If I could use a single word to describe a theme of this month’s issue, it would be correlation.
It is human nature to confuse correlated events with causal events. Correlated events are ones where there is a pattern of one event followed by another. Since World War II, September has been the worst month of the year to hold stocks. A causal event occurs when one event causes another. The tornadoes which formed over Moore, Oklahoma, a day before we went to press caused the sad deaths of many as well as considerable property damage. (Our hearts and prayers go out to all those who were affected by May’s storms.) On the other hand, the month of September does not cause stocks to fall. Though there are contributing factors, it just so happens that September tends to be a lousy month for stocks.
Understanding what correlations have held up over time can help you put returns into context. An adviser, website or newsletter citing good returns based solely on this year’s performance so far should be approached with skepticism, since January gains are typically followed by full-year gains. At the same time, any market weakness this month should not be a cause for concern since June is the second-worst month of the year for the Dow Jones industrial average, according to Jeff Hirsch of the Stock Trader’s Almanac. Jeff is an expert on calendar cycles and explains the three major ones here.
High valuations are also correlated with stock market reversals, and I think the long-term relationship could arguably be described as causal. The rationale is simple: Higher valuations lead to greater expectations, and greater expectations create more opportunity for disappointment. It is a cycle that has happened continually over history. While asset values can stay irrational for an extended period, unusually high valuations are followed by corrections and bear markets. This does not just apply to stocks either; we are still recovering from the bursting of last decade’s housing bubble.
Best-selling author and Yale University Professor Robert Shiller tracks valuations and investor behavior in reaction to market cycles. I had the pleasure of being able to meet with him and discuss both his CAPE (cyclically adjusted price-earnings) ratio and his S&P/Case-Shiller Home Price Index. You can see a transcript of our interview here.
If you enjoy the interview, come to our Investor Conference this November. Thanks to the efforts of Connecticut AAII Chapter President Ronnie Braun, Robert will be the luncheon keynote speaker. More information about the conference can be found here.
Low reasonable valuations, growing dividends, underlying financial strength and good price momentum are a combination associated with good future stock price performance. AAII President John Bajkowski uses Lowell Miller’s “Single Best Investment” strategy to build a new stock screen. Though current valuations limit the number of passing companies, stockpickers would do well to pay attention to the screen’s criteria. John’s article starts here.
Many individual and institutional investors view our weekly Sentiment Survey as a contrarian indicator. The survey has a reputation for signaling changes in market direction, particularly when optimism or pessimism reach extraordinary levels. Is the reputation warranted? I looked at the data and the answer is generally yes, though there have been two notable periods when optimism or pessimism stayed at high levels. You can see my analysis of the data here.
There are two articles in this issue that have nothing to do with correlation, but I think you will find them to be of interest. The first is about money market funds. Mike Krasner explains exactly what a money market fund is and gives a great overview of the ongoing regulatory efforts to reform them starting here. It is a must-read for anyone who owns a money market fund. The second is my latest Retired Investor column. I discuss the complex rules governing required minimum distributions here.
Wishing you prosperity,
Charles Rotblut, CFA
Editor, AAII Journal