Persistence of the Memory
(Painting Credit: Salvador Dali, “Persistence of the Memory” signifies the irrelevance of time)

Markets continue to wrestle between the bulls and the bears. The S&P 500 has had seven major trend reversals during 2010, with two more occurring during Q3 (see Chart I).

Most recently, the market rallied off of July lows when value investors bought on strong corporate profit results, and then declined into August on slowing economic results.

Chart I – S&P 500 Choppiness in Year 2010

Current Markets Mirror Historical Patterns

As discussed in recent newsletters, markets typically move in a volatile sideways manner during the second year of recoveries from recessions, consolidating massive gains from the first year such as we had in 2009.

This market volatility is a result of the uneven handoff from declining government stimulus to increasing private market demand.

Most recoveries push through this volatile phase after two or three quarters, eventually leading to a renewed bull market (which would be in late Q4-2010 if the textbook sequence plays out).

The big question on everyone’s mind is: Is this time different?

What Do Leading Indicators Say?

Definitively speaking, we don’t know! Not to be tongue in cheek with our response, but there are many tried and true indicator models that are pointing in complete contradiction to one another on any given day.

For example, leading indicators are pointing downward, while the yield curve is incredibly steep, and recessions tend to only take hold when the yield curve is flat.

Then there is the Hindenburg Omen, the Elliot Wave Model, Sentiment Indicators, Yield Spread Indicators, and possibly my favorite pair, The Golden Cross and its evil twin The Death Cross.

These myriad of models are vacillating between buy and sell signals on a weekly basis.

How Does Policy Affect The Markets?

Adding to the confusion are the ongoing policy mysteries in DC.

For example, businesses are deciphering the cost implications of the recently passed 2000-page health care reform bill, the financial industry is still figuring out implications of the recently-passed 2300-page Dodd-Frank bill, and individuals are unsure about what their personal and investment taxes will be next year.

Markets tend to absorb good and bad news alike, but have real difficulty with uncertainty. So, it’s no wonder that businesses and investors are confused, scared, or plain exhausted with all the mixed signals.

Many are sitting on the sidelines until the smoke clears, which is retarding investment and growth.

Is This Time Different?

Now back to the question. Some say markets will rebound (optimists) and others say it will decline (pessimists).

Here are three truths:

1) No one knows for certain

2) They will both be right at some point

3) This is precisely what creates a market

With some current indicators pointing upwards and others pointing downward, the sideways chop will likely continue until there is more clarity.

A Major Market Event

Politically, clarity will most likely happen around the November election when democratic control or gridlock will prevail. Economic and tax policy implications make this a major market event.

More importantly, businesses and individuals will make decisions to progress forward with clear direction on the environment they face, regardless of their determination of whether the policy is good or bad.

What Are We Doing About This?

Until conflicting models converge, we are taking advantage of the volatility by increasing allocations to uncorrelated asset classes, and by actively trading client portfolios within the sideways range. We sell when positive news drives prices higher and buy when pessimistic news drives them lower.

We will continue to do so until more clarity is reached and a new upward or downward trend develops. It’s profitable to be greedy when most are pessimistic and fearful when most are optimistic.

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