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It's Time to Practice the 'Great Secret' of the Markets

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What to do when you see the crowd in the rear-view mirror.

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When I was a young boy, I remember my father coming home looking very ashen from a visit with a dear friend dying in the hospital. His name was Dell Zink and he was one of my father's closest friends. Mr. Z, as we kids affectionately called him, was a very religious man; he was a man who was regarded by his friends as intelligent and philosophical.

Dad told me about the visit. He said Mr. Z told him that he was prepared to meet his maker, and at last he would know "The Great Secret." My father did not elaborate, obviously under great emotional stress because he was losing his friend. I never forgot Mr. Z. I never forgot that phrase – at last he will know "The Great Secret." In later years, whenever anybody I knew died, I would often think that person, too, would learn "The Great Secret." That phrase just never left my mind. I often thought about "The Great Secret," about what it really meant, about what the secret really was. After wrestling with the possible answer for years, it appeared to me to be unanswerable, so I set it aside.

(Also read 12 Cognitive Biases That Endanger Investors)

Recently a friend of mine became very ill and the phrase "The Great Secret" came back to mind. It haunted me and kept me awake at night. I struggled intellectually with what it meant, what the answer could possibly be. Then one day, near the end of my friend's struggle for life, he seemed to arrive at a great tranquility -- a peaceful acceptance of his fate, a serene, almost holy calm seemed to surround him. I suddenly realized that he knew "The Great Secret," and by being near him, nursing him, watching him deal with his illness in such a brave and dignified manner, I at last knew the answer, too.

"The Great Secret" is how you have lived your life, how you have raised your family, how you have treated other people, and what you gave back to society. In other words, you don't have to wait until death to learn "The Great Secret." If you did well by your fellow man, you don't have to worry about the hereafter; it is already taken care of. But it's not the end; it's just the beginning... for you see, my friend lived "The Great Secret."

Life is a series of great secrets. One not so profound, but necessary for the here-and-now, is learning the great secret about how to make a living. You learn early in life that just making money is not enough. You have to save part of it, or invest it, to make it grow, and take what one would consider sensible risk in that direction – especially when you learn the hard way about inflation, about how it robs you of your purchasing power – because tomorrow's dollar will inevitably be worth today's nickel. Moreover, real salaries for the typical worker have been declining for decades, while even the richer employers can no longer provide you job security. Hence, you become an investor in the stock market where you strive to learn "The Great Secret" about how to make money on Wall Street.

So you study the history of markets. Peter Bernstein, the great financial philosopher, wrote an essay titled "Awaiting the Wilderness":

Imagine yourself as an investor in 1945 when World War II came to an end. Your own memory bank, and the entire history of the stock market, would have told you bonds were the superior asset class for the long pull. The rate of returns on bonds had matched the equity return over the last 75 years and with far less volatility.... Furthermore, there was the unforgettable experience of the Great Crash to humble anyone who dared to think differently.

Even Benjamin Graham, in the early edition of "Security Analysis," viewed bonds as the asset of choice. To be sure, the risk back then seemed to be deflation, not inflation. So what happened? Well, over the next 10 years, inflation averaged about 4% per annum while large capitalization stocks returned 16.7% per year, long-term corporate bonds 1.8% per year, and long-dated government bonds about 1.3% per year. But nobody believed it would continue that way; so in 1955 (10 years later), the focus and foundation of portfolios was still centered on bonds. Subsequently, over the next 10 years (1955 - 1965), stocks returned 13.2% per year, corporate bonds 2.6%, and government bonds 1.9%. At that point (the mid-1960s), everybody started to believe in stocks and a stampede into equities began that climaxed in 1968 with a valuation price high for the Dow (INDEXDJX:.DJI) of 985.21, which commenced that generation's 1929 bear market, leading to the devastating secular bear market of 1968 - 1974.

