Stock Market Commentary, October 2005
By Art Nunes, Market Strategist -- IMS Capital Management
T he major stock market indexes have been flat to down so far in 2005. In fact, they have
been fairly flat since the end of 2003. In the third quarter, market action deteriorated with
fewer stocks making new 12-month highs and more stocks making new lows.
Additionally, the transportation sector, which tends to be a leading economic indicator, has been
trending lower this year. Many investors are confused and frustrated by the overall stock market
in light of healthy economic and corporate profit growth over the last few years.
In an attempt to understand current market trends, consider the market’s long-term history. Over
time, the stock market has gone through 10 to 20-year periods where valuations (P/E ratios) trend
up. These periods have been followed by 10 to 20-year periods of declining valuations. The
historical average range of P/Es has been between 10 and 20. For example, the P/E ratio of the
S&P 500 index was about 8 in 1982 and topped out around 34 in 2000. From there, the P/E
declined to 20 at the end of 2004 and is currently around 14 based on forward looking 12-month
earnings estimates. If stock prices move lower and corporate profits move higher, P/Es could fall
further in coming months.
Why could stock valuations head lower? Investor psychology -- Investors appear to be growing
more risk averse. Even if corporate profits continue to grow nicely, investors may continue to
worry about higher interest rates and inflation, energy prices and a recent decline in consumer
confidence and spending. In the background are such things as high consumer debt, high budget,
trade, and current account deficits, along with polls showing low confidence in the government
(both the Bush administration and Congress). None of these factors have ever been positive for
the economy or market, in our opinion.
Under the present circumstances, one possible scenario is for the stock market to make its low
next year, which would be consistent with the historical pattern of stocks making their lows in the
second year of a 4-year presidential cycle. The two years following that low (late 2006 to 2008)
could be banner years for stocks as both profits and valuations trend up together. (Since 1833 --43
administrations -- the DJIA produced a total gain of 227.6% in the first two years of a presidential
cycle and 742.8% during the last two years). (source: Stock Traders Almanac).
Getting through this challenging market environment will require some risk management
techniques. At IMS, we seek to manage risk as follows:
1. Stock selection.
In the IMS Capital Value Fund (IMSCX), we do not focus heavily on the noise coming from the
macroeconomic environment. Instead, we pay careful attention to company fundamentals using a
disciplined bottom up research approach. We look for “seasoned” undervalued mid cap stocks
that are demonstrating signs of positive momentum. “Seasoning” refers to the 18 to 24 months a
company must be down from its high before we will buy. The presence of positive momentum
characteristics helps us pinpoint the most opportune time to buy an undervalued stock and can
come in the form of relative price strength, earnings momentum or earnings surprises. The
combination of seasoning and momentum in a stock help us build a portfolio of securities which
we think can better perform in both up and down markets.
2. Income dividends.
In the IMS Strategic Income Fund (IMSIX), we invest in various income-producing securities in
an effort to produce the highest possible combination of yield and stability of principal. These
income-producing securities can include high yield bonds, dividend-paying common stocks,
business and energy trusts, REITs, convertible bonds, preferred and convertible preferred stocks,
international debt and investment grade bonds. With a strong total return history and a record of
paying dividends every month since its inception, the IMS Strategic Income Fund may just be the
winning combination your fixed income clients are seeking in this uncertain market environment.
3. Strategic asset allocation
In the IMS Strategic Allocation Fund (IMSAX), we use technical analysis to help us identify
opportunistic sectors and asset classes and avoid areas we believe pose downside risk. Since we
sense higher risk in small caps and growth stocks right now, we are underweighting these sectors
in the Fund.
Past performance is no guarantee of future returns and fund shares, when redeemed, may be worth more or
less than their original cost.
The Funds' investment objectives, risks, charges, and expenses must be considered carefully before
investing. The prospectus contains this and other information about the investment company. Please read it
carefully before investing. The prospectus is available at www.imscapital.com. Distributed by Unified
Financial Securities, Inc., member NASD.
The opinions expressed are those of IMS Capital Management and these views are subject to change at
any time based on market and other conditions, and no forecasts can be guaranteed. The information and
data presented here is subject to change at any time and were obtained from sources we believe to be
reliable but cannot be guaranteed as to its accuracy.