Emotions rule the day

It's a happy New Year for stocks but we get off to an inauspicious start.

Investors seemed to be looking for clarity – something that would provide a catalyst for the next direction for the market.  Today's midday Fed news seemed to do the trick.

When you have a late December sell off when typical action is a strong rally, it can be confusing to investors who then become reluctant to do much of anything.   Remember all the talk last January about years ending in ‘5’, always being strong years or stocks?  Then we get a Dow ending in negative territory in 2005, first time for a year ending in '5' since the late 1800’s.  More head scratching by investors. 

Now the first day in January opens with the Dow up 40 points, it quickly turns into a 40 point loss, then flat lines until the minutes from the December the Fed meeting three weeks age is released and investors jump on it.  This must be what they are excited about…

"Although future action would depend on the incoming data, this characterization of the outlook for policy was seen by most members as indicating that, given the information now in hand, the number of additional firming steps required probably would not be large." - from released Fed minutes.

        

That’s quite a reaction and there's not much us TSP participants can do to take advantage of an intraday move like that.  While that instant strength could put momentum in the bulls' court for a few days, particularly while some of the shorter term indicators were oversold, my intermediate term indicators tell me this is an emotional reaction that may not last too long.  I will point out that the 10-day moving average of the OEX options put/call ratio, or "smart money" is looking quite bullish, as well as the ARMS index which I won't bore you with right now.  So there is some temptation to jump into stocks but it seems so similar, in an opposite sort of way, to what happened to me in October (No, not that again!)

We were on the sidelines while the market had been dropping pretty hard into the end of October and my indicators said it was time to buy, which I did.  The market rallied for a couple of days and one severe down day scared me back out of the stock funds.  An action I came to regret.  I let the emotions of a big down day trump the fact my indicators said to buy.  For the record the bigger mistake for me came when I waited for a pullback to get back in but it never came and I missed that end of year rally.

So here we have a big emotionally charged rally that seems very positive on the surface.  I won’t say that it won’t lead to higher prices in the very short term but I’m not so sure jumping in here is the best choice unless it is a short term trade.  We anticipated a possible sort of short term bounce this week after the late December drop, but early January rallies are not unusual as we see in the seasonality chart.


                             Chart provided courtesy of www.sentimentrader.com

If you remember, I had considered staying in stocks for the first two days of January because of this data, but I took the atypical Christmas weakness to be a warning to us that the seasonal strength was not much of an advantage this year.  I felt a bit frustrated that I lost money in stocks last week when my indicators were telling me to be cautious - … and now this?  Ugh!

So, before you evaluate your next move, whether it was to buy or to sell, be sure you are making a decision based on something other than an emotional response.  I’m sure you will agree that this is frustrating action if you lost money Christmas week and pulled out of stocks only to see this jump in stocks prices yesterday.  But if you take a step back and separate yourself from the situation and decide your next move based on the charts, the economic outlook, and your investment strategy and goals, you will likely make a better decision rather than just following the herd.  Not that the herd is necessarily wrong in this instance.  That remains to be seen.  I just don’t want you to make a decision based on emotions alone.

The dollar dropped like a rock yesterday and combined with the strong action of overseas stock markets, the I fund had one of the biggest one day gains we have seen since it became available in 2003.  It ended the day up 3.3%.  To put that into perspective, in the first trading day of the year the I fund gained 73% of the total 2005 return of the G fund. 

So once again the market mocked our short term trading strategy.  If you do move in and out of the funds during the year, it is inevitable that it is going to happen to you many times.  Some days you look brilliant, and others like a fool.  Although it doesn’t seem like it, they do tend to even out over the year. 

But the majority of your year’s performance is going to come from being right over the longer term.  Like we mentioned yesterday, we expect big gains from the S&P 500 before 2006 is over.  Sitting on the sidelines now waiting for a better buying opportunity could prove somewhat detrimental or somewhat beneficial to our final 2006 numbers.  It remains to be seen.  But the big gains or losses will be determined by how correct we are in our assessment of the next six to twelve months, not six to twelve days.  So please don't just follow us.  Anything can happen in the short term and with the information you have, your call may be as good as any.

The past two years have not really provided us with the type of market action that makes allocating your own account rewarding.  It has benefited a diversified account.  But when the market moves up or down 20 to 30% or more over the course of a year, that is when your account will benefit over a buy and hold account.  Aggressive account will be hurt badly in big down years, and diversified accounts will not do as well during big market increases.  We expect 2006 to be one of those years.

Administrative note:  A few minor mistakes have pointed out to me on the TSP Calculators.  You may want to re-download the corrected versions.  See here... TSP Calculators for 2006.

Thanks for reading.  Currently 50% G, 50% F.