In line with our commentary last month, “bending like trees in the breeze” was the correct play throughout April as the indexes continued to power higher. Leading stocks continued to show strong accumulation throughout the month and many made sizeable gains. Remaining flexible is vital, even as the natural contrarian in us identifies signs to jump to the other side of the ship to avoid capsizing. We remain especially cautious at current price levels, albeit ending the month with a long bias to our holdings. We must remain flexible with our opinions and rock solid with our interpretation of actual data.
Given overall market action, we theorize a short-term top could develop anytime that will eventually lead prices lower to the tune of 15-20% before resuming an uptrend to an ultimate bull market top in early 2014. Per last month, we’re still eyeing a fall for the Nasdaq to somewhere between 2726 and 2810, which would be a 17-20% drop from current levels. For the October 1979 to February 1980 precedent period we’ve examined in the History & Precedent section below over the past few months, the S&P 500 climbed 21.9% to all-time highs before correcting 21.6% in a month and a half. Please refer back to prior months’ analysis to see how this period aligns with the action we are seeing today. While we won’t trade based purely on this analysis, the similarity remains striking and must be noted.
I’m going to dive right into analysis under the assumption that readers of this commentary have read our previous installments and have developed a basic understanding of our approach to the market. For first time readers, I recommend reviewing our February 2013 Commentary and earlier to ascertain a detailed explanation of why we at Satellite Capital examine what we do, and why we are interested in certain stocks over others. And as always, please don’t hesitate to contact Thomas or myself with any questions.
Indexes
For the month of April, the Nasdaq rose 1.9% while the S&P500 closed the month up 1.8%. Both indexes continued to press into new bull market highs despite divergent action from other indexes. Of interesting note this past month is the action of small cap stocks, as demonstrated by the Russell 2000. Having lead much of the rally since the November lows, small caps displayed a change of character in April. Similar to the action from February-March 2012, the small cap index has begun trading sideways while the larger primary indexes have continued to new highs. This divergence suggests the rally may be losing steam (small caps usually begin to lag first). We would next watch for midcaps to start lagging, and eventually for large caps to buckle under the weight of the market. This isn’t a hard and fast rule, but rather a gauge to aid us in timing our commitments.
For example, with the Dow Transports (DJT) at all-time highs, one should peel back the onion to see which stocks in that sector were the leaders. The DJT started showing real power in January, and consequently many of the top performing stocks hailed from that sector (airlines, railroads, etc.). It pays to monitor various indexes to get a feel for whether money is flowing into or out of an industry. This is why we watch so many indexes and sectors to find which are performing best; in the best performing industries/sectors, you will often find the best performing stocks.
The Dow Transports also became more than 18% extended from their rising 200 day moving average, which in the past has led to corrections of 15-20% after a consolidation period. Similar to last month, this still jibes with our thesis we’re seeing play out via the action of indexes and stocks. Our observation, verbatim from last month:
“Based on historical models, we feel probabilities are highest that the indexes would move higher in the short-term (albeit somewhat sideways), and eventually break through the rising trend line/head and shoulders neckline in early-mid May. April has proven a pretty good month for stocks throughout this bull market, as April 2009-2010-2011-2012 all preceded solid drops (ranging 12-19% over the 4 years) that really accelerated in May. “Sell in May and go away” is the old proverb. Would we be wise to heed that advice for a 5th straight year? Time will tell.“
As always, we allow the ACTION of the market and leading stocks to dictate how much stock we own and how we should be positioned for a move. Opinions in the market mean little, as the market is filled with bright and talented individuals who bet with their wallets and not their mouths. Our objective is to detect and understand what they’re doing with their wallets, then build a set of enough possibilities based on all other factors to help us play the game well.
Overall, the market is demonstrating resiliency at these levels and is continuing to make new highs. April’s action could represent the left shoulder from the head and shoulders pattern for which we’re looking, but we can’t be certain until trend lines are violated and a Head pattern is clearly in the books. We maintain an elevated sense of caution going into May and recommend an investor be prepared to back away significantly on the first hint that supply is overpowering demand, thereby driving prices lower.
