Why a little market volatility would be welcome

As I mentioned previously, the hardest part of 2013 for Peattie Capital portfolio was staying invested, as there were a number of scary headlines. Peattie Capital’s investment process of focusing primarily on individual stock selection but also remaining flexible and opportunistic and having an opinion about the overall environment led to solid returns last year.

Broadly speaking, the global economy is improving yet central banks remain accommodative. This provides a very friendly backdrop for equities, and I expect 2014 to be another good year.

Obviously, I do not have a crystal ball, but in my opinion this year will be more difficult though, as historically mid-term election years tend to be more volatile. According to a recent interview with Sam Stovall, (head of S&P research) the two weakest quarters of the presidential cycle are Q2 and Q3 of the midterm election year.

A little volatility would be a good thing, as far as I’m concerned, because it would take some of the froth out of the market and would provide better entry points for names I’d like to own.

I don’t know what this year’s surprises will be, but broadly speaking I think the environment is favorable. The most bullish earnings estimate I’ve seen is for S&P operating earnings to reach $122, according an analysis by Don Hays with Hays Advisory.

According to Goldman Sachs, nominal GDP is up 73% and S&P 500 earnings have nearly doubled over the past 13 years, yet the S&P 500 has only risen 18%. And Morningstar reported that through October, investors had put $111 billion into stock mutual funds and ETFs, which is less than they took out from 2009 to 2012.

Leaving aside the unknowable, such as an exogenous event, from a near-term perspective I think optimism is too high, as bulls (61.6%) far outnumbered bears (15.2%) in the most recent Investor’s Intelligence poll and the VIX hasn’t been above 20 since October, according to Richard Russell’s Financial Sense newsletter.

Another issue to watch in 2014 would be a surprise rise in interest rates and the potential pressure on the market’s multiple which has been steadily expanding the past few years.

In early 1994 rates backed up very quickly, much more so than the market had been anticipating, and there are parallels between then and today. For example, in both cases the Fed had been in lengthy easing cycles, and there was a notoriously slow recovery unfolding.

None of this is to say that a correction will happen, only that history provides some lessons. Based on what I know today, I would expect any near term correction to be a buying opportunity.

January is a tricky month because there are so many cross currents at work in the markets, so I don’t read anything into the weakest start since 2005 (and 2013 was the best market since 1997). Still, the market tends to follow January’s lead (even better is when both January and February are both positive), so on balance I would prefer to see the market start the year with a positive return.

Regardless, I believe that paying the right prices to own the right stocks is a good approach to the market.

DISCLAIMER: The investments discussed are held in client accounts as of December 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.