The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

09 February 2009

Another way, a better way

I realize you seek doom, gloom, and oodles of despair, amid predictions of more (equity markets) weakness to come -- but I do not agree. And will not -- at least not for a long while to come.

I have disagreed with the bearish perception since mid-September 2008, as you know. Not only do the bears have it all wrong, but they are all wet, as their short positions now rapidly take on water. They watch in horror, or they should, as the market trades from strength to strength -- just as I called for several months ago. And all despite the bears repeated cries of imminent terrible declines still to come.

Let's be clear, even though I only repeat myself, that each investor has his or her standard definitions. Most investors, especially those statistically inclined, define a bear market as a decline of 20% or more. Using that definition, the decline from mid-September to mid-November qualifies easily as a bear market. But I find the definition lacking, so I have my own: a bear market is a down trend of (a minimum) 3 lower highs and 3 lower lows. The current decline qualifies under my definition -- but only if dated from the high trade in October 2007; begin in September 2008 when the bears began to really growl, and it does not qualify.

I mentioned here (on this blog) in late-September that the coming decline would be an ending and not a beginning; i.e., it would complete the bear market in force since October 2007. And, son of a bitch, if that is not precisely what occurred; an all-out panic, a crash, that ended the decline with a punctuation mark on 10 October 2008. Recall (and, please, begin to piece together my many lessons) that I perceive tops and bottoms to occur in three waves: the price low (or high), the momentum low (or high), and the divergence or breadth low (or high). I alerted you here (on this blog) of three (3) crucial dates: mid-October (note the momentum low of 10 October), 15 November, which would mark the end of hedge fund selling (note the intra-day price low of 21 November), and 1 January, which would possibly mark the incipient beginning of a melt-up in share prices, as professional investors would see finally a divergence low, which in fact occurred on 20 January 2009. Even to my tired eyes, time proves me correct on all three dates. So far.

I can hear you now, even thousands of miles away. "Say what...?! How can I be so cavalier about a 50% decline?!" you scream. The decline of October and November 2008 was horrific, and ushered in a financial and economic nuclear winter. Right?

Please understand that much of what occurs today fits within my expectation perceived years ago. No prediction, just specific fears about the economy and global markets that I have shared here and elsewhere for the past 10 years. A handful of you will recall my repeated cautions on the old (George) Gilder forum (GTF) to "shatter your assumptions." I did not explain then what I meant, but will now.

I thought then that too many investors assumed portfolio positions with a bullish mindset and expectations. For several reasons, most of which were based on technical analysis, I believed this dominant bullish expectation to be folly, as the subsequent decade has since proved. I wanted to encourage investors to question their expectations, to shatter their assumptions, to consider that, just perhaps, the markets would trend sideways for a decade or longer rather than trend higher with periodic declines. (To be fair, readers then had no idea what or how to perceive a change, because I was, I admit, insufficiently clear. Which error begat this blog.)

In fact, the reality of many years of sideways (or range) trading is a common occurrence; par for the course, in fact. Using an annotated chart, I showed you the past 100 years of Dow Industrials with these periodic (regular) sideways trends that interrupt the more common, and primary, up trend. I showed several items in that chart, but especially that

1) The horrific declines of the 1930s (1928 to 1932 and 1936 to 1937) fit within a primary trading range that proved part of a massive (26 years) base; and

2) The 50% decline of 1974 is a common and expected occurrence, and fit within a large and wide (16 years, 1966 to 1982) trading range that also proved to be a base.

The news was terribly bad during each of these, and other, primary base-building times, and equally as bad — though different — than today's news environment. Yes, it is ugly out there. Yes, the news will worsen, likely throughout all of 2009, and perhaps into 2010 before we see even a glimmer of light (good news). But the markets and the economy often wage separate battles, often creating a disconnect that causes many spectators to scream, "What? How could the market rise (decline) in the face of such bad (good) news?!" The chart below shows graphically my expectations for this trading environment.

