The current uptrend that started on November 16th is now a month and a half old. While we can’t be sure how long it will last, we can look to the market’s action to dictate to us how much exposure we should be undertaking. In the following sections, we break our analysis into the 4 categories we use to assess market health (deemed our 4 Pillars of Market Health). Each pillar discussed below plays a part in evaluating the market’s behavior, with the highest weight to be placed on the 1st and 2nd pillars. Given the market’s size and complexity, having a roadmap available to evaluate its action is of utmost importance.
Indexes
Our first pillar of market health is the actual day-by-day action of many broad indexes. We look at (in order of importance) the Nasdaq, S&P500, NYSE, and the Dow Jones Industrial Average as our primary gauges of market health. The Nasdaq is the most important index because the young, upstart growth companies in America tend to list their shares on this index, and these companies in turn are the ones that power the U.S. to new levels of innovation and value creation. Similarly, the S&P500 is a broad measure of business activity across 500 of the largest and most reputable companies in America. Both should be watched closely and their individual action should be held above all other indexes.
For the month of December, the Nasdaq rose 0.3% while the S&P closed the month up 0.7%. The Nasdaq finished just 5.5% off its current bull market high of 3196 and is already above its 2007 high of 2861 by 5.5%. Notably, the index still remains 41.1% below its March 2000 peak of 5132. Comparing this index’s action to that of the Dow in 1929, the Dow was unable to clear its September 1929 high of 386.10 until November 1954, 25 years and 2 months later. Meanwhile, the S&P 500 closed 3.2% off its bull market high and is only 9.5% below its all-time high (and 2007 peak) of 1576.
With Fiscal Cliff threats looming throughout much of the month and news of solid progress or stalemate tugging the indexes in opposite directions, December was a bit of a choppy month. Largely, each of the major indexes digested the gains generated as they rose off the November 16th low. A short pullback after the start of a rally like this is very, very commonplace. The pullback is usually in some proportion to the initial move off the bottom. For example, look at the rally from 10/4/2011 to 10/27/2011 and the subsequent pullback that followed. The Nasdaq rallied 19.7% in this move before experiencing an 11.3% giveback of those gains. Shortly after the giveback/consolidation period, the index began a solid bull uptrend through April 2012.
The current rally saw the Nasdaq rise 8.9% before giving back 3.6% of those gains. News of a Fiscal Cliff deal on 12/31 propelled the indexes on what is normally a very quiet day in the markets (New Year’s Eve), as traders are off for the holiday. The Nasdaq rose 2% in increasing volume, an indication that institutional investors were driving price action in the market. Signing of the deal spawned a massive burst on January 2nd in which the index rose 3.1% in well above average volume. The uptrend we called on 11/16 is alive and well, and index action indicates that this bull market, while in its later stages, still has power to run to a final top.
We cautioned in this section last month: “Given the breadth of accumulation thus far and the aggressiveness of the move off the bottom, it wouldn’t be uncommon to see a short 2-4 week pullback before a continued uptrend into the foreseeable future. The indexes will likely meet resistance at key moving averages, the 50 and 200 day simple MA’s, before finally breaking free and powering to new highs.” Charts confirm this diagnosis fit the bill, as opportunities to profit were much more limited than during November’s two distinct trends (aggressively down the 1st half of the month, aggressively up the 2nd half).
Overall, 2012 brought many challenges to investors, but those who kept their eyes on the ball and focused on the larger cycle’s trend were able to benefit. The year started with a bang and ended just about on the same note. For the year, the Nasdaq ended up 15.9% and the S&P 500 finished up 13.4%, solid returns for the 4th year of an aging bull market. As we’ll soon enter the 5th year of this bull market in March 2013, we need to be cognizant that the last phase of a bull cycle is usually marked by hysteria, as the public realizes they are late to the party and race to inject money into the market. As Fiscal Cliff clouds fade away, we’ll no doubt see many more challenges in 2013, notably the debt ceiling in February, potential work on entitlement reforms, and a challenging economic environment. A bull market truly does climb a wall of worry.
