KIM: Have we seen second quarter of 2012 before?

The following is an excerpt from Kirr Marbach’s quarterly client letter, available in full at www.kirrmar.com.
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The U.S. equity market tested the confidence and resolve of investors in the second quarter of 2012. Like the same period last year, the swoon was caused by a combination of economic reports here and around the globe best characterized as duds/clunkers and yet another eruption of the European debt crisis.

Still, even after the anxiety-inducing 10-percent plunge in the S&P 500 Index from April to early June, the U.S. equity market finished the second quarter in solidly positive territory for the year-to-date. We think if you had asked investors at the beginning of the year if they’d be pleased with a high-single-digit return at midyear, most would have replied in the affirmative.

We believe our economy will improve, but expect setbacks along the way. The pace of employment gains has been disappointing. With the U.S. presidential election now four months away and the “fiscal cliff” looming at the start of 2013, uncertainty likely is paralyzing potential employers.

The Facebook IPO ended up a fiasco that shed an unflattering light on a number of Wall Street practices. JPMorgan revealed a self-described “sloppy and poorly designed” hedging disaster some think could end up costing as much as $9 billion. The scope of the Galleon Group hedge fund insider trading scandal widened to snare Rajat Gupta, former head of McKinsey & Co. and board member of Goldman Sachs.

Following the 2008 global financial meltdown, investor psychology is extremely fragile. There is an old truism in poker that there’s a “fish” (sucker) in every game. If you can’t figure out who the fish is after an hour, it’s you. It is not surprising many investors have concluded the game is rigged and they are obviously the fish.

They have responded by abandoning the stock market in droves. Investors withdrew $67 billion net in the first half of 2012 from U.S. equity mutual funds, and almost $540 billion since the beginning of 2007. Bond mutual funds have been the beneficiaries, as $160 billion flowed in during the first half of 2012, over $1 trillion since the beginning of 2007.

Investor sentiment is as negative as it can be—a positive for contrarians like us.

Downdrafts likely will continue. U.S. stocks suffered deep corrections in 2010 and 2011, with peak-to-trough declines in the S&P 500 of 16 percent and 19.3 percent, respectively. The drop was a comparatively mild 10 percent in the second quarter of 2012.

The Leuthold Group examined peak-to-trough declines for calendar years dating back to 1928. The results might surprise you. The average and median declines for the last 85 calendar years were -16.8 percent and -13.5 percent, respectively. The largest decline was -57.5 percent in 1931 and smallest was -2.5 percent in 1995. Leuthold noted that none of these declines led to the end of Western civilization.

The message is twofold. First, as equity investors, volatility is what we signed up for. The drops experienced during 2010, 2011 and thus far in 2012 are not wildly out of line with history. Second, the cost of avoiding volatility (i.e. buying 10-year U.S. Treasury Bonds at 1.65 percent) is unacceptably high and will ultimately be harmful to long-term performance.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.