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Why the Markets Look Safe Until Summer


The data suggests that the equity markets have once again dodged the opportunity to correct in any meaningful manner.

From Acorn Fund's founder and portfolio manager Ralph Wanger:

Zebras have the same problem as institutional portfolio managers. First, both seek profits. For portfolio managers, above average performance; for zebras, fresh grass. Secondly, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions. Third, both move in herds. They look alike, think alike and stick close together. If you are a zebra, and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. When you think that conditions are safe, the outside of the herd is the best, for there the grass is fresh, while the middle see only grass which is half-eaten or trampled down. The aggressive zebras, on the outside of the herd, eat much better. On the other hand – or other hoof – there comes a time when lions approach. The outside zebras end up as lion lunch, and the skinny zebras in the middle of the pack may eat less well but they are still alive.

We saw many "outside zebras" gorging themselves on stocks in late 2007 as the Dow Jones Industrial Average (INDEXDJX:.DJI) made a new all-time high and then registered a Dow Theory "sell signal" in November 2007. Subsequently, those outside zebras ended up as "lion lunch" when the senior index shed an eye-popping 53% over the ensuing 17 months. By March 2009, many of those outside zebras had moved to the inside of the herd just in time to miss the bottom. Since those lows, more and more zebras have ventured back toward the "outside" of the herd driven by performance pressures. I have repeatedly commented that given the immense amount of cash still on the sidelines, as the equity markets continue to rally, the performance pressure, subsequent bonus pressures, and ultimately job pressure become just too great, causing portfolio managers to "pay up" for stocks. And that, ladies and gentlemen, is why the corrections have been short and shallow since the November 2012 "lows."

As the Jeremy Grantham writes:

In markets, where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone's ultimate job description becomes "keep your job." Career risk-reduction takes precedence over maximizing the client's (portfolio) return. Efficient career risk management means never being wrong on your own; so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from their fair value as people buy because others are buying.

Clearly, this performance pressure is currently playing on the "street of dreams" as the Dow Jones Industrials and the Dow Jones Transports (INDEXDJX:DJT) have tagged new all-time "highs" over the past few months (yet another Dow Theory "buy signal"). Accordingly, I revisit Ralph Wanger's "Zebra" story this morning having returned from the RJFS National Conference, where I interfaced with a number of portfolio managers (PMs) that are currently experiencing the same "performance pressures" that many investors are feeling, having missed the recent rally. Yet one of the most frustrating comments came from a PM that was almost fully invested, but is still woefully underperforming. His problem is he is fully invested in US companies that generate more than half of their revenues outside the United States (internationals). Surprisingly, companies generating more than 50% of their revenues inside the US (domestics) are outperforming the internationals by a wide margin, as can be seen in the chart below from the sagacious Bespoke organization. Indeed, the domestics are better by 21.3% over the last 12 months while the internationals are up only 8%.

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No positions in stocks mentioned.
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