Market Commentary

6/28/06

The second quarter of 2006 was certainly a lively one. The recent sell-off is fairly modest in magnitude compared to what we experienced between 2000 and 2002, but compared to the relatively placid environment of the last couple of years it is significant. The two plots below show the S&P 500 and the Russell 2000 over the last ten years to illustrate this point.

S&P 500

Russell 2000

Where did the sell-off come from?

The rally preceding the sell-off was driven by skyrocketing oil and metals prices. Commodity prices were going up in response to demand created by low borrowing costs. A similar effect is driving the housing boom.

Markets tend to be irrational. Commodity prices and the housing market kept on rising as if demand would continue forever and companies active in these areas followed suit. The rally was built on these traditionally very cyclical sectors.

This quarter, the market was reminded by Bernanke that cheap money would not be available indefinitely and that demand would probably be reduced as a consequence. This was by no means the first time this was pointed out, but this time the market took note, which resulted in a drastic mood swing. The Russell 2000 dropped over 10% in a matter of days and the other indices did not fare much better.

What does it mean?

Most likely nothing. We call this a mood swing, because it seem implausible that the true underlying economic situation really changed by over 10% in the course of less than two weeks. Either the price before the sell-off made no sense, or the sell-off makes no sense, or both. It is out view that in the short term price moves reflect market psychology and little else. Of course prices cannot stay disconnected from economic realities forever, but as the internet bubble showed it can take years for reality to reassert itself.

It is frequently unclear what the economic reality is until years later. For example, we could find that the present commodities prices are a true reflection on inflation and will never go back to earlier levels. If this is the case, the market correction will be short-lived and commodities prices will continue to increase, albeit hopefully at a slower pace. On the other hand we could find that prices were driven up by a speculative frenzy in which case the sell-off in commodities related stocks will continue until prices have come back to historical levels. Do you know which scenario describes the current economic situation? We sure don't, but if we had to guess we would say it is probably a little of both.

These examples illustrate why it is difficult to time the market or make any other trading decision based on fundamental considerations.

How do Pivot Point Advisors' strategies deal with this?

Our strategies use objective stock selection criteria to identify good long term bets. By design our strategies do not respond to short-term price moves driven by market psychology. Our selection rules look at time windows of 6 months or more. One month's worth of new data usually does not change the averages by enough to turn a buy signal into a sell signal. This allows us to ride out fluctuations without having to trade into and out of the same positions frequently.

Our strategies also implement the idea that one 'should not argue with the market.' While our strategies do not respond to a sell-off immediately, they do exit affected positions if a short-term sell-off turns into a protracted downturn. This feature reduces our exposure to sectors and markets in long term declines.

In the present situation most of our strategies have significant exposures to Energy and Basic Materials, because many of these companies have reasonable valuations and growth rates. If the sell-off turns out to be a dip on the way up, our strategies will keep these positions, but if these sectors have had their run, the strategies will scale out of them over the course of the next few months.

Like almost all strategies with a trend-following component, our programs generally participate in the initial sell-off as a long term trend comes to an end. This is the price of participating in the gains while the trend exists.  However, thanks to the 'do not argue with the market' component, funds are gradually redeployed into other sectors that have attractive valuations and price momentum to avoid giving back all of the gains.

Over time our disciplined approach helps generate superior results. We do not get caught up on the daily mood swings of the market. Instead we make the same simple bet every month. While it doesn't pay off every month, over time our discipline coupled with well-tested strategies generates attractive returns.