(Also read The 6 Stages of Bull Markets -- and Where We Are Right Now)

Now the emotion from that era's secular bear market, and the valuation price "low" of December 1974 at 577 on the Dow Jones Industrial had gone full cycle – from loving stocks in 1968 (at ~1000) to hating stocks in 1974. In 1974 stocks were sold at prices that were below all known values with the Industrials selling below book value, at a P/E multiple of 6x, and with a yield of 6%+. Thus a mini-bull market emerged that would again lift the senior index to 1000 in September 1976 before backing and filling into yet another valuation price "low" in August 1982 (at 777). At the time I was screaming for investors to buy stocks, but the response was, "Why should I buy stocks when I can get 22% in a money market fund?" To which I said, "That is exactly why you should buy stocks because high interest rates have sucked all the money out of the equity markets, again leaving them trading below known values." From there a new secular bull market was born that would carry the Dow from 777 to its valuation high of 11722.98 in January 2000. Hereto, the Dow Industrial had gone full cycle – from hating stocks in 1982 to loving stocks in 1999/2000; and, even though the Dow would make a new nominal price high in October 2007 (at 14163.80 followed by a Dow Theory "sell signal" on November 21, 2007), this generation's bear market actually began with the Dow Theory "sell signal" of September 23, 1999.

Interestingly, the chart pattern between 1968 - 1982 and 2000 - 2013, for the INDU are eerily similar; and so are investors' sentiments. In 1982 and early 1983 when the Industrials were breaking out decisively above 1000, I was being told by the then "seasoned pros" to sell stocks because every time over the past 14 years the INDU had approached 1000 the correct strategy was to "sell" and wait for the subsequent pullback to 700 – 800 where you re-bought stocks. Of course, that has been the same lament this year as both the INDU and the Dow Jones Transportation Average (INDEXDJX:DJT) have traded to new all-time highs (yet another Dow Theory "buy signal"). This time, there are no 22% money market fund yields to lure investors away from stocks. There are, however, many worries for not buying stocks, ranging from – it's only a Fed-induced liquidity rally, to worries about Korea, Iran, China, sequestration, dysfunctional governments, etc. – but the result seems to be the same in that stocks have broken out of a 13-year trading range to the upside with positive implication for the years ahead.

Drilling down into the short-term, the now legendary "buying stampede" is at session 67 punctuated with a "buying climax" last week for S&P 500 (INDEXSP:.INX). Recall that a buying climax is when the SPX reaches a new 52-week high and then reverses to close below the previous week's closing price (read: red flag). Also "red flagish" was that the two leading indices for the year, the TRAN and the Russell 2000 (INDEXRUSSELL:RUT), broke below their respective uptrend lines and their 50-day moving averages (DMAs); while the TRAN recaptured its 50-DMA, the RUT did not. Other short-term warning "cracks" mentioned during the week in my reports were non-upside confirmation from the advance/decline line, ditto the new high/new low indicator, waning Buying Pressure, increased Selling Pressure, softening economic reports, etc. Indeed, Friday's employment report stunk on the surface, but parsing the internals showed that over the past two months there have still been 178,000 jobs created per month. Nevertheless, said report caused the SPX to collapse early Friday morning and test its March 19 low of 1539, which was a logical place for stocks to hold, and they did, leading to a late day recovery that left the SPX at 1553.28. The history of such action on an employment report is that following the initial collapse, some kind of intraday bounce develops, which is what we got. But, then the typical pattern calls for renewed selling in the days ahead. If so, I continue to think any selling will be contained somewhere between 1490 and 1535 and consequently remain a buyer of select stocks.

(Also read Four Real-World Investing Rules That Should Be Taught in Schools)

The call for this week: In the stock market, "The Great Secret" is this: When you see the crowd in the rear-view mirror, go contrary to the crowd, and then wait for the daring to think differently. In life, "The Great Secret" is more profound. I lost a friend last week, but in his final hours, he seemed to arrive at a great tranquility -- a peaceful acceptance of his fate. I suddenly realized he knew "The Great Secret." But you don't have to wait until death to learn "The Great Secret." If you did well by your fellow man, you don't have to worry about the hereafter; it is already taken care of. It's not the end; it's just the beginning -- for you see, my friend was my 92-year-old father who indeed lived "The Great Secret."
No positions in stocks mentioned.
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