Market Summary
May 31, 2006
The reality of increasing interest rates finally sank in during May. Instead of an announcement by the Federal Reserve that interest rates would now level out and reduce the risk of uncertainty for investors, the Fed stubbornly asserted its independence of the investment community. Based on the now discredited assumption of interest rate stability, investors had pushed up values of both US and international investments at a rapid pace. At the beginning of May interest rates begin to break through the upper ceiling levels that had been set. Almost immediately investment values began to fall. In very speculative situations, values fell by 25 % during May. India and Russia come to mind. Almost all funds and underlying stocks fell. For the investor this decline is a correction. For the trader, the rapid run up in prices was a great opportunity to take profits. For the trader the approaching correction was obvious. An increase in values of 20-50% during a four month period is unsustainable. Even the charts showed that investment prices were making their last scramble up the charts before starting their descent down the other side.
Given the predictability of this scenario, what’s an investor to do? One clear possibility is to take some profits and move money out of the investments that have been so kind. Since we all want to own investments that are going up in value, few are able to decide to sell when prices are going up. However, if investors plan ahead, if they set their goals for selling and stick to them, then they will be able to sell without and book a respectable gain in value. This reasoning is the basis for exercising the art of portfolio rebalancing.
Another possibility for managing investment gains is to exercise the art of effective pruning. During a time period when values are growing, some sectors will grow much faster than others. An investment that increases much more than the average market such be examined carefully so that it can be harvested before it falls to the ground from its own weight.
There is another important investment management technique. Investors and their advisors must stay very close to the daily developments in the market. This discipline is always difficult. When the market is doing well, investors often see no reason to make any adjustments. Conversely, when the market is going down, investors see little opportunity to improve on their relative performance. The discipline that investors must follow is one in which the markets trends are defined, the underlying assumptions are known, the risks are evaluated and the alterative courses of actions ready for implementation.
In future market commentary, we will explore some concepts that may be attractive, especially at times like May 2006. How should investors and their advisors set targets for selling an investment? Should investors ever exit the investment market entirely? How should the risks and rewards of investments be balances for each investor? How do we identify the alternatives to those investments that have already performed well?