Q1 earnings season is partially completed and while companies have been beating bottom line numbers (EPS), most have been coming up short in their top-line numbers (revenue), which is not what analysts were expecting. We need to watch how this and other economic factors may potentially influence prices. The market is a forward-looking beast, and the today’s numbers are likely already baked into the equation of where we presently stand. The key remains in observing the action itself.
Leading Stocks
Leading stock returns crushed general market returns in April 2013. ARMH gained 10.3%, CELG 1.9%, FB 8.6%, LNKD 9.1%, and QIHU 15.8%. We’ve discussed each of these 5 stocks in prior months, as these are the stocks we feel are positioned to drastically outperform throughout the remainder of this bull market. Another to add to this list is Hertz Global Holdings (HTZ). Hertz sits among the top stocks for this current rally, up about 65% from late November 2012 and up 8.2% in April. By simply holding an equal amount of these 6 stocks last month, an investor would have enjoyed a 10% month without the use of leverage. Prior months’ commentaries confirm that the 5 main stocks listed above have been on our target list for some time now, and Hertz has been in the mix just as long.
Power of the 6 stocks above notwithstanding, 6 stocks alone don’t make for a powerful market uptrend. Many other second tier leaders such as NFLX, GMCR, LL, CREE, ALK, TM, and V also made strong progress in April. Market gains are coming from a broad variety of industries, though primarily concentrated around biotechs, transportation, and select technology sectors. One troubling occurrence was the leadership seen in the Utility space. Utilities are generally a safe haven play, and to see their prices rising so rapidly is somewhat concerning. While not a deal breaker, it’s a divergence from what we would normally expect to see, so we must take note and add it to our list of items that could help tip the scale from bull camp to bear camp.
Overall, the 6 stocks discussed in the first paragraph above are the true liquid leading stocks that must be closely watched for the remainder of this bull market. Other leaders are likely to emerge if the correction we’ve been expecting actually starts to materialize, but until then, these 6 stocks are the cream of the crop both fundamentally and technically. Acquiring their shares at proper entry points and resisting unnecessary trading around your core positions is the best way to generate longer-term gains in these leaders.
Sentiment & Psychology
As the market continues to push to new highs, we approach the realm of extreme bullish sentiment. At some point, the last bear will turn bullish and the trend will reverse itself, as there will be no one left to buy at higher and higher prices. Bullish advisors still outweigh their bearish counterparts by a better than 2:1 ratio and the print media is still fawning over the market, both of which could be treated as contrarian items. However, using these indicators as timing mechanisms may prove fruitless, as our adage that “the market can often remain irrational longer than we can remain solvent” still applies.
During April, the Put/Call ratio did reach a reading of 1.2, which means that there were 1.2 puts (option buyers expecting prices to fall) to every 1 call (option buyers expecting prices to rise). This 1.2 level has generally been associated with an extreme that tends to reverse itself in quick fashion. It’s a great contrary indicator that helps us to detect when sentiment has shifted sharply one way or another. Since the option markets are generally more speculative than the vanilla equity markets, a hard shift towards net puts or net calls is often a good indication that a trend is about to shift. Sure enough, after hitting this 1.2 level in mid-April, the indexes bounced and made their ways into fresh bull market highs, affirming the contrarian theory.
Similarly, the NYSE Advance/Decline line continued to plug higher and higher during April despite mid-month volatility. This gauge is best viewed as an internal market reading of what’s actually happening in the broader market. The A/D line will usually weaken ahead of prices, offering some indication that a trend could be about to change. As of this writing, the line remains at its highs and is showing no signs of slowing. This is a positive development that would seem to indicate ever rising prices over the short-term.
