Evidence for a Pullback Is Mounting
The number of warning flags is rising with the Volatility Index touching "complacency levels" last seen in April 2010 right before a correction.
I had a very interesting request from one of our financial advisers last week. He asked me, "Jeff, have you heard of anyone who has gone through the exercise to see what would have happened if you dollar-cost averaged every month from the October 2007 stock market high until now?"
"Wow," I responded, "That's a really good question and not all that hard to check." Recall that dollar-cost averaging is an investment strategy whereby participants invest equal amounts of money over specific time periods, say $100 a month, in a particular investment. That strategy allows investors to buy more shares when prices are low and fewer shares when prices are high. With that concept in mind, we begin.
On October 11, 2007, the S&P 500 (SPX) recorded an intraday high of 1576.09. Seventeen months later it would bottom with an intraday low on March 6, 2009, of 666.79. In 2010, the S&P 500 closed out the year at a December 31 price of 1257.64 and currently changes hands around 1283. Hence, if an investor began buying one dollar's worth of the SPX at the end of September 2007, and continued to purchase one dollar's worth of the SPX at the end of each month until year-end 2010, the dollar-cost averaged performance is about 15.4% (excluding commissions) over that 40-month period.
This compares to roughly an 18% loss over the same time frame for the investor who "rode it out" with no dollar-cost averaging. That's a whopping 33% out-performance if our fictional investor had been able to conquer their fear and had employed a dollar-cost averaging strategy. Regrettably, there's the "rub."
Ladies and gentlemen, while it's true over the long term that it's all about earnings, in the short to intermediate term the stock market is fear, hope, and greed only loosely connected to the business cycle. This Fear, Hope, and Greed cycle can be seen in the attendant chart.
Beginning at the lower left of the chart we have Optimism with the chart rising to Excitement, Thrill, and Euphoria where the bullish psychological environment peaks and turns down. You can liken this ascending pattern to what occurred following the Long Term Capital Management, and Russian default, back in 1998. Said debacles pressured the SPX from its July 1998 high of about 1167 into its despondency low of about 957 in October of that year. At those lows, Fear reigned supreme. From there, however, stocks bottomed and traveled higher into their late 2000 highs, accompanied by the aforementioned ascent into the Euphoria region. Subsequently, stocks peaked and turned down. Over the next two years the SPX would shed some 49% of its value, causing investors' mindsets to travel down the other side of our psychological chart (Anxiety, Denial, Fear, Depression, Panic Capitulation, and Despondency) with the SPX bottoming in October 2002. At that point investors were despondent; ergo, they were liquidating their stock portfolios just in time for stocks to bottom and begin a rally that would again cause investors' psyches to rise into the stock market's October 2007 peak.
I revisit the Fear, Hope, and Greed cycle this morning not because I think we're approaching the Euphoric zone, but because I continue to believe we're near the Optimism level and therefore due for anywhere between a 3% to 10% correction. Still, any pullback is probably for buying as, scribed in last Tuesday's strategy report:
Since 1940 there has never been more than one 10% (or more) correction in an ongoing bull market. And yes Virginia, according to Dow Theory this is a bull market. A fair question, however, would be "Is this a tactical, or a secular, bull market?" Personally I think it s tactical within the context of the broad trading range we have been experiencing since the turn of the century, but that's a discussion for another time.
Indeed, since entering 2011, I've been cautious; and except for the 14-point, first-day-of-the-year "yippee" (to 1273), the SPX hasn't really done all that much. Moreover, I have been commenting that the number of warning flags is rising with the Volatility Index touching "complacency levels" last seen in April 2010 right before a correction.
See also, Time to Hedge Stocks and Go Long Volatility
Ditto, Investors Intelligence data show advisory sentiment approaching the bullish extremes of October 2007. Meanwhile, stock market leadership has been narrowing, internal momentum waning, and every macro sector except Utilities is overbought. Additionally, correlations between various asset classes are decreasing, implying investors are becoming increasingly selective.
I further opined that if a 90% Downside Day was registered, a cautionary stance would become even more important. Well, last Wednesday turned out to be a 90% Downside Day with 90% of the total volume, and 90% of total points, coming on the downside. The result caused the SPX to experience its first loss of more than 1% since November 23, 2010. Yet, Wednesday's Wilt was worse than the official figures suggest because strength in a few high-priced stocks masked just how weak the market's internals actually were. Last Wednesday also showed a change in the recent daily trading pattern in that morning weakness was not greeted with buyers. In fact, looking at last Wednesday's minute-by-minute trading chart saw a decided pickup in selling when the previous day's intraday low was violated. Plainly, all of this leaves me believing caution is still warranted.
For those not wanting to adhere to my near-term cautious strategy, I offer a risk-adjusted investment idea from Raymond James' research universe. As readers of these missives know, I have been an energy "bull" for a long time. Of course, that includes coal, which has garnered increased attention given the flooding in Australia that has shuttered 75% of their coal mines. In addition to the coal names I have previously mentioned, this morning I would have you consider Rhino Resources (RNO). Rhino is a diversified met and steam coal producer with proven and probable reserves of 273 million tons of steam coal and 13 million tons of met coal. Rhino also owns a 51% interest in Rhino Eastern, which controls 22 million tons of met coal. One of the benefits of such a substantial reserve base is the ability to boost production through internal expansion projects. While Rhino current pays no dividend distribution, our energy analysts expect a distribution to begin soon at roughly a 7% annualized distribution rate. That would compare favorably with the MLP universe of stocks' 6.6% rate, implying a higher share price.
See also, Two ETFs to Play Coal's Rising Appeal
The call for this week: Sometimes me sits and thinks and sometimes me just sits. Currently, me just sits, believing the evidence for a pullback is mounting. In addition to the aforementioned warning flags, since September 1, 2010, every time the Russell 2000 (RUT) has closed below its 20-day moving average, buyers have showed up the very next day. Not so last week. In fact, last week was the first down week for the SPX in eight weeks as the divergences in the stock market continue to grow (the DJIA was the only major index to register a new high on Friday; most of the other averages peaked on Tuesday). As legendary Dow Theorist Robert Rhea observed, mounting divergences suggest stocks are being distributed (read: sold) by smart money. In conclusion, it is worth considering that my notes indicate there is a tendency for the equity markets to "top" coincident with the State of the Union address (Tuesday night). Consistent with these thoughts, I'm currently "just sitting;" or as Warren Buffett is fond of saying, "In this game the market has to keep pitching, but you don't have to swing. You can stand there with the bat on your shoulder for six months until you get a fat pitch."
Follow the markets all day every day with a FREE 14 day trial to Buzz & Banter. Over 30 professional traders share their ideas in real-time. Learn more.
Daily Recap Newsletter