The markets have been flashing warning signs for months now. Believe it or not, it started in January with a blow off top where we ran 8% in the first couple weeks of the year. Within a few days after that, the market gave every bit of this move back by dipping into the red within the first few days of February. In hindsight it is easy to see that this was a change in character.
Now, despite incredible economic data such as an annualized 4.1% GDP, historically low unemployment and another quarter of double digit earnings growth, the market is no longer responding in a bullish fashion. All you have to do is look at the stock action in Amazon (AMZN) to see the current mood of the market. After reporting a blockbuster quarter with net income more than a billion dollars higher than expected, it wasn’t enough; and two short days after the report, the stock is now lower. This fickle market mood is not just in tech either, but it is also in industrials such as Caterpillar (CAT); just yesterday, the company reported $1.79 Billion in revenue when analysts were expecting $1.63 Billion. This resulted in earnings per share of $2.97 versus an expectation of $2.73. In pre-market trading yesterday, the bulls were in love with CAT as the stock traded higher by more than $3.00. A few hours later, the selling kicked in and by day end not only had CAT given back the entire pre-market gain but traded lower to the tune of 2%.
This action we’re seeing is precisely the action that indicates a broader correction is upon us. It is for this very reason we’ve taken steps to raise our cash levels in our managed accounts and proceed with more caution. Rather than holding and hoping things work out; we’re choosing to adopt patience, knowing that we have the buying power at the ready to take advantage of opportunities as they become available.
This is the time that almost all other advisers, I observe, go into hiding. They seem to adopt the approach that they will hold on no matter what. I just can’t understand this idea and have never followed this methodology. On the contrary, I’m never shy about sharing our strategy as it is really quite simple. At Joule we begin with a top down view of the overall market: its fundamental valuation, macro-economic views and where we may be within the economic cycle. This assessment determines whether it is prudent to be fully invested or whether we should be underweight. At present, our conviction levels regarding a correction are high, so we find ourselves with over 35% in cash within our most aggressive managed account.
After a high-level market view, we evaluate each and every sector, comparing its current weighting within the S&P to our conviction level regarding valuation. We think that the manner in which the S&P is weighted (market cap) allows us to make changes with our own weighting to potentially add value for our clients. For example, at present the technology sector represents 26% of the S&P, while the materials sector represents less than 3%. This means that for every dollar someone invests in the S&P 500, 26 cents finds its way into technology while only 3 cents into materials. While this has been the right play over the last few years, going forward, we think this vast difference in allocation is far too wide. We believe it would be imprudent overweighting a group of stocks that, in our opinion, are considerably overvalued while neglecting, or significantly underweighting, a group that looks undervalued and worthy of consideration.
Tonight, we have another earnings on tap with Apple. If the current theme holds true, Apple’s report will be solid; however, the stock has been pricing in perfection for a very long time, which makes me think that regardless of the report a decline in the stock will be the result. Nonetheless, it should be interesting to watch.