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January's Market Slide Deflates Investor Expectations

8 February 2014 in Trading Ideas

After a 30% run-up in stocks last year, many investor and analysts were hoping the market’s good vibe to continue into 2014, if perhaps on a less-spectacular scale.

But with the S&P 500 falling more than 5% already this year – and most of that drop coming in the last two weeks – many traders seem less sure that up is the new favored destination for stocks, at least in the near term.

As Randall W. Forsyth noted last week in Barron’s, there is at least some anecdotal evidence to suggest what happens early in the year can portend the market’s direction for the entire 12 months. According to the Stock Trader’s Almanac, Forsyth wrote, the positive-or-negative direction of the market in the year’s first month has aligned with how it performed over the full year 88.9% of the time since 1950.1 Of course, basing an investment strategy on the market performance from the first 31 days of the year may not sound like strong fundamental research and as you might imagine, history has revealed its share of notable exceptions.

But what also could be putting investors in a more pessimistic mood is that the market’s recent slide comes amid some troubling fundamental developments that suggest a rising market faces some tough sledding.

One may choose to begin with the US Federal Reserve, which had previously thought well enough of the recent domestic economy to force the decision to throttle back on the quantity of bond-buying it has been doing.

For many, the Fed’s back-to-back tapers was a clear message that prices of some of the higher-risk assets were no longer going to enjoy the support of the Fed’s liquidity.

Witness the crumbling of many emerging-market stocks this year (continuing a trend of late last year). With many foreign currencies falling against the dollar, fears have risen that emerging-market countries will experience greater inflationary pressures and debt burdens.2

In addition, concerns about emerging-market distress began to hit stocks of large-cap companies, which tend to have higher international sales than smaller companies.

deflation motifIt’s also seems to be no coincidence that a glum economic report on January 23, from China, the Mother-of-All Emerging Economies, was when global stocks began to tumble. A preliminary reading of the country’s purchasing managers index showed its first contraction in six months.3

Add to the mix some fairly uninspiring earnings reports from big names like Amazon, Boeing, Apple, Twitter, and Bed Bath & Beyond, and one could make a case that the current market doldrums could have some legs to them.

In times like these, a common strategy is to get defensive: slide part of your portfolio into noncyclical sectors, as well as income-generating equities and keep a close eye for signs of continued market deterioration.

Another alternative to defensive positions is seeking fixed income. Our deflation motif contains long-term bonds with the idea of locking in an interest rate during a period when you may be anticipating deflationary pressures in the market. The Deflation motif is up 4.0% for the month and so is the Vanguard Long-Term Government Bond Index ETF (VGLT). Over one year, the motif is down 5.1% while VGLT is down 5.4%.

1Randall W. Forsyth, “January Goes Off Script,” Barrons.com, Feb. 1, 2014.

2Blaine Rollins, 361 Capital Weekly Research Briefing, 361capital.com, Feb. 3, 2014, http://www.361capital.com/weekly-briefings/dont-stranger/.

3Vito J. Racanelli, “Dow Dives 5.3% in January as Fed Pulls Back,” Barrons.com, Feb. 1, 2014.

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Historical performance as of February 8, 2014.

Tags: Deflation