While everything looks rosy at the moment, we’d like be the first to heed caution at current price levels. Despite our current view, we must always place the action of the market and leading stocks at the forefront of our indicator list. Regardless of the analysis laid out below on the path we see the market taking over coming months, if the market moves strongly higher we need to position ourselves accordingly and take advantage of opportunities as they come. A common investment maxim is that as investors, we need to “bend like trees in the breeze.” We must remain flexible with our opinions and disciplined with our interpretation of actual data.
Our current interpretation of broader market action finds us in the process of setting a short-term top and fulfilling the necessary chart action to produce a selloff of approximately 15% by mid-July. We hypothesize the Nasdaq will fall somewhere between 2726 and 2810 before rallying strongly (perhaps >40%, taking the Nasdaq to north of 3900) through next year and setting the ultimate 2009-2014 bull market top. During that final topping phase, investor sentiment hits extreme levels as hungry investors rush into the market to scoop up what shares they can, dramatically inflating prices. The mantra ‘be greedy when others are fearful and fearful when others are greedy’ seems crafted especially for market phases of this manner.
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 March, the Nasdaq rose 3.4% while the S&P500 closed the month up 3.6%. Both indexes made fresh bull market highs, with the Nasdaq making further progress over its 2007 high and the S&P500 closing about 0.4% below its all-time peak of 1576. Moderate levels of professional selling have come into the market as we enter new high ground. While not a solid indicator that we’re going to turn and go straight down, understanding the supply-demand balance (or imbalance) is vital to positioning a portfolio correctly.
Both indexes are still holding above rising trend lines drawn from their November 16, 2012 lows, a solid indication that the general trend is still upward. One interpretation of the late February – early March sell off is that the indexes formed the left shoulder of a head and shoulders topping pattern. This would indicate we’re likely to head much lower within the next 1-1.5 months. While we could be executing a topping pattern, this doesn’t necessarily mean that the peak highs of this move have already been seen. The market could move higher, and will if its participants carry it there.
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.
Overall, while we feel we could be tracing what ultimately will become a short-term market top, leading stocks can still make significant progress in an environment where indexes are stalling near new high ground. Be sure to have a fresh watch list and be ready to jump on stocks that could be poised to explode higher into the coming Q1 2013 earnings season.
Leading Stocks
Leading stocks in March were largely quiet and mainly digested gains made in prior months. We continue to closely watch the action of ARMH, CELG, FB, LNKD, and QIHU. CELG led the pack last month with a 12.2% pop as the stock continues to make new all-time highs. LNKD is nearing the end of an 8-week hold rule and currently sits 49.8% from its proper entry point. ARMH, FB, and QIHU continue to build constructive basing patterns and appear poised to assume the leadership reins in coming months.
Many other stocks with top-notch fundamentals and excellent technical action are currently building base patterns. We continue to watch these patterns and to seek out points of entry with minimal risk, were these stocks to breakout and move higher in strong volume. Our overall goal is to seek out those stocks that realize the biggest price gains, and to seek exposure to them accordingly. Our target list today is comprised of the 5 stocks above; carefully and skillfully acquiring positions in these leaders will likely prove to be the key to earning outsized returns throughout the remainder of this bull market.
Overall, the true leaders have likely shown themselves by this point in the rally. We now must manage our existing positions and wait until our rules either force us to sell or retain these positions. The stocks mentioned above have made great progress since breaking out of early stage patterns, and appear to be positioning themselves to move higher still. We recommend you watch these stocks closely over the next 6-12 months and look for opportunities to acquire shares at attractive prices. With earnings season starting very soon, an investor must be prepared for increased volatility, and should look to eliminate positions before earnings announcements in which a solid gain has not yet been achieved. Earnings season will either catalyze breakouts or breakdowns. Don’t be caught holding the bag with the latter.
Sentiment & Psychology
At this stage of the game, the market feels fairly obvious to even the casual investor. When Hollywood A-lister Mila Kunis starts talking about how she’s interested in the stock market on CNBC, I’m not sure what other signal exists to communicate the time to be greedy with this rally has probably passed. That isn’t to say that we can’t see further gains, but when the market appears obvious to everyone, and the majority of news is fairly positive, who is left to buy (thereby sending prices higher)?
For a second straight month, bullish advisors outnumbered their bearish counterparts by more than 2:1. The percentage of bearish advisors is waddling near 5 year lows and is in very dangerous territory. The NYSE Advance/Decline line has continued to move into new high ground, but there has been a divergence in the breadth of stocks making new highs. Any divergence is key and must be noted! While the indexes made fresh new highs, the number of stocks hitting new highs failed to confirm this action, showing us that market internals are actually weakening before our very eyes.
As excitement over new highs runs unabated across mainstream periodicals like USA Today, now is the time to heighten your awareness of what’s going on with this rally. Sentiment has held near or at peak levels for a sufficiently long period of time now to fulfill the trappings of a short-term market top. Market sell offs are fabulous as they help to cleanse the excesses of sentiment. Remember that our job, first and foremost, is to interpret and invest with the trend of the market based upon the action of indexes and that of leading stocks. We recommend being cautious as we enter the month of April, and being poised to cut any positions that begin to show you even minor losses.
History & Precedent
I’d like to start this section by saying that the following analysis is purely for educational purposes. Being a successful stock market operator requires monitoring and mastering a wide array of available tools. Some are fairly straight forward, while some are more subtle. As always, the action of the indexes and that of leading stocks are by far our most important beacons, period. The analysis below can supplement the analysis above, but the tail should never wag the dog. What the below information truly offers is a model to examine prior historical periods, and to demonstrate how the psychology of the market (unchanged over hundreds of years) repeats itself in the form of cyclic patterns and rhythms. And as statistician George Box reminded us, “All models are wrong, but some are useful.” Let’s dive in.
