Dear Member,

The market can be finicky over the short term.

This has particularly been the case over the past few days, with stock prices fluctuating widely. Some stocks have been excessively volatile. Take Mastercard (MA), for instance. Shares of MA fell 10.6% on Monday, rebounded 10.6% on Tuesday and fell 5.9% on Wednesday. The stock gained 7.7% today. One does not have to be an expert on Mastercard to assume that its business does not change that much on a daily, or even weekly, basis.

In his classic book, “The Intelligent Investor,” Benjamin Graham described Mr. Market as a business partner who “lets his enthusiasm or his fears run away with him.” The description certainly applies to the erratic price movements we are currently seeing. Over short periods of time, the markets do not act in a rational manner.

This is not to say that everything is fine or to ignore some of the recent headlines. Economic growth has been slower than economists expected and could remain sluggish for the foreseeable future. The risks of a recession have increased. Standard & Poor’s downgraded the United States’ credit rating. People are worried about the economy, the stock market and now, French banks.

Yet most of this is not surprising. There have been several economic reports that pointed to sluggish growth. The U.S. debt exceeds $14 trillion, and our elected officials in Washington have yet to agree on a long-term solution, whether it is based on Simpson-Bowles or an alternative. Predictions of when the Federal Reserve will raise interest rates have proved to be premature, as Tuesday’s Fed statement made even clearer.

If the markets were truly efficient over the short term, prices would reflect not only these facts, but also the realities that the U.S. economy is still growing and large-cap stocks are cheap relative to trailing and forecast four-quarter earnings. Rather, we are seeing volatile conditions caused by a combination of headline risk, investor emotion and rapid-fire electronic trading systems. It’s not fun, but this volatility is why stocks deliver high long-tem returns. The annualized 9.9% long-term gain for large-cap stocks is Mr. Market’s way of saying “I’m sorry for driving you crazy.”

So what do you do with Mr. Market? The temptation is to love him when stock prices are rising and leave him when stock prices are falling. The problem is that his mood can change quickly and he rarely announces that he has gone from being glum to chipper. So, you have to either correctly guess what his mood will be from day to day (a very difficult task) or invest for the long term and ride out his temper tantrums.

Either way, you should use down markets to look for bargains. Fear, as uncomfortable as it is, causes stocks to be mispriced. Even if you think stock prices can fall further, you should at least create a list of stocks that either look attractive or would be attractive if their prices fell further.

I have yet to see a correction where people didn’t fear a catastrophe, or a rebound where people didn’t wish they had bought during the correction. I don’t think this time will be any different.

Consider a Roth IRA Conversion

Now is not a bad time to consider a Roth IRA conversion, if you can afford to pay the taxes. The decline in stock prices has reduced the value of any equity-related investments you hold in a tax-deferred account, such as a traditional IRA. This means, relative to earlier this summer, you will have a lower tax bill for converting or can move more shares over to a Roth IRA for the same amount of taxes.

A conversion occurs when you move assets from a tax-deferred account to a Roth IRA. Since a Roth IRA is funded with aftertax dollars, you will have to pay taxes on any assets that are converted. The advantages are that future withdrawals will be tax-free (subject to certain limitations) and that there are no required minimum distributions (RMDs). Thus, the decision on whether to convert or not depends on your ability to pay for the conversion, the projected tax savings and your long-term financial plans.

Retirement Plans: Evaluating the New Roth IRA Conversion Opportunity gives a good overview of the various factors to consider. Though you can no longer spread the tax bill from the conversion over two years, as you could last year, the majority of the article remains applicable to today.

Have you converted or are you planning to convert to a Roth IRA? Tell us on the AAII.com discussion boards.

Significant Pickup in Insider Buying

Buying activity by corporate insiders is running at the fastest pace this month since May 2008, according to data released today by research firm TrimTabs. Executive Vice President David Santschi told me that the pickup is most prevalent in the consumer discretionary and industrial sectors.

Though insider buying can be a sign of belief in the prospects for one’s company, insiders lack insight into how the market itself will perform. David pointed out that insider buying was also strong in late 2007 and early 2008, just before the bear market worsened. Thus, while this is an encouraging sign, insider activity is merely one indicator. Always look at a variety of factors before making an investment decision.

If you prefer companies with insiders who are buying, take a look at the Insider Net Purchases strategy in the Stock Screens section of AAII.com. This strategy looks for small-cap companies where insider buying is exceeding insider selling.

The Week Ahead

Approximately 25 members of the S&P 500 will report quarterly results next week, as profit season shifts to the retailers. Dow components Home Depot (HD) and Wal-Mart (WMT) will both report on Tuesday. Joining them will be Lowe’s (LOW) on Monday and Target (TGT) on Wednesday.

A third Dow component will also report earnings: Hewlett-Packard (HPQ) on Thursday.

The week’s first economic reports will be the August Empire State manufacturing survey and the August National Association of Home Builders’ (NAHB) housing index on Monday. Tuesday will feature July housing starts and building permits, July industrial production and capacity utilization, and July import and export prices. The July Producer Price Index (PPI) will be published on Wednesday. Thursday will feature the July Consumer Price Index (CPI), July existing home sales, the August Philadelphia Federal Reserve manufacturing survey and the Conference Board’s July leading indicators index.

Cleveland Federal Reserve President Sandra Pianalto will speak publicly on Friday.

August stock options will expire on Friday.

AAII Sentiment Survey

Bullish sentiment rebounded 6.3 percentage points to 33.4% in the latest AAII Sentiment Survey. Even with the improvement, optimism that stock prices will rise over the next six months remained below its historical average of 39% for the 14th time in the last 17 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 1.2 percentage points to 21.8%. This is the lowest neutral sentiment has been since February 3, 2011. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped 5.1 percentage points to 44.8%. This is the 22nd time in the past 25 weeks that bearish sentiment has been above its historical average of 30%.

Even with this week’s decline, bearish sentiment remains at high, though not excessive, levels. Pessimism is more than one standard deviation above its historical average, which makes it unusual, but not extraordinary.

The high level of pessimism shows that individual investors remain worried that stock prices could fall further. The improvement in bullish sentiment does signal that some believe the brunt of the recent declines is over (or is nearing an end), however. Headline risk remains problematic, especially with many individual investors previously concerned about the pace of economic growth and the federal deficit, prior to the start of the current market correction.

This week’s special question asked if the Federal Reserve or the president or Congress should introduce new stimulus to accelerate growth, and if so, what type (e.g., buy more Treasuries, spend on infrastructure, extend the payroll tax cut). AAII members responded with a variety of ideas. The most popular were spending on infrastructure, extending the payroll tax holiday and reforming taxes and/or lowering them.

A minority said the government should not provide any additional stimulus. The deficit and a sense that prior stimulus has not worked were commonly listed as reasons for objecting. Some members thought the government should cut spending.

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor

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