Leading Stocks
Our 2nd pillar of market health is to follow the stocks with the best fundamentals in the marketplace. These are the companies providing innovative solutions to drive productivity and serve people across the globe. We at Satellite Capital look for the following fundamentals: large and accelerating quarter-over-quarter earnings and sales growth (preferably 25% QoQ or higher), high returns on equity (preferably 20% or higher), solid 3 and 5 year earnings and sales growth rates (preferably 25% or higher), high levels of cash flow generation relative to yearly earnings, and some product or service that is innovative and is enriching the industry in which the company plays.
As you could imagine, given our preference for the large numbers stated above, the universe of stocks in which we’d want to invest dwindles quickly. It’s rare to find a stock exhibiting all the above criteria to the highest level, but they do exist. For stocks that don’t meet all of the above criteria, which are the majority of all stocks listed on U.S. exchanges, striving to invest in companies that meet as many of the above criteria as possible is key in outperforming averages in a rising bull market.
The month of December opened with a string of breakouts, as many stocks formed proper consolidations and broke out of them into fresh high ground. Notable breakouts in December included (in alphabetical order): AMZN, CRM, EBAY, HTZ, QIHU, RAX, and URI. A wide basket of leading stocks are acting well and shaping up properly, and warrant both attention and capital. With the market currently continuing a consolidation that began last month, wading in slowly is the proper play; only increasing exposure once solid gains are made is the prudent way to limit risk and maximize reward in the current environment.
It wouldn’t be a market commentary if we didn’t take time to comment on the action of the investment world’s darling stock: Apple (AAPL). Apple has experienced a sharp selloff from its September 2012 highs just over $700 to its current lows right above $500. Despite this sell off, Apple has yet to clearly violate any of our sell rules and we feel it should still be watched closely. Given that its weighting is 20% of the Nasdaq 100 and a little less than 5% of the S&P 500, this stock still commands a lot of attention.
We have been examining a couple stocks of Apple’s nature over the years and wanted to briefly comment on each. Both stocks are what we’d consider “true market leaders” of their day, in that each held a similar stature to that of Apple within the investment community. Both companies had innovative new products that dominated the markets, and this dominance was reflected in both their fundamentals and stock prices.
First, we look at Xerox from 1962-1966. From its IPO in July 1962, XRX went on an absolute tear, rising from about $25 per share all the way to $130 per share. The stock then formed a deep cup pattern that undercut its prior pattern and provided room for a fresh run up. The correction that XRX experienced was similar to what Apple is going through now AND at a similar stage in the overall market cycle. After falling from $130 to $93, XRX rocketed until the 1966 bull market top by climbing to just over $260 per share (+180%).
The other stock we examine in comparison to Apple is CSCO from 1997-1998. After a sharp correction in 1994, CSCO ran up from about $7 (split adjusted) to over $50. The stock then experienced a heavy volume sell off extremely similar to Apple’s current pattern, falling from $50 to $30. Volume on the descent was massive at just over $600M traded per day (average volume times price). Such volume was heavy at that time (Apple, the true market leader today, trades over $11B of volume on an average day of trading). After bottoming at a round number ($50→$30), CSCO then spiked upward with the final wave of the 1996 bull market until the 1998 top. From $30, the stock catapulted to over $100 per share by the time the summer 1998 bear market set in, leaving a better than 200% return for astute investors.
One final interesting note is the performance of the financial sector in 2012 was among the best of all industry groups. Financials typically perform best in the 1st year of new bull markets and then usually perform at the market rate or slightly worse from there onward. In 2012 (as measured by the ETF: XLF), financials returned 26.0%. Looking back further to 2006 (which was the second to last year of the 2002-2007 bull market), financials returned 16.0%. If 2012 proves to be the second to last year of the 2009-2013(?) bull market, the similarity would be striking.
Overall, we hope you took our advice and were diligent about your watch list in November and December. Many stocks have begun their ascents and buying them correctly is vital to limiting your downside risk. Many more leaders should emerge in the coming 2-3 weeks, and a broad array of stocks from vastly different industries should lead the market higher if this trend proves genuine and has legs. The key now is not whether or not to be in the market, but rather in how to correctly manage the positions you do have, cutting your losses short, and letting your winners run to maximize the gains from this bull uptrend.
