The Stock Market: Sisyphus Succeeds?

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In Greek mythology Sisyphus was the son of Aeolus, who was the King of Thessaly. Noted for being sly and evil, this cunning knave waylaid travelers and murdered them. After betraying the gods, Hades himself intervened and as punishment required Sisyphus, for all of eternity, to roll a huge stone to the top of a hill only to have it plunge back down just as it was about to reach the crest. According to the dictionary, Sisyphus means “endless and unavailing, as labor or task.” Since mid-September there is little doubt investors have felt the same frustration Sisyphus did as the media trumpeted the D-J Industrial Average’s (DJIA/9995.91) failed assaults on 10,000. Last week, however, Sisyphus succeeded as the senior index legged it past the 10,000 mark for the first time in over a year, causing one Wall Street wag to ask, “Is this a breakout or a fake out?”

Nevertheless, many people continue to view the stock market’s advance with skepticism. As our technical analyst, Art Huprich, pointed out at Raymond James’ Vancouver conference last week, “both Jeff and I continue to get questions about DJIA 2700, or in some cases DJIA 400, as is being forecast by certain pundits.” Worth considering, however, is that these same pundits have been forecasting those downside targets for 10 years. Still, the media trots them out and subsequently Art and my phones light-up with the question, “do you really think this is a rally in a bear market; and, can the DJIA really go to 400?”

To us it is interesting that despite the monstrous rally in stocks, accompanied by extremely strong advance/decline statistics (Art showed a great breadth chart of this at the conference, which is attached), the negative nabobs continue to call this a bear market “sucker’s rally!” While it’s true that markets can do anything, the real “suckers” have been the bears who didn’t employ adaptive asset allocation and consequently have “sat” out the seven-month rally. Clearly, we disagree with the bears’ assessment, having maintained the view that this is a new bull market since April. Moreover, participants got the Dow Theory confirmation of that “bull market” strategy either in July, or August, depending on which levels you used for the Dow and the Transports. Whether the current rally turns out to be a tactical bull market within the longer-term confines of a trading range market, or the first “leg” of a new secular bull market, remains to be seen. But, as we told our friend and founder of the “must have” minyanville.com website, “does it really matter?!” Indeed, as the title of Ned Davis’ legendary book reads, “Being Right or Making Money?”

Obviously, we’ll opt for “making money.” To that point, we have argued that with credit spreads (Ted spread, OIS to Libor, etc.) back to pre-Lehman levels, there is no reason why the equity market can’t “fill” the downside vacuum visible in the charts created by the Lehman bankruptcy. In the S&P 500’s (SPX/1087.68) case this implies at least a 1200 upside target. To be sure, there will eventually be a healthy correction, yet there is little question the primary trend is “up.” As the good folks at Riverfront Investment Group scribed recently, “(even) a healthy correction will not alter the trend.” Plainly, we agree and would note what the astute Lowry’s organization wrote last Friday:

“This week’s advance pushed most of the major price indexes to new rally highs in the primary uptrend dating from the March ’09 market low. But, perhaps an even more important indication of the internal strength of the market from a longer term standpoint is this week’s drop in our Selling Pressure Index to a new 12-month low. This persistent contraction in selling indicates that, despite occasional corrections, investors have become increasingly convinced that prices are headed higher in the months ahead.”

“Occasional corrections?!”... well so far said corrections have been brief and shallow. We have often opined this is because many portfolio managers have too much cash and have therefore underplayed the “bull run.” Consequently, they now have performance risk, bonus risk, and ultimately job risk as they approach their fiscal year-end. Certainly, there will eventually be a healthy pullback, but our sense is it will be contained to somewhere between the 50-day moving average (DMA) and the 200-DMA. In the SPX’s case that currently targets the zone between 1038 (50-DMA) and 910 (200-DMA). Still, there is nothing “saying” there has to be a pullback, which is why we have repeatedly exclaimed, “cautious – yes, bearish – no.” It is also why we have recommended not “disturbing” investment positions since we continue to believe stocks will be higher at year-end even if there is a near-term pullback. As ISI’s Francois Trahan writes, “the fourth quarter is seasonally the strongest of the year with average gains of 3.5%, a full 100 bp higher than the second seasonally friendly period: Q1... Indeed, since 1960, Q4 has finished in the black nearly 75% of the time.”

As for the all the “doubters” we encountered last week, who keep pointing to the rising unemployment numbers, we reminded them that employment is at the back-end of the cycle. Nevertheless, their chant goes like this, “how can we have a durable economic recovery when consumers account for roughly 70% of the economy; and, unemployment continues to rise while consumers continue to leave their “billfolds on their hips?” Ladies and gentlemen, the typical economic recovery is driven by corporate profits, not consumption! Those profits turn into the “investments” that foster a capital expenditure cycle, which eventually spurs corporate hiring. That’s the typical sequence and we think it plays that way this time. Verily, corporate profits are surging, which should stimulate more than just the “inventory rebuild” the naysayers suggest will quickly peter out. Accordingly, we think there will be a more durable capex cycle followed by the envisioned improvement in employment, which will indeed drive consumption.

