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A Stock Market Correction Has Likely Begun, but Have We Seen a Major Top?

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Any correction affords investors the opportunity for new buying in favorably rated stocks.

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From Andrew Hall, www.coastal.udel.edu:

Every year from November to March, strong lows develop along the Aleutian chain. These systems are the early stages of large open ocean swells that make the north-facing side of the Hawaiian Islands so well known for big waves and big wave riding. The great distance between these two regions allows swells to become more organized and gain strength. On the north-facing side there is a seafloor that more or less rises gradually. This results in slower breaking waves with less of a top to bottom curling effect. When the seafloor rises abruptly, the shoaling process is sped up, leading to a much more intense breaking wave. That is very much the case for the coasts of the Hawaiian Islands, in specific a spot called Jaws on the north shore of Maui. The bottom topography of Jaws shows an abrupt underwater ridge that juts out towards the northwest. This is often the direction from which Aleutian swell arrives, which makes Jaws an ideal large wave receptor. Because the ridge peaks at about 20 feet, Jaws won't break until there is a swell large enough to provide such size. When the conditions are correct, the relationship between Aleutian low pressure systems and the underwater ridge on the north of Maui creates some of the more impressive breaking waves on the planet.

Last month I was reminded of "Surf's Up!" while rereading said report from my departed friend Stan Salvigsen of Comstock Partners fame. While that is the organization Stan, Michael Aronstein, and Charles Minter formed in the late 1980s, Stan's investment career actually began in 1964 as an analyst with the Value Line Investment Survey. Subsequently, he was an equity strategist at a succession of firms, including Dreyfus, Oppenheimer, C. J. Lawrence, and Merrill Lynch. Stan wrote the most engaging, entertaining, colorful, and insightful strategy reports I have read in my 43 years in this business. Select titles of his reports were: "That Ain't Mud on Your Boots Partner," "Revenge of the Nerds," "Homesick," and my favorite, "Surf's Up!" "Surf's Up" showed pictures of a plethora of landside observers watching the few daring surfers willing to brave the 40-foot waves of Waimea Bay (see picture below). Stan likened those surfers to the few investors who had the courage to buy stocks in the summer of 1982 and ride the "big bull waves" that were likely going to occur as short-term interest rates declined from 22%. It was a tempestuous time when my pleas to investors to buy stocks fell on deaf ears as their mantra was, "Why should I buy stocks when I can get 22% in a money market fund?" My response was, "That's exactly why you should buy stocks!" Stan died of a heart attack in 1996 at the tender age of 53 in the office of one of his best friends. He remains a true Wall Street icon and his keen-sighted investment strategy reports are missed by many of us.



I revisit "Surf's Up!" this morning because I think many investors are in the same positions now as they were 31 years ago; they are standing on the beach watching those few brave souls that had the courage to grab a surfboard and paddle out to catch the really big waves, aka buy stocks and ride the "bull waves" that have rolled onto the investment beach since November of last year. Indeed, to ride such waves you need to grab a board and get into the water. Since the beginning of the year I have suggested one way to timidly approach those "bull waves" was to decide how much money you wanted to commit to equities or mutual funds, say $100,000. Then break that amount into four separate pieces and commit the first $25,000 tranche today. Next, determine some point in time where you will buy the second tranche, say six weeks later, irrespective of whether the market is up or down, and so on for the remaining two tranches.

Of course after such a discourse the question always arises, "But Jeff, isn't it too late to be buying stocks?" Manifestly, many investors are wary of the stock market because of their shared experiences of the past three years. To be sure, about all you had to get right over that time frame was to raise some cash in April/May and wait for the ensuing double-digit decline. Then all you had to do was pick your spot, sometime in the summer, to recommit that money to stocks; but, as repeatedly stated in these missives, "I don't think that 'sell in May' kind of strategy is going to work this year for the following reasons." Despite the S&P 500's (INDEXSP:.INX) rally since November, and subsequent breakout to new all-time highs, it is far from the overextended levels reached at the prior peaks of early 2000 and October of 2007. Indeed, on a trailing EPS basis the SPX is trading at 15.1x trailing earnings and 13.7x forward estimates. Juxtapose that to 25.1x estimates in 2000 and 15x at the 2007 peak. On a price/book value basis the SPX trades at 2.4x book verses 5.4x (2000) and 3.4x (2007). Further, enterprise value/ EBITDA for the SPX currently stands at 8.9x as opposed to 14.1x (2000) and 10.4x (2007) and with a dividend yield of 2.19% versus 1.10% (2000) and 1.80% (2007). Combine those metrics with the tried and true mantra of, "Don't fight the Fed," and is it any wonder stocks are doing well? Moreover, the Fed has made it abundantly clear it will continue with quantitative easing until the outlook for the job market improves substantially.

"But Jeff, economic growth is not all that strong and the risk from Euroquake is high." Granted those are risks, and there are many others, but America has become a mature economy and there is evidence that such economies grow more slowly. The relevant growth rate for investors, however, is the world's growth rate since they can hold global portfolios to benefit from the world's stronger growth rate. For example, 46% of the S&P 500 companies' sales, and 40% of profits, come from outside the US. Meanwhile, recession risks from Europe are fading and Cyprus appears to be only a bump in the road. Here at home auto sales remain brisk and the recovery in housing is for real. Remember, house price gains are a powerful stimulant for the economy. Consumer net worth is raised, bank balance sheets become healthier and are therefore more likely to lend, builders begin new projects, etc. This is certainly visible in St. Petersburg, Florida, where projects that were "shelved" in 2008 are again under construction. One interesting statistic I heard last week was that sales of single family homes that were priced at $400,000 and up improved by 78% year-over-year.

As for last week's stock market action, it was the best setup yet for the long awaited pullback to end the now legendary 75-session "buying stampede." The SPX even closed below its 50-day moving average (DMA) for the first time this year. It also broke below an intermediate uptrend line and has lost 3.5% from its April 11 reaction high. Moreover, since that high my short-term proprietary trading indicator has been losing steam, the Buying Power Index has been declining, and the Selling Pressure Index has been rising. Still, John Wayne rode to the rescue again on Friday, preventing the Dow Jones Industrials (INDEXDJX:.DJI) from making three down sessions in a row that would have ended the stampede. Some of the recent stock weakness is attributable to worries regarding lowered earnings guidance as more than 200 of the companies in the S&P 500 reported last week. This week we will get even more earnings reports; last week 58% of the companies that reported beat the consensus earnings estimate but only 43.9% beat the revenue estimate. Last week's action also left the technology and energy sectors deeply oversold and the industrials and materials mildly oversold. Likewise, the McClellan Oscillator is mildly oversold. There will be a number of economic reports this week that could impact stocks with the most important being the Chicago Fed and Existing Home Sales reports (Monday), New Home Sales (Tuesday), Initial Claims (Thursday), and the GDP report on Friday.

The call for this week: I think the odds that a correction has begun remain pretty high, but there is little evidence we have seen a major "top." Accordingly, any correction affords investors the opportunity for new buying in favorably rated stocks. Indeed, if you want to catch a wave you have got to grab a board and get into the water! There are three broad arguments for this optimism: trends in globalization, trends in technology, and large negative expectation by business and investors. Remember, the US spends more than anyone else on research and development and has the most registered patents in the world. This is along the intangible capital theme lionized by my friends at the astute GaveKal organization. I am actually having dinner with Steve Vinnelli, portfolio manager of the GaveKal Knowledge Leaders Fund, here in Dallas at a Raymond James national conference. I will also be speaking with other portfolio managers I have come to know over the years and hopefully will return next week with some investable ideas.
No positions in stocks mentioned.
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