“What in the world is going on?!”  That was the start of a recent phone call I had with a client.  He was worried about the market and the severe downturn we have taken.  As everyone knows, we here at Aerie are big fans of Ben Graham and his star pupil Warren Buffett.  Ben Graham, in one of his seminal books on investing, The Intelligent Investor, humanizes the market as “Mr. Market”.  Mr. Market is a bi-polar individual who is giving away the store one day and buying it back with fervor the next.

With all of this recent stock market volatility, I know that many are wondering just where we are headed.  One day the market is on fire and the next day it’s ice cold.  We’re up.  No, we’re down.  We’re heading for record territory!  Oops!  Make that a double dip!

First, let’s put the market into perspective.  To help with this, take a look at the chart below.  This chart comes from http://stockcharts.com which is an excellent source of charts and charting tools for the technically inclined.  The way this chart is interpreted, a column of X’s indicates a rising market and a column of O’s indicates a falling market.  If you look to the far left of this chart, you will see a very low point around the 670 level.  This is the low point from last March.

SPX PNF chart

Currently, the chart’s last column is a column of X’s meaning the most recent trend is upwards.  You can also clearly see that it has been a back and forth march upwards.  This chart clearly shows that we have been two steps forward, one step back since August (the column of X’s near the middle of the picture that is a long column up).

While this chart clearly paints an optimistic outlook on the market, it would be naïve to assume that all is hunky-dory, of course.  We all know things are not well, yet.  Unemployment is still stubbornly high.  The housing market – a major portion of our economy – is still in the doldrums with a lot of unsold homes to go through before home prices start recovering.  So we may have a lot to worry about after all, right?  That means we are in danger, aren’t we?

Well, not so fast there pilgrim!  Let’s take a look at one additional chart.  This is another chart like the one above.  The difference is in what is being measured.  The chart below measures something called the VIX or volatility index.  It’s measured by counting the number of call options (options that are betting on higher prices) relative to put prices (options that are betting on prices falling).  The higher the VIX ratio, the more volatility there is in the market.  The far left side of this chart goes back to March of last year when the stock market bottomed out and the long rally up began.

VIX PNF chart This chart is almost a mirror image of the S&P 500 Index chart from above.  As the stock market has climbed, volatility has declined.  This is a good thing – at least from our perspective.  What this essentially means is that we are not in any immanent danger of a severe market drop – assuming, of course, no exogenous shock such as a terrorist attack.  What this chart tells us is that investors are generally sanguine with the market at current levels, though the recent “pop” on the right-hand side of the chart indicates a little bit of fear.  This would be caution creeping in, as investors attempt to shield themselves from any serious setbacks.

So the question then becomes, what do we do in the face of this current situation?  Do we buy insurance on our holdings or back up the truck?  Is it time to take money off the table or put money to work?

At the moment, we are cautiously optimistic.  I long ago tired of the green shoots analogy to describe the economy.  I do see spitting and sputtering signs of a recovery but we are not out of the woods yet.  Investors remain stubbornly bearish in opinion and that, oddly enough, may be the most positive sign out there.  As long as investors remain cautious, we are not likely to see any dramatic declines.  There is an old maxim that Wall Street will climb a wall of worry and that is often true.  During recovery periods, investors are most cautious but companies are really getting better.  They have pared labor and expenses, so any increase in sales, no matter how small, will flow through to increased earnings.  This will get translated into higher stock prices even as investors remain cautious.

Stock markets tend to anticipate good news, so the likelihood of a continued rally is very good.  In fact, the charts continue to stubbornly point higher and will until they don’t anymore.  I know… I know… That’s not exactly a ringing endorsement, but in the absence of omniscience, it’s the best we’ve got.  We will continue to pay attention to economic news and data and set reasonable limits.  Most importantly though, we will continue to seek out great businesses that we feel are selling at steep discounts to their intrinsic value.  Stay tuned as we will be addressing some of our current holdings and some new stocks as we add them over the next few weeks.