This month I’m going to delve into something called Elliott Wave analysis, the basic premise of which holds that the market has a certain rhythm to it, much like circadian rhythms generated as a result of the sleep cycle. In a bull market environment, one would expect to see 3 strong moves up and 2 moves down (in this order: Up 1, Down 2, Up 3, Down 4, Up 5) followed by the opposite cycle. The bearish side would be just the opposite: 3 strong moves down with 2 moves up (1 Down, 2 Up, 3 Down, 4 Up, 5 Down).
It might not be surprising to hear that many analysts abhor Elliott Wave analysis, as it’s rooted more in behavioral psychology than in efficient market theory. While this analysis may feel VERY subjective and open to interpretation, remember that we maintain investing is an art and not a pure science. We strive to hold and monitor as many tools in our belt to analyze happenings as possible. A great handyman knows when a certain tool is more appropriate and efficacious than another (or several tools in combination). Investing in the market is no different.
Below, I’m comparing the October 1974 to November 1980 bull market versus the bull market we are in today (March 2009 through April 2013, at present). Last month, I demonstrated how this 6 year time period in the late 70’s was acting oddly similar to what we are seeing today by way of percentage moves over the whole bull market. This month I’m going to apply Elliott Waves and demonstrate this fact from yet another angle.
On the first chart below, I’ve highlighted what I feel are the major moves within this bull market (remember, 3 strong up moves with 2 interceding down moves). The 2 down moves were sell offs of 15-20% and ended major moves of the broader trend. One of the handy facts about Elliott Wave analysis is that you can generally pick apart each of the waves below and find 5 more distinct smaller waves within each larger wave. On the second chart below, I examine the last leg up of this bull market (marked by Up 5 and broken down into its 5 corresponding waves).
There are a few interesting things to note in both the timing and overall action of this phase of the move. What I’m calling the Up 5 wave took place over a 29 month time period. The smaller Up 3 wave within the larger Up 5 took 16 total months. After making strong progress and coming close to new all-time highs at the end of Up 3 in February 1980, the market sold off sharply, creating a Down 4 wave. The interesting thing to note about the Down 4 wave is that it always undercuts the low of the last correction during the Up 3 wave but never undercuts the low of the Down 2 wave. I have this marked above to help you understand what I’m seeing. After this sharp sell-off, a massive burst off the lows began and the index rocketed 50.6% over the next 8 months to the ultimate bull market top in November 1980.
Comparing the 1974-1980 bull market to our current bull market, we find similar undertones. Again, I encourage you to revisit our February commentary to see a comparison of both timing and percentage gains for each part of the move, but below is my take on the Elliott waves from this current bull market. Similar to our precedent period, I feel we are currently in Up 5 of the bull market that started in March 2009. This Up 5 wave has been underway since October 4, 2011, which puts us at a total of 19 months so far. The current smaller Up 3 wave within the larger Up 5 wave is 11 months old.
On the second chart below, I break out the “waves-within-the-waves” for Up 1, Up 3, and the current Up 5 wave. Given the substantial progress we’ve made without a healthy sell off like the sharp February-March 1980 Down 4 precedent wave, we feel we could be nearing a similar drop in the current market. This interpretation would see the S&P500 fall to between 1266 and 1343 (about 15% below current levels) and the Nasdaq drop to between 2726 and 2810.
If we assume the timing of both Down 4 and Up 5 from our precedent period lines up with what we’re currently experiencing, this would suggest a major bull market top sometime around March 2014. Remember, we don’t invest based on this analysis. We simply allow it to guide our thinking and to understand the broader context of where we are within this bull market cycle. A March 2014 top would mean the bull market that began in March 2009 would last 60 months, or 5 total years.
A key difference to note between the precedent period and current market above is the overall timing. Down 4 on the 1st chart (Sept 1976 – March 1978) lasted 19 months while Down 4 in the current market environment (May 2011 – October 2011) took only 5 months. The percentage decline was nearly identical, but the difference in duration reinforces our conclusion that the current bull market will likely end at about 60 months. The precedent period lasted 71 total months and we stand at 49 months in the current cycle.
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. As always, our goal remains not to predict what lies ahead, but rather to interpret what we are experiencing at present. 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, leading stocks have been fairly quiet the last month, which could be a good indication they are setting up to move higher, or that they are taking a breather to build basing patterns that will eventually lead to fresh breakouts and higher prices. Despite our view that the indexes are forming a short-term top, we need to remain faithful to the trend, which is largely up at present. Until the facts change, our portfolios need to be positioned accordingly. While April has largely preceded downward moves in every year of this bull market, we must not get sloppy but stay diligent with our daily analysis to ensure we can remain invested for as long as is optimal, then move to cash or short if a downward trend presents itself.
At present, we feel rather confident that we’re within 12 months of a final bull market top. The facts could change (and we’d of course shift with them), but currently, the action of leading stocks is confirming the moves of the indexes, which is also lining up with sentiment and psychology, and further combines with the analysis we presented above in the History & Precedent section. True leading stocks run for 12-16 months after breaking out of 1st stage patterns, and many of those leaders did just that starting in November 2012 through January 2013. If the ultimate top is indeed within 12 months, the dramatic upward market move that could generate life-changing gains may be mere months away.