[click on all charts to enlarge]

Recognize the pattern? You should; it is a high level consolidation (HLC). I first identified the two trend lines in January 2000; the upper boundary required only observation whereas the lower boundary required some speculation. But not too much speculation, because the lower boundary of a high level consolidation is almost always 30-50% from the high, which counts as 775, but then a level of support (former resistance) must be found nearby to confirm the assumption; the 725 area provides such support. And has stemmed many declines the past 12 years. So a 50% decline is neither surprising, nor startling, nor unexpected.

Mega-patterns, such as the HLC I identify in the chart above, trump all lesser patterns and trends; the lower line (drawn at ~725) will stem all declines, just as the upper line (~1550) will halt all advances -- until finally breached in one direction or another. These two lines identify inflection points; all trading within the lines is not unusual, atypical, or unprecedented. Despite the bears jumping on every negative bit of news, every negative market open as a resumption of the bear market, while ignoring every spot of positive market action that begins to predominate, I see nothing overwhelmingly negative in the current chart set-ups (daily, weekly, and monthly). In fact, I see many, many positives. Many of which I have shared already, in advance of the market's increasing upside strength.

Assuming my analysis correct, then the markets appear to be ~50% through the process of its mega high-level consolidation, its inception marked by the momentum high of June 1998, the price high of June 1999, and the divergence or breadth high of March 2000. (Remember that market epoch, when almost every sector but technology, and especially telecom, were headed sideways at best, but more likely down? Such price action describes a divergence.)

My perception that the market decline of October and November 2008 is neither special nor unusual; that the decline since October 2007 is a garden variety bear market. If the decline of October and November 2008 is at all atypical, it is that everything (all asset classes, including all stocks, groups, and sectors) everywhere (globally) declined concurrently... but only to crucial support. The recent declines fall within allowable parameters -- expected, and conforming to precedent; i.e., the price declines have not fallen off a cliff in waterfall form into the center of its respective chart.

So while the news environment is obviously bleak, even dire, and guaranteed to worsen, the markets have yet to do anything but the expected -- well, my expectations -- based on historical trends. (A breach of crucial support at ~725 and a subsequent down trend, though, would materially change my expectation for the worse.) Despite the prevalent gloom and doom, and overwhelming fear, I believe the markets will continue to meander between the two major trend lines for another 5-10 years.

Declines come with the territory (a trading range), but serve only to shake out the weak, cause temporary losses, and have you fear that each new market day will be worse than the day prior. But if instead the markets continue to respect their primary trend lines (up, down, but sideways, sideways, sideways), then you can expect new sectors, sub-sectors, and groups to emerge into their own bull markets, as they race to new all time highs — even while the market averages go nowhere fast.

I recognize that most investors manifest the news response syndrome (described previously); fearful when they should be hopeful, hopeful when they should be fearful, and mostly paralyzed into inaction as the news grows increasingly bleak.I have shown repeatedly how to surmount this emotional obstacle, just as I have shared an item-by-item checklist that showed precisely how the market would build an intermediate term bottom, and which time has proved correct -- item by item. I have mentioned over the past several 'difficult' months several stocks that I like, all of which have been poo-poo'ed due to market fears; among the few is Amazon/AMZN, which subsequent to my mention is up an astounding 100% and Corning/GLW, which only recently began its lift-off.

Face it: most investors never will get market timing, but you could pursue a different method, a better way. I have discussed this methodology, but, based on your fears and misdirected and misguided perceptions, seem wholly unable to convey its beauty to you. Fortunately, the research firm, Dorsey Wright, perceives opportunity and risk similar to me, and is more articulate to boot, so I quote them liberally below. Dorsey Wright is rich with insights, so please respect their copyright; in fact, please subscribe. You will be that much more enlightened, that much less terrified, and that much richer.