Sentiment & Psychology
Our 3rd pillar of market health is to examine market sentiment and psychology. Understanding market sentiment and investor psychology is secondary in importance behind following the action of the indexes and that of leading stocks. Various gauges of sentiment and psychology are helpful when many indicators are at extremes. When indicators are at moderate levels, less useful information can be gleaned. No one indicator is better than another, and a good analyst will maintain a dashboard of many indicators to help them effectively evaluate the market. At key turning points, many of these indicators will be telling the same story and flashing similar signals (both positive and negative depending on our location within a market cycle).
As of the end of December, the sentiment and psychology associated with the Fiscal Cliff has come and passed. Your author had read more than one prediction that the fiscal cliff would lead to an “August 2011 debt ceiling like sell off” and that a big recession was coming if nothing was done. The press had way overblown the potential ramifications of any fiscal tightening.
An article in Barron’s by Gene Epstein from the week of 12/31/2012 titled “Cheer Up! The Fiscal Cliff Doesn’t Look So Grim” provided an excellent description of how this has happened before and we came through it okay. Epstein writes: “Looking back at the years since World War II, nothing remotely compares with the fiscal tightening that occurred in 1946 and ’47. Despite warnings at the time from Keynesian economists about an imminent depression, the deficit as a share of nominal GDP fell to 7.2% of nominal GDP in ’46 from 21.5% the year before, a tightening of 14.3 percentage points. And to add insult to economic injury, that 7.2% deficit turned into a surplus of 1.7% by ’47, after a further tightening of 8.9 percentage points.” No recession set in from this fiscal tightening. To continue further, a secular bull market (discussed in the next section) started in 1949 and said tightening may well have been one of the catalysts.
The only indicator worth mentioning from December was the NYSE Advance/Decline line, which has continued to poke higher and higher. The A/D line is like a magnet for the market; it pulls the market with it, both higher and lower. Until the current uptrend of this line is broken, it’s best to not fight the market, as more stocks are advancing than declining. As we play a game of probabilities, attempting to swim upstream is usually a losing proposition. When stocks are advancing we want to be long, and when they are declining we want to be short. This is not bottom-up market analysis, rather, this is top-down. Everything starts with a thorough analysis of the broader market and attempting to position one’s portfolio in alignment with the trend of that broader market.
History & Precedent
Our 4th and final pillar of market health is examining history and precedence. This is the least important of the other 3 pillars listed above, but can often provide insights into the action of the market that may resemble prior periods of market action. History repeats itself whether we like it or not, and those who forget history are doomed to repeat it.
On the charts that follow, we’ll look at 3 bull market tops that could be similar to what we have in our future. Specifically, we examine the Dow Jones / S&P500 bull market from 1962-1966, the S&P500 bull market from 1974-1980, and the Nasdaq 1987-1989 bull market. Each of these charts displays some similarity to current happenings, and in each the market began a very clear bear market after the bull top peaked (labeled on each chart). Remember the point of our analysis here is that “history doesn’t exactly repeat itself, but it often rhymes”. By understanding what has happened in the past, we are better able to use psychology and precedent to gain insight to what we may be experiencing at present.
First, we examine a chart of the S&P 500 from May 1965 to May 1966. You can see that the left side of the chart starts with a serious initial downtrend followed by bottoming action in late June 1965. The index springboards off its lows in a short consolidation area with the whole process taking approximately 2 months. After this consolidation period, the index powered higher to its final bull market top in February 1966. From the low of the correction to the final top of the bull market, the S&P 500 gained 17.3% over 7 months. During the same period, the Dow Jones Industrial (a comparable index at the time) gained just over 20%. From the bull market top through the right side of the graph, I included the beginnings of the bear market for you to get a feel for what could happen when we finally enter a true bear market.
Our 2nd precedent is the S&P500 from January to December 1980. After an initial downtrend that started in February, the index hit bottom in late March and then proceeded into its consolidation phase. Similar to that above, the bottoming and consolidating process took about 2 months. What followed was a very sharp uptrend into the ultimate November 1980 peak. From correction low to bull market high, the S&P 500 rallied 50.6% over an 8 month time period. Not too shabby. Also interesting to note is that the market TOPPED the month that Ronald Reagan was elected President. A 20-month bear market set in at the start of the dotted line above that finally ended in August 1982.