Regardless of the mixed data we’re receiving here, it’s important for an investor to keep his or her guard up and not be caught flat-footed if the market trend changes rapidly. Excitement abounds at market peaks, as everyone is happily making money with prices at highs. To quote Martin “Buzzy” Schwartz in his classic trading book ‘Pitbull’: “When you feel like doing the mashed potatoes [a 1962 song/dance by Dee Dee Sharp→ check it out on YouTube], it’s a visceral clue that you’ve lost your objectivity, you’ve gotten too emotional, and you’re about to go into the shitter.” We definitely see signs of advisors and market commentators starting to do their own versions of the “mashed potatoes”, so again must caution an investor from being too aggressive at current market levels. Exposure is still presently warranted, but as prices continue to rise, our risk tolerance should fall in equal proportion.
History & Precedent
Every month we examine a period in market history where an index, a stock, or a group of stocks are following similar patterns to those that happened at some point in the past. This month, we continue to closely eye the precedent we’ve been observing comparing the bull market from 1974-1980 versus that of today (2009-2013/14?). We’ve covered this precedent in detail in our March 2013, January 2013, & December 2012 commentaries.
This month I’m going to comment briefly on how we feel this precedent is still developing. As of this writing, the markets are pressing to new highs at a rapid pace, which has begun to turn some sentiment gauges overly bullish. A market top (either short-medium-or long-term) is created by an excessive wave of optimism at precisely the wrong time (when people should be growing fearful). We currently view the 4/11/13 peak as the left shoulder in a bigger head-and-shoulders pattern that the indexes could realize. The current sharp rise to new highs will likely serve as the head to the pattern, and a right shoulder would emerge at some point thereafter.
In Elliott Wave world, from the selloff from the head of the pattern to the neckline would be Down 1, the rise to the top of the right shoulder would be Up 2, and then the real carnage would start with the break of the neckline in Down 3 (the wave where real gains are made on the short side). The Nasdaq has risen more sharply than at any other point during its run, similar action to that of September 2012 just before a short-term top emerged (and March 2012 for that matter). Based on the precedent analysis we’ve laid out over the past few months, we could see the Nasdaq fall to between 2726 and 2810, a loss of about 17-20%.
Based on recent action (some degree of euphoria), we are now looking for a May 2013 short-intermediate term top to be followed by the aforementioned correction. The selloff should be steep enough to scare off even the most prolific bulls and to generate the types of price levels that value investors perceive as good investments.
In conclusion, we can’t be sure if the precedent described above will continue to play out. All we can do is closely observe the action of the indexes as described above. If the precedent does play out, we could expect to see Down 4 followed by Up 5 through the top of this bull market. We invest purely based on the rules we have laid out for ourselves and a strict discipline of analyzing the day-to-day action of indexes and leading stocks.
Conclusion
In summary, the strong behavior of leading stocks suggests that higher prices are still possible. Their action combined with that of the indexes indicates to us that the time to reduce market exposure or begin moving to the short side has not yet come. Despite our view that the market will eventually fall, we need to first see proof that index action has tilted toward supply far outweighing demand, thereby pushing prices lower. Until this change happens, our portfolios need to be positioned accordingly on the long side of the market. We do ultimately feel that the old maxim “Sell in May and go away” will hold, but knowing when to do so is the key that helps lock up and preserve spectacular gains.
A market selloff this summer could be just what we need to reset expectations, and catalyze the very best stocks to start huge runs to an eventual bull market top early next year. Given how this cycle has been developing, a bull top in early 2014 is not out of the question and would mark a 5-year bull cycle, which would be one of the longer cycles in history. The preceding bull market was also an exact 5-year cycle (October 2002 to October 2007), which isn’t to say it will happen that way again, but examining certain fundamental criteria about this cycle seems to suggest that 5 years isn’t outside the realm of possibility. Understanding where we are on the risk-reward spectrum of a cycle is a maxim of Oaktree Capital Chairman Howard Marks (a fellow Chicago Booth MBA alumnus) and a subject we study thoroughly. Have a great month!