Investment Roadmap: Stocks

In the short run, it is apparent we have some upside left.  If you had been reading this blog, you would have seen a discussion of When To Go In right before the Nov21 bottom, and another discussion of getting ready for the Obama Rally right before the Mar6 bottom.  After it ran up a bit, it broke out of its channel for the prior 20 months, signaling this was in a major rally.  Technical analysis points to a rally that should retrace at least 38-50% of the whole drop, and might go as far as 62%.  Right now two of the most bearish pundits both see a sharp rally.  Glen Neely Monday morning said he expects a 100 pt jump in the S&P.  Steve Hochberg of Bob Prechter's Short Term Update (STU) service Monday evening said he expects a strong rally to at least Dow9500 and SP1000. 

So jump in, right? 

Well, we are already well off the bottom, and might only have a 12-15% upside ahead.  it would have been better to have gone in back around Nov20 or early March.  Of course, 20:20 hindsight is an awful thing (just like in golf, where that mulligan or second shot always seems to be so much better ...), yet it can teach you that to win in investing you have to take risk.  When you go in with trepidation, when 'the herd' is staying out, you can make much better returns than if you join in with the herd after the trend becomes clear.  

Now, if this runs up to 50% or more of a retracement, you still have good upside ahead.  In that case your biggest enemy will be your growing confidence with immediate profits.  As this market continues on, the sentiment will get very positive.  Indeed, history shows that in the first big rally after a large drop, as in 1930, or 2004-07, the sentiment can often get more positive than at the prior bubble peak!  It is as if the Echo bubble is more ridiculous than the original - the market participants feel that they were clever enough to catch the bottom, and it emboldens their risk-taking.  You will thus see an increasing number of stories from respected pundits that the bottom is in! Don't be fooled. As the STU said:

Part of the purpose of a bear market rally is to turn the great majority of investors back into confirmed optimists; those who believe the worst is behind and a sustained new bull market is underway. This behavior creates the sentiment extremes that so often accompany the end of the bear market rally phase and set up prices for the next big decline. Part of the progression toward an optimistic extreme will entail an embrace by the media of the perceived enduring nature of the rally. Now that the S&P is back into positive territory for 2009, headlines should proliferate hailing the “good news,” which should help to feed the push toward a greater degree of optimism. Next up will be the Dow, which his still down 3.98% for the year. The optimum condition for the start of [the next big move down] will be a wide-spread outbreak of bullish stock market pronouncements.

Put differently, at some point this summer President Obama may get up and do what Hoover did in 1930: declare "Mission Accomplished!", that his stimulus worked, and the worst is behind us.  THAT is when you get out!  But of course at that time all those many people around you giving you unsolicited advice will be so over-confident they will convince you to stay in, and you will be inclined to believe them.  Such is the comfort of running with the herd. 

In the middle term, it is pretty clear that this is not a new bull market, but a counter-trend rally in a larger bear market.  How do we know this?  What if this really was the bottom, and the recession will be over pretty soon? 

Major market bottoms in 1921, 1932, 1938, 1974 and 1982 had a very different look and feel to the recent low in March.  P/E ratios for example get into the single digits at a real low (7 in 1932, 5 in 1982).  You will see the press report P/E's at around 14, and even that number is suspect.  E has dropped so much that the P/E was at 60 at year-end 2008, and over 100 at the end of Q1.   John Mauldin likes to distinguish as-reported earnings, from which all the official ratios are taken, and EBBT or Earnings Before Bad Things, the real operating profits before adjustments dress them up.  P/E from EBBT is a horrific 191 right now, and may go infinite since for the first time ever the overall E in the S&P is going negative. 

Instead of seeing that in the financial press, you see numbers that often are based on manipulation by the reporting companies.  If you doubt this manipulation of numbers, just look at how Goldman Sachs disguised a huge loss in December by changing its fiscal year; December magically disappeared! Similarly, Citi reported a big profit, much of which turned out to be a write-down of its own debt, driven by the terrible banking crisis!  A crisis is a terrible thing to waste, especially with accounting statements.