-- Begin Dorsey Wright commentary --

"There have been numerous studies done in order to determine whether the risk associated with buying stocks is related to the individual stock, sector, or overall market. One study, published by Benjamin King and discussed in Investors Business Daily in 1994, found that only 20% of the price movement of a given stock is directly attributable to the company itself. Therefore, about 80% of the price movement is attributable to the overall market and sector. However, most people spend 80% of their resources towards researching the company itself and only 20% of resources are spent evaluating the overall market and sector. The bottom line is that even if you are dead right on the stock, and bought it for all the right reasons, if it is in a poor sector than you are more then likely fighting a losing battle, or at least an uphill battle.

In order to put some more actual numbers on the benefits of implementing a sector rotation strategy into you portfolio management process we wanted bring out a study. In this look back at the markets, we have four investors, each of whom has a different series of outcomes based upon how they invest. The first investor is who we'll term, "the buy and holder." He just buys the S&P 500 and rides it up and rides it down, making no movements at all in the portfolio. Our second investor is only invested during those months that the S&P 500 has an up month. So for instance, in 2006, there was only one down month (May, down 3.09%) so he would have had the returns of the S&P 500 for each month except May. In 2008 he was invested only in April, May, August and December. Or said another way, he was able to perfectly time the market. Our last two investors were sector investors. The third investor was smart enough to know every year what the best performing sector would be, and he invested 100% in that sector. The fourth investor was an unfortunate fellow who perhaps was following the sage advice of magazine covers, but he bought the worst performing sector every year. The image below will show you the results and presents a very strong case for the need to incorporate sector rotation into the portfolio.

As you might imagine, each of investors had dramatically different results from their initial investment of $10,000 in 1990. Mr. Buy and Hold currently shows a portfolio value of $25,559. Mr. Perfect Market Timer has a portfolio value of $655,034. Mr. Perfect Sector Timer though has seen his portfolio swell to just over 5 million while Mr. Poor Sector Timer's portfolio is now only $112! So that is the answer. It is that easy, right? All you have to do is invest in the best performing sector each year and simply walk away. Unfortunately, it is not that easy, nor are we advocating that you try to pick the absolute best performing sector and put all your eggs in one basket; rather this is a powerful illustration of just how important incorporating a sector rotation plan can be into your overall portfolio strategy. It can also be an eye opener that the magnitude of buying the best sectors is even greater than that of being able to perfectly time the overall market.

If you were to look at a chart of the S&P 500 from July 1998 to the end of 2008, basically the last decade, what you'll find is that we have seen six periods where the S&P 500 has had a correction of 20% or more. As well, there have been five moves up of 20% or more. But the next result of the last decade or so in the S&P 500 is a loss of over 19% while just putting money in a money market fund would show your account posting a gain of 38%. But the S&P 500 is not a true representation of what has happened in the market over the last decade. Under the surface there have been numerous opportunities to make money in specific sectors if you were willing to "look under the hood." As you saw in the image above, sometimes a sector is on the positive side of the ledger and other times it is on the negative. For us, the most important tool to use to determine when a sector is in and out of favor is with relative strength. The key is knowing when to rotate into a group and have exposure to and perhaps more importantly when not to have exposure to a particular area. Successful investing requires a solid sector rotation strategy.

-- End Dorsey Wright commentary. --
I realize other investors perceive risk, opportunity, and reward differently that do I; perhaps I am an anomaly. I perceive all price oscillations merely as opportunity; opportunity to sell (up oscillation) and opportunity to buy (down oscillation). It is my task, as a money manager, to seek and find (new) leading sectors, and then identify the crème de la crème within those sectors; i.e., the individual stocks that will help increase my clients', and my, portfolio values. Investors either can stand aside, or astride, the market -- but is an investor an investor if he or she owns no positions? Risk and opportunity are the yin and yang of the market.

Question your ability to time the market. Consider hiring a professional to manage your portfolios. Consider a sector rotation strategy that allows you, as investor, to invest with caution, with care. Worry and fret all you like, study everything with a gimlet eye, but never, ever despair; not to the exclusion of the many investment opportunities that lurk beyond your gaze. Yep, right over there. Can you see them now...?

Full Disclosure: Long many exciting investment opportunities. And happy.
-- David M Gordon / The Deipnosophist

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