Recently the Pinnacle investment team met to discuss the state of the world, the views of the independent analysts we follow, our market expectations, and what it all means to the asset allocation of Pinnacle portfolios. As always, it was a lively discussion that swung between business cycle dynamics, technical condition of markets, valuation, and bigger picture themes.
We were pleasantly surprised by the clarity coming from some of our independent analysts. Over the last year it has been rare to find them communicating a consistent view on how to invest markets. Now however, their views are becoming more uniform. The overriding theme for the quarter seems to be that a correction is imminent, but that it probably won’t bring an end to the current bull market. This thesis seems validated by much of the technical, economic, and valuation data we follow, and has helped us develop our investment theme for the second quarter.
Here it is: Consolidation and Continuation. In other words, we expect the market to pull back, but that the bull market should ultimately climb to new highs once the correction has run its course.
Currently it appears that the Consolidation from recent highs has already begun. How far the market correction will run is uncertain, and a pullback could last from a few weeks to a few months. In terms of magnitude, our best guess is that price swings will be anywhere between a very shallow 4% already booked, and as much as 15% if it becomes deep and protracted. Corrections contain a time element, and our best guess based on seasonal patterns and prior history is that corrective activity will likely last a few months, with a chance of dominating the remainder of the quarter. That said, there are no guarantees, and it has been surprising to watch the market clear some of its excess sentiment and short term overbought conditions with very minor price depreciation since the beginning of April.
When faced with correction, the critical question is what to do with it? Since we believe the correction will be confined to declines that wouldn’t fit the classic definition of a bear market, and that the greater probability is that the market will see a Continuation of the bull towards greater highs, we will look to build volatility on the correction rather than get defensive. We don’t know how high this bull market could ultimately go, but it’s fair to say that the old highs of 1560 on the S&P 500 index appear to be a reasonable target.
Given our current quarterly theme, the investment team has been busy working on tactics that align with our thesis. The current plan of attack will be to use any market correction over the coming weeks and months to dollar cost average into risk assets and fully invest our portfolios to benchmark levels of volatility. After we neutralize volatility, things will become market dependent. If the correction is of the deeper variety, we will likely take our volatility profile slightly over the benchmark as long as systemic risk stays contained. If evidence materially changes we always reserve the right to modify our view and take action, but for now the plan is to utilize the downdraft in markets and buy the dip.