Robert Shiller of Yale prefers a modified P/E called P/E10, which uses the 10 year smoothed E.  The P/E10 has been running up from under 14 to over 16 in this rally.  And if the rally continues, it should continue to climb even faster as E is expected to drop throughout the year.  These are not levels found near bottoms - if we creep over 20, it is a level found near tops!

In the long run, where are we?  In a recent post, I argued that once this rally fails, we fall again to new lows, with a bottom in the 2011 time frame.  If we look to previous credit bubbles in 1929, 1873 and 1837, the subsequent market fell hard for four years, having a first bottom in 1842, 1877 and 1932.  This also suggests a 2011 first bottom, four years after the 2007 peak. 

2011 is unlikely to be the end of the bear market.  Since the modern management of the economy began after WWII, we have run in broad 16-18 year cycles: up from 1949-1966, down to 1982, up to 2000, and now down towards an end that this pattern would suggest is around 2016 +/- 2 years.  Don't be fooled by the peak in 2007 being higher than 2000; the S&P peaked in real terms (inflation adjusted) in 2000, and adjusted for the CPI is down 58% from the 2000 level. The bull market from 2003 to 2007 was merely a cyclical bull inside of a larger secular bear. Similarly, the market peaked in real terms in 1966, just as the Great Inflation got underway, and bottomed in real terms in 1982, just as it ended.  It hit a nominal high in 1973 and a nominal low in 1974, but in real terms it was a 16 year bear market. 

Modern management of the economy, or if you like meddling and intervention in the economy, has been massive even before Obama's stimulus.  The current problems seem largely to have been caused by Greenspan trying to avoid deflation after 2000, and ironically to cure one bubble he created an even bigger one in 2007.   The aftermath of 1873 and 1837, where we had no government intervention, were relatively brief (4 - 5 years), whereas the Great Depression, where we had massive intervention, lasted at least into 1942, or 13 years; this runs the eventual bottom of the current Great Recession out as far as 2020. 

It seems the more the government tries to abate the problem, the more it extends the bear market.  Japan had a similar experience after its credit bubble in 1989.  The government jumped in to stimulate the economy, and eventually put in $6T (equivalent to the US having $14T of stimulus).  When they no longer could afford to continue, having borrowed to the limit, the economy fell back.  In other words, it had been on life support, and the patient went back to critical when the respirator was turned off.  The intervention simply delayed the real bottom.  Japan stimulated until 1997, or 8 years; and despite a revival during the recent credit bubble, are now in a moribund state, 20 years after their 1989 bubble peak, with a sizable national deficit, an aging workforce, and a plummeting industrial production.  Many Japanese economists now believe the stimulus was a huge mistake. 

You can play the market during its sickening slide to lower levels, or just stay out and focus investing elsewhere. In a secular bear market, traders ride the cyclical bulls up and down, while buy-and-hold investors just watch their investments whither away.  From 1966 to 1982, we had three expansions and four recessions, and the market would rally 50% during those expansions.  So you could play them; but had to avoid a buy-and-hold approach.  Instead, consider shorting: if you had been so wise to short the S&P in the summer of 2007, you would have had an 800 pt drop in a mere 18 months, an unprecedented fall and a huge windfall to the shorts.  Buy-and-hold would have lost over 50% in the same 18 months.

Comments

[Rob]

Does Hochberg's target for this rally of 1000 SPX and 9500 DJIA represent the top for the year? Or is it the end of an A up leg?

I assume we are in wave [2] up, but I am hard pressed to be able to say that we had a wave (2) down within that wave. Are we in wave (3) up now, or some completely different wave count?

I would like to think that this rally will now stall out at the January high of 943.85 SPX, which is 2.65% above today's close. I can't see the DJIA reaching its January high of 9088.06 before pulling back. This is 6.76% above today's close.

With Cisco beating the street, it looks like a higher open tomorrow!

[da bear]

the latest EWFF has this wave [2] up as an a,b,c rise. so we are in wave c now...

this feels like the final spike. feels kinda strong too so it could be the c wave.

I think they are still saying that after wave [2] is over near those levels then the big Wave 3 down will begin.

da bear