Tagging along with U.S equities markets on their new reaction high “hit parade” were the Goldman Sachs Commodity Index, Crude Oil (and the Energy sector in general), many of the precious metal indexes/stocks we follow, a number of “soft” commodities, most of the exchange-traded funds (ETFs) we have recommended that play to emerging and frontier markets, and the list goes on. We think there is a message there. Should the various markets continue to trade higher in the months ahead, our sense is the sectors/stocks that have been the best performers off the lows will continue to be the best performers into year-end. Therefore, we would avoid playing the “laggards” in favor of the “leaders,” believing they will continue to “lead” if the equity markets trade higher. In addition to the aforementioned sectors, we would re-emphasize technology. Manifestly, tech is “cheap,” as well as being a second derivative play on the emerging and frontier markets. Moreover, technology companies tend to be “volume monetizers,” as opposed to “price monetizers,” a concept proffered by the sagacious GaveKal organization and often referenced in these missives. And we continue to invest, and trade, accordingly.

The call for this week: Since the March “lows” we have repeatedly argued that the equity markets were three to four standard deviations below “normalized” valuation levels. Since then, they have merely rallied back to “normalized valuations.” Indeed, the DJIA only trades at a P/E ratio of 16 times earnings (according to Barron’s) and the gap between companies’ free cash flow yields and bond yields is at the widest since the early 1990s. As the prescient QB Asset Management folks write, “As the Fed and other central banks have been inflating their respective monetary bases dramatically over the last year, it is logical that gold has appreciated in dollar terms. It is also logical that stock markets have risen. In monetary base terms, the S&P 500 would have to rise to 1300 just to match the real/March ’08 lows.” Obviously, we agree with the implication being that the equity markets can rally to one to two standard deviations above norms, bringing price target objectives of 1200+ on the SPX into view. Consistent with those views, as well as the fact the SPX closed above the often mentioned 1070 – 1080 resistance zone, trading accounts should have judiciously added some “long” index positions last week despite our continuing cautious consul. Indeed, many of our trading cycle indicators have topped out, and sector leadership is beginning to show some “cracks.” Therefore, while the investment account remains pretty engaged, the trading account is only marginally engaged on the hope that we will get a pullback before the anticipated November/ December year-end celebration.

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“The absolute price of a stock is unimportant. It is the direction of price movement which counts.”

“During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn’t worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.

In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price – by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.”

“Stock Profits Without Forecasting,” by Edgar S. Genstein

I am leaving for a speaking tour in Michigan and then will be out of the country speaking again, so I wanted to leave you with the above paragraphs to ponder. They are two of the most important paragraphs I have encountered in more than 40 years of studying markets. Do not read them just once. Go off to a quiet spot that invites contemplation and read them several times. Then reflect on all of the mistakes you have made in trading and investing. Bells will ring, and curses will be uttered, if you are truly honest with yourself. My advice is to keep this quote handy, read it over, and study it every time you get ready to make an important buy or sell decision; especially if your emotions are reigning.

Ladies and gentlemen, Edgar Genstein’s comments are as cogent today as they were when first written in 1956! The most recent example would be the two-stage “melt up” that began on March 6th from the S&P 500’s (SPX/1071.49) demonic low of 666. The first stage took the SPX up 39.6% into its first intra-day reaction high of roughly 930. From there the index “flopped and chopped” around, but never gave back much ground. Stage two of said “melt up” began on July 13th and has extended every since. So far the second stage has tacked on 24.3% from the July 8th intra-day low of ~869 into the September 23rd intra-day high of ~1080.

While memories are short on the “Street of Dreams,” recall what many pundits were saying when stage one stuttered-stepped in May. The “cry” went out that the short-covering, bear market rally was over, and the March “lows” would be retested and broken. That mantra caused many investors to sell their investment positions and go to cash. Admittedly, we turned cautious in early May and sold, or were stopped-out, of most of our trading positions. However, we never “lost” our investment positions, consistent with Mr. Genstein’s advice. Further, on July 14th, when we luckily recognized that stage two of the “melt up” was beginning, we recommended re-buying trading positions. Unfortunately, we sold those trading positions the week of September 21st, fearing that the vacuum created by the stage-two “melt up” might be “filled” to the downside once quarter’s-end window dressing was over. Still, we NEVER lost our long-term investment positions, again consistent with Edgar Genstein’s advice. Nevertheless, that short-term trading strategy looked pretty good as the SPX peaked on September 23rd (at ~1080) and slid into its October 2nd low of 1020 where it tested, and held, its 50-day moving average. Since then the SPX has gained 4.6%, which brings us to this week.

