline our thoughts on the coming year.

The JSK equity portfolio finished the year up approximately 30% and our enhance yield portfolio was up roughly 22%. While we are pleased with the year end results, specifically for the equity portfolio, the gain is somewhat bitter sweet. Sweet in that we handily bet our benchmark comparison which is the S&P 500 which finished up close to 14%, bitter in that we largely underperformed the benchmark in the final quarter of the year.

In our opinion we witnessed a complete breakdown of market sentiment and fundamental theory as the market was trading purely on headline data stemming from Washington D.C.

That said, we produced our market call in mid-December that took us from a short position to a long position and we managed to recoup some loses that hurt us in the final quarter of the year and we are off to a very strong start for 2013. We continue to be long this market but are Leary as to the strength of this rally.

Market optimism and complacency is one key item that concerns us.

Fund Flows

The investment Company Institute released their fund flows data and it turns out that a whopping $8 billion poured into U.S. equity mutual funds during the week of January 9. This represents the highest amount of inflows since the company began tracking this data in 2007. Mutual fund investors are usually considered the “late” money and can be viewed as a contrarian indicator.

Lipper also reported some $18 billion moving into both foreign and domestic ETF’s and mutual funds which is the biggest one week reading since 2008 and the fourth largest weekly inflow since the firm began tracking the data in 1992.

All told, many on Wall Street point out that these types of money flows usually precede a market correction as less sophisticated money starts to chase returns from a market that is at new five year highs.

While we would not predicate our investment thesis solely on these types of sentiment indicators, it bears further analysis and monitoring.

AAII Investor Sentiment Survey

One item we tend to track in the American Association of Individual Investors (AAII) Sentiment Survey. Taken from their web-site, “The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.”

While we do not incorporate this model into our behavioral calculations, we track the results for certain anomalies. This survey has been used in the past as a contrarian indicator.

“Investor sentiment measures have historically been used as contrarian indicators—meaning one would expect the market to do the opposite of what the data was saying. The analysis here appears to support that point.

While little may be gleaned from changes in investor sentiment, identifying extreme levels of positive or negative sentiment appears to offer a glimpse of where the markets may be headed. In looking at the AAII Member Sentiment survey, we found that when sentiment reached overly bullish levels, the markets normally responded negatively in the months that followed. Conversely, the market tended to rise when members became overly bearish.

While our results here seem to lend validity to the notion that investor sentiment may be used as a contrarian indicator, it would not be wise to base all your investment decisions upon it. Indicators such as this are best used in tandem with others so that you receive confirming signals of potential market movements. Sentiment merely serves as an additional tool when making investment decisions.

Lastly, even if you do not use sentiment data as an indicator, it is a good idea to be mindful of it. As investors become overly bullish or overly bearish, it is easy to get caught up in the herd mentality.

However, as we have shown, if you run with the herd, you might get trampled.” - Wayne A. Thorp, CFA, associate editor of Computerized Investing and AAII’s financial analyst.

Last week, the survey produced 43.9% of respondents saying they are “bullish” towards the market and only 27.3% claimed to be “bearish. These results are at extreme levels and have been for the past several weeks. Since the start of the year, investors responding to the AAII survey have been overly bullish as the percent of bullish responders has remained above 40% while those that claim to be bearish have hovered near 30%. We use a ratio of bullish to bearish respondents to attempt to capture an increasing sense of bullishness.

CNNMoney’s Fear and Greed Index

We found this interesting tidbit on the internet.

“Investors are driven by two emotions: fear and greed. Too much fear can sink stocks well below where they should be. When investors get greedy, they can bid up stock prices way too far.

So what emotion is driving the market now? CNNMoney's Fear & Greed index makes it clear.

We look at 7 indicators:

•Stock Price Momentum: The S&P 500 (SPX) versus its 125-day moving average

•Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange

•Stock Price Breadth: The volume of shares trading in stocks on the rise versus those declining.

•Put and Call Options: The put/call ratio, which compares the trading volume of bullish call options relative to the trading volume of bearish put options

•Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds

•Market Volatility: The VIX (VIX), which measures volatility

•Safe Haven Demand: The difference in returns for stocks versus Treasuries

For each indicator, we look at how far they've veered from their average relative to how far they normally veer. We look at each on a scale from 0 - 100. The higher the reading, the greedier investors are being, and 50 is neutral.

Then we put all the indicators together - equally weighted - for a final index reading.

When the S&P 500 (SPX) plummeted to a three-year low on Sept. 17, 2008 - the height of the financial crisis -- the Fear and Greed index sank to 12. The index gained some ground to 28 before stocks finally bottomed out on March 9, 2009 and the latest bull market began.

Most recently, in the first quarter of 2012, stocks staged their best run in decades, and the index showed pure greed.” http://money.cnn.com/investing/about-fear-greed-tool/

Paul R. La Monica from CNNMoney sums the results of this model in the following way, “If you didn't know any better, you'd think that earnings were surging, the economy was expanding at a robust pace, everyone who wanted a job had one and that there was peace and harmony in Washington.

That's obviously not the case. But look at the stock market and it's as if we've all been transplanted back to the good old days of the mid-1980s or late 1990s.”

Bottom Line: We remain in a long position and are enjoying this January rally. That said we are very cautious regarding the strength behind this rally and will take profits quickly come the first signs of a market breakdown.

Joseph S. Kalinowski, CFA