The more interesting note from this chart is that it was not only the top of the bull market that began in 1974, but it was also the top of the secular BEAR market that began in 1968. A “secular” bull or bear market is simply a longer period of many bull and bear markets where either progress is made and kept (secular bull market) or any gains generated are blown apart in the next bear market (secular bear market). The whole cycle tends to look like climbing stairs over 15-20 year periods (15-20 years up, 15-20 years sideways, rinse and repeat). The psychology of the chart above is spectacular because as everyone expects great things with Reagan coming into office, the market fools the masses and goes into a bear market. It’s often said that the market will either wear you out or scare you out. The market serves to fool the greatest number of people and this was a great opportunity to demonstrate it.
I bring this up because we are at what Thomas and I feel is near the end of the secular bear market that began in March 2000. The last secular bear market was approximately 14-16 years in length before the new secular bull market set in (1966/68-1982). If we go to an eventual bull market top in 2013 and go through a bear market, a new secular bull market COULD start as early as 2014. There are many catalysts that could drive this, but I’ll reserve discussion of those for another month. Think about the gains that accrued from 1949-1966/68 and 1982-2000. That is what a secular bull market could bring.
The 3rd and final precedent chart above should look eerily similar to regular readers of this commentary. Last month I outlined how the period after a “waterfall sell off” in October 1987 was very closely mirroring the action of the indexes today (with the more recent waterfall sell off in August 2011). After rallying off the 1987 lows (not pictured- see November commentary), the Nasdaq shot up over 36% and then proceeded to trade essentially sideways for the next 8 months. This continued into the 1988 U.S. presidential election, which is the start of the chart above (“Initial Downtrend”).
President George H.W. Bush was elected and the market sold off hard following the election. In late November 1988, the index bottomed, turned upward sharply, and then went into a consolidation phase. The bottoming and consolidation phase took approximately (~) 2 months, as noted on the chart. From there, it rose sharply into the final October 1989 bull market top. From the November 1988 bottom to the October 1989 top, the index rallied 33.9%. A sharp bear market then set in, as shown above.
When comparing the charts above to current market action, the first similarity to consider is that a prior initial downtrend led to bottoming action, followed by a 2 month period of consolidating off the lows. In November 2012, the indexes sold off on President Obama’s re-election, hit bottom on November 16th and have since been in rally/consolidation mode. If the precedent above holds to the letter, a continued market uptrend could come as early as the middle of January. While not a guaranteed outcome, we will position ourselves according to analysis of the indexes and leading stocks as we have laid out above, which suggests that this type of continued move upward is the highest probability.
Similarly, after the consolidation periods on each of the 3 precedent periods described, uptrends of 5, 6, and 9 months persisted. From January 2013, that would put a potential bull market top in June, July, or October 2013. Based on the analysis Thomas and I have done, we speculate (but do not position our portfolios) that the ultimate top will be closer to the October time frame based on current leading stock action.
To close this section, we can’t be positive if the precedents described above will continue to play out. All we can do is closely observe the market’s action and take exposure in leading stocks as the market grants us that opportunity. We must position our portfolios according to what the market is telling us. Blindly investing in good companies during choppy markets is a recipe for disaster. Right now, market action dictates that we continually increase our exposure and be vigilant about keeping our losses small and letting our winners run. If the precedents do play out, you can be sure there will be BIG money to be made in 2013 and those who are in front of it will have the opportunity to experience life-changing gains.
Conclusion
In summary, while the market has been digesting its gains off the November 16th low, many leading stocks are breaking out and starting to gain some headway. A bull market requires a breadth of leaders to power it higher and the current breadth dictates that a powerful move could be coming. As I reminded last month, it is vital to keep in mind that we are in the later stages of this bull market and need to adjust our expectations accordingly. The biggest and easiest gains in bull markets are generated in the initial leg off the bear market lows. Each subsequent leg will get weaker in strength until an eventual bear market sets in. Today the market is strengthening and the action we are seeing dictates solid equity exposure. We hope our analysis provides you some insight into how much effort and thought we put into evaluating the markets every single day. Studying the markets is our passion and being able to profit from that analysis is just an added bonus. Until next month, we wish you all the best and hope you had a great holiday season.