To be sure, this week all eyes will be focused on the S&P 500’s September 22nd bull market closing high of 1071.66. While many pundits think bettering that peak is a fête de compli, we are not so certain. As our friends at the sagacious Bespoke Investment Group wrote last Friday:

“Unfortunately, the gains this week (read: last week) might make it tough to reach those highs next week (read: this week). The S&P 500 closed higher on all 5 days this week. Believe it or not, this is the first time this has happened during the current bull market. The last time we had a 5-day Monday through Friday winning streak for the S&P 500 was in November 2006, and the index declined 1.38% the next week. Over the last ten years, this has happened 12 times, and the index has gone down the next week 8 times for an average loss of 0.65%. Obviously this one piece of data isn’t enough to rest your bearish hat on, but it’s still a worthwhile piece of information to know. With the way this market is going, not many investors are willing to bet against it right now, regardless of what any data is projecting.”

Plainly, we agree with “(not) willing to bet against it right now,” which is why we have not “disturbed” our investment positions.

Speaking to investment positions, since the March “lows” we have recommended numerous investments from the Raymond James universe of Strong Buy and Outperform-rated stocks. This morning, we revisit a few of those yield-oriented, Strong Buy-rated recommendations (that still look good to us) for your consideration. To wit, Allstate (ALL/$31.92), Automatic Data Processing (ADP/$40.17), Chevron (CVX/$72.76), Digital Realty Trust (DLR/$45.73), Republic Services (RSG/$26.97), Inergy L.P. (NRGY/$30.10), NTELOS (NTLS/$17.11), Teekay LNG Partners L.P. (TGP/$25.89), and Teekay Offshore Partners L.P. (TOO/ $16.88). Of course, we would prefer to buy them on weakness, but then the equity markets are not operated for our benefit.

As for the trading account, we have been “flat” for the past few weeks, which looked like a pretty good strategy until last week’s spurt saw the SPX tack on roughly 4.5%. Consequently, if the SPX can travel above its overhead resistance between 1070 -1080, we will be forced to reconsider our cautious approach and look to add some trading positions. In the interim, we remain cautious.

The call for this week: “I am leaving for a speaking tour in Michigan, and then will be out of the country speaking again, so I wanted to leave you with the aforementioned paragraphs to ponder in my absence. They are two of the most important paragraphs we have encountered in more than 40 years of studying markets. Do not read them just once. Go off to a quiet spot that invites contemplation and read them several times.” That said, while I continue to think stocks will be higher by year-end, I am less sanguine about the short-term. Evidently I am not the only one who is cautious, for my colleague (in a past life), market wizard Larry McMillan, sold ALL his trading positions last week, lamenting that the S&P has tried to break out above its 1070 – 1080 overhead resistance zone four times; this is the fifth time. Indeed, the S&P has expended a lot of energy in its four previous attempts to breach its overhead resistance zone. If it fails this time we could be in for the “October Ouch” referred to in last week’s letter. This morning, however, the “forereach” from last week’s “win” (+4.5% basis SPX), combined with a new reaction high for the DJIA, has the pre-opening futures better by 7 points. And that’s the way it is on the session after the stock market’s two-year anniversary of its all-time closing high of 1565.15 (basis the S&P 500); be apprised...

P.S. Since I’ll be out of the country, these are likely the only strategy comments for the week.

WORST WIPEOUTS PERCENTAGE

PLUNGE

October 1987

October 1929

October 1907

October 2008

October 1932

October 1917

October 1937

October 1930

-23.22%

-20.36%

-14.80%

-14.06%

-13.50%

-10.74%

-10.61%

-10.52%

Source: Bespoke Investment Group.

October isn’t a four-letter word, but it should be... especially with the month’s hysterical history. And while it’s true that statistically the month of September is the worst month, it should be noted that more than 40% of the Dow’s biggest daily declines have come in October. Unsurprisingly, more than 70% of the Dow’s worst “daily dives” have occurred in the September/October two-step. Accordingly, this year investors entered the dreaded month of September with a bearish mindset only to experience one of the best months on record. That wrong-footed, bearish strategy left portfolio managers scrambling for stocks right into quarter’s end, causing many folks to think there isn’t going to be an October “ouch.”

Comes October, and according to our friends at the invaluable Bespoke Investment Group, last Thursday represented the fourth worst opening day (-2.58% basis the S&P 500) of the fourth quarter since the index data began in 1928; it was also a 90% downside day. While we are clearly not clairvoyant, we did indeed caution that the upside vacuum created by the recent melt-up might get “filled” on the downside once third quarter’s window-dressing was over. Consequently, we entered 4Q09 with a cautious, but not bearish, strategy. And while the jury is still out, our confidence level is rising that for the first time since the March “lows” we have the potential for a correction of more than 7%. The only question to us is what shape the correction will take? Will it resemble the smash of October 1978, which saw the senior index surrender more than 10% in three weeks, or will it lay around and then dribble-down in a slow-motion “melt?”