"I have been speaking recently to a number of my smart friends" he said, "And all of them are getting out of the stock market."
"They tell me that they are worried about a number of things, but mostly about the reappearance of problems in the euro zone. Europe is in turmoil. The failed Spanish auction earlier this week is only the beginning of a credit crunch."
My client paused, then went on.
"They also worry about the re-election of President Obama, which seems likely at this point. They believe that Obama is anti-business, and that after the election he is going to raise taxes and impose regulations that will hinder American business."
"Finally, my friends tell me that there is too much bullish sentiment around, too much complacency. After six months of strong stock market returns, investors have forgotten about the economy, and are depending on Bernanke and the Fed to bail everyone out."
"What do you think?"
I paused, then asked a question.
"Where are your friends putting the proceeds of their stock sales? Bonds? Gold? Cash?"
"Anything safe," my client answered. "Their point is that now is not the time to be any asset that could be hit by another downturn in the global economy."
Here's how I responded:
There is no question that we've come a long way since last September, when the world's market looked ugly, and most of the investment conversations centered around gold. Typically when stocks rise by +25% or so in just a few months - as they have starting with the huge rally in October - it would not be surprising to see at least a modest stock market correction.
Moreover, there is some historic precedent for selling in May, and then reinvesting in the fall. While not successful every year, spending the summer months on the sidelines in cash has worked enough times that it has become almost axiomatic among institutional investors.
But I question whether now is the time to selling stocks in favor of cash.
Money market rates remain essentially zero. And, as Fed Vice Chair Janet Yellen said yesterday, there remains the very real possibility that rates could stay very low heading into 2015 (I have added the emphasis):
WASHINGTON — Janet L. Yellen, the vice chairwoman of the Federal Reserve, said Wednesday that the lackluster trajectory of the economic recovery might require the Fed to continue its efforts to bolster growth even beyond the end of 2014...
She said that one economic model used by the Fed suggested that interest rates should be held near zero until late 2015. While others have suggested an earlier increase might be appropriate, she said there still might be reasons to wait, including the insufficiency of current policy and the risk that the economic recovery might falter.
With rates at 0%, and inflation running at 2%, the "real" cost of trying to time the market is a steady loss of purchasing power.
In addition, while it appears that the first quarter earnings season might be characterized by lackluster results and cautious guidance, it is worth noting what happened after fourth quarter 2011 earnings results were announced.
According to Merrill Lynch:
4Q '11 was the worst earnings season in terms of positive surprises since 4Q '08. Only 47% of companies beat on sales and 52% beat on EPS.
Then, after this "crummy" earnings season, the S&P 500 jumped by over +12% in the first quarter of 2012.
Another reminder that the economy and the stock market do not always move in the same direction.
Finally, as regards to bullish sentiment, it is not clear that "everyone" is really all that bulled up.
Outflows from equity mutual funds continue, especially from domestic mutual funds. Main Street does not trust Wall Street.
Surveys of bullish sentiment do not indicate rampant optimism - at least the ones that I've seen. For example:
NEW YORK (MarketWatch) -- Bullish sentiment fell among financial advisers surveyed in the weekly Investors' Intelligence poll from last Friday.
The percentage of financial advisers who are bullish on the market fell to 48.4% from 52.7%, while bearish sentiment was unchanged at 21.5%.
The percentage of financial advisers expecting a market correction rose to 30.1% from 25.8%.
So here was my bottom line to my client:
Stocks remain reasonably valued, and there are few signs of "irrational exuberance". The problems in Europe are well-known, and while the problems are huge and potentially unsolvable, a full-scale financial crisis seems unlikely at this point - no one wants to go through another credit crisis.
The alternatives to stocks - cash, bonds, gold, etc. - all pay low or no rates of interest, and offer a generally unfavorable risk/return trade-off to most investors.
The problem with market timing is that you have to be right on two decisions: when to sell, and when to get back in. Few, if any, investors have had much of a successful track record when it comes to trading the market.
So for now at least my client is going to sit tight.