S&P at 1400: Where Next and What to Do About It?

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Referenced Stocks:BA;CIM;MSFT;PM;VOC;VXX;WMT;YUM

By Martin Tillier

The S&P closed above 1400 on Wednesday, for the first time since May. Our love of round numbers will result in a slew of articles predicting that the index will continue to roar on up or come crashing down. Both sides will have strong arguments for their case, and which you believe will depend on your positions and disposition.

When Bill Gross spoke this week of the death of equities he was referring to long-term yields, and cautioned not to expect 6-7% from a passive buy and hold strategy, as has been the case in the past. He is co-founder and CIO of a company that makes its money from bonds and the active management of equities, so he has been accused of talking his book. As I said, our own positions and disposition are the biggest influence on our views. It is a matter of perspective, not deception or cynicism.

I am well aware of Casey Stengel’s advice to “Never make predictions, especially about the future,” but will wade in anyway. I am, by nature, a contrarian. Twenty years in the FX market will do that to you. It is tough to take a contrarian view when commentators are about equally divided between surge and collapse, but an honest analysis of the situation leads me to one anyway. I hereby boldly predict that, over the next year or so, the market will move violently . . . wait for it . . . sideways! Okay, so a prediction that we are not going anywhere for a while is not very sexy, but I believe it is logical.

The thing is, in their own way, both arguments are right -- with caveats.

Corporate profits are high, but profit growth is slowing. Another recession in Europe is possible, but, in my opinion, there will not be a complete breakdown. The housing market is recovering, but over half of new mortgages are still re-finances. The fiscal cliff is coming, but history tells us a last minute deal will be reached. Unemployment is stubbornly high, but productivity is at record levels and any increase in demand will probably trigger more hiring. You get the picture.

A wise trader impressed on me years ago that there are three positions: long, short and square. Understanding that the market will be volatile, but directionless, leads to three conclusions.

1. Buy high-quality, range bound stocks on bad news and sell them on good news: Yum! Brands (YUM), Microsoft (MSFT) and Boeing (BA) are all quality companies whose stock pays a dividend, and has been somewhat range bound over the last 6 months, but is vulnerable in the short term to bad news. Buying a falling stock on bad news is hard for most people to do, but if you accept the “violently sideways” big picture view it makes sense. Similarly selling near the top of the range is easier as part of a plan.
2. Embrace Volatility : I would rarely recommend derivatives of derivatives because of technical problems with contango, but the iPath S&P 500 VIX ST Futures ETN (VXX) offers a convenient way to access the measure of volatility. With this note trading at or near record lows, there would certainly seem to be some room to the up side right now. Keep in mind, however, that, if the overall assumption is correct, bad news will be followed by good. The strategy therefore requires selling into any rally in the “fear index” and reverting to tactic number one.
3. Buy Yield : If you are expecting an essentially flat market, having a portion of your stock portfolio dedicated to yield only makes sense. Try mixing traditional, defensive dividend stocks such as consumer staples with high yielding, volatile instruments such as mortgage REITs and energy trusts. In the consumer staples sector, tried and trusted names such as Walmart (WMT) and Phillip Morris International (PM) are worth consideration. Mortgage REITs are well positioned to take advantage of further improvements in the housing market. In that sector Chimera Investment Corp. (CIM) may have potential now that the uncertainty surrounding their SEC filings has been resolved, and has a juicy 15% yield. VOC Energy Trust (VOC) is a young trust with experienced management and also has a yield around 15%. Don’t get carried away with these two, however. Yields this high are reward for significant risk, but riding out the swings is easier as part of an overall strategy.

In general, that is the point. Periods of violent sideways movement are tough on traders and investors alike. Entering them with a clearly defined strategy, however, makes it easier to stay the course and can even be quite profitable. Of course, the other way of dealing with volatility that takes us nowhere is to pull out of the markets altogether and accept a miserly interest rate on a money market account or CD, but where’s the fun in that!

Martin Tillier has been dragged, kicking and screaming into the 21st century, and can now be followed on Twitter @MartinTillier.