Monday, March 5, 2012

Market Still Suggesting That Investors Be Cautious, Though Not Bearish-

Some people can have a lot of experience and still have good judgment. Others can pull a great deal of value out of much less experience. That’s why some people have street smarts and others don’t. A person with street smarts is someone able to take strong action based on good judgment drawn from hard experience. For example, a novice trader once asked an old Wall Street pro why he had such good judgment. “Well,” said the pro,“Good judgment comes from experience.” “Then where does experience come from?” asked the novice. “Experience comes from bad judgment,” was the pro’s answer. So you can say that good judgment comes from experience that comes from bad judgment!-- Adapted from "Confessions of a Street Smart Manager” by David Mahoney
Years ago I read a book that a Wall Street professional told me would give me good stock market judgment by benefiting from the bad experience of others who had suffered various hard hits. The name of the book was One Way Pockets. It was first published in 1917. The author used the non de plume “Don Guyon” because he was associated with a brokerage firm having sizable business with wealthy retail investors and he had conducted analytical studies of orders executed for those investors.
The results were illuminating enough to afford corroborative evidence of general investing faults that persist to this day. The study detected “bad buying” and “bad selling,” especially among the active and speculative public. It documented that the public tends to “sell too soon” and subsequently repurchase stocks at higher prices by buying more stocks after the stock market has turned down, and finally liquidate all positions near the bottom -- a sequence true in all
similar periods.
For instance, the book shows that when a bull market started, the accounts under analysis would buy for value reasons; and buy well, albeit small. The stocks were originally bought for the long term, rather than for trading purposes, but as prices moved higher on the first bull-leg of the rally, investors were so scared by memories of the previous bear market and so worried they would lose their profits, they sold their stocks. At this stage the accounts showed multiple completed transactions yielding small profits liberally interspersed with big losses.

In the second phase of the rally, when accounts were convinced the bull market was for real, and a higher market level was established, stocks were repurchased at higher prices than they had previously been sold. At this stage larger profits were the rule. At this point the advance had become so extensive that attempts were being made to find the “top” of the market move such that the public was executing short-sales, which almost always ended badly.

Finally, in the mature stage of the bull market, the recently active and speculative accounts would tend not to overtrade or try to pick “tops” using short-sales, but would resolve to buy and hold. So many times previously they had sold only to see their stocks dance higher, leaving them frustrated and angry. The customer who months ago had been eager to take a few points profit on 100 shares of stock would, at this stage, not take a 30-point profit on 1,000 shares of the same stock now that it had doubled in price. In fact, when the stock market finally broke down, even below where the accounts bought their original stock positions, they would actually buy more shares. They would not sell; rather, the tendency at this mature stage of the bull market and the public’s mindset was to buy the breakdowns and look for bargains in stocks.

The book’s author concluded that the public’s investing methods had undergone a pronounced, and obvious, unintentional change with the progression of the bull market from one stage to another -- a psychological phenomena that causes the great majority of investors to do the exact opposite of what they should do! As stated in the book:
The collective operations of the active speculative accounts must be wrong in principal [such that] the method that would prove profitable in the long run must be reversed of that followed by the consistently unsuccessful.
Not much has changed from 1917 and 2012, just the players, not the emotions of fear, hope, and greed, or supply versus demand, as we potentially near the maturing stage of this current bull market. Of course stocks can still travel higher in a maturing bull market, but at this stage we should keep Don Guyon’s insight about maturing “bulls” in mind. Verily, this week celebrates the third year of the Bull Run, which began on March 9, 2009, and we were bullish. With the S&P 500 (SPX) up more than 100% since the March 2009 “lows,” this is one of the longest bull markets ever. As the invaluable Bespoke Investment Group writes: Going all the way back to 1928, the current bull market ranks as the ninth longest ever. Even more impressive is the fact that of the nine bull markets that lasted longer, none saw a gain of 100% during their first three years. Based on the history of prior bulls that have hit the three-year mark, year four has also been positive.
Now, recall those negative nabobs who told us late last year the first half of 2012 would be really bad? W-R-O-N-G, for the SPX is off to its ninth best start of the year, while the Nasdaq (COMPQ) is off to its best start ever!
In seven out of the past 10 “best starts,” the SPX was higher at year-end, which is why I keep chanting, “You can be cautious, but don’t get bearish.” Accompanying the rally has been improving economic statistics, and last week was no exception.

Indeed, of the 20 economic reports released last week, 15 were better than estimated. Meanwhile, earnings reports for fourth quarter 2011 have come in better than expected, causing the ratio of net earnings revisions for the S&P 1500 to improve. Then, too, the employment situation reports continued to improve. Of course, such an environment has led to increased consumer confidence, punctuated by the February Consumer Confidence report that came in ahead of estimates at 70.8, versus 63.0, for its best reading in a year. And that optimism makes me nervous.

Nervous indeed because the SPX has now had 42 trading sessions year-to-date without so much as a 1% Downside Day. Since 1928 the SPX has only had six other occasions where the SPX started the year with 42 or more trading sessions without a 1% Downside Day. Worth noting, however, is that in every one of those skeins, the index closed higher by year’s end.

Still, in addition to the often mentioned upside nonconfirmations from the Dow Jones Transportation Average (TRAN) and the Russell 2000 (^RUT), seven of the SPX’s 10 macro sectors are currently overbought, but the NYSE McClellan Oscillator is now oversold, Lowry’s Short Term trading Index has fallen 12 points since peaking on January 25 (which interestingly is the day before the Buying Stampede ended), and the Operating Company Only Advance/Decline Index (OCO) has nearly 1,000 fewer issues than where it was on February 1 -- suggesting the rally is narrowing.

The number of new highs confirms the OCO (last April the index had similar readings right before a correction), and sticking with the April 2011 comparison shows a striking similarity to the December 2010 – February 2011 trading pattern for the SPX, and we all remember how that ended.