What to Expect Now in the Stock Market

Just wanted to start with a quick word of optimism about the future of the stock market, and the potential for making money in the months and years to come.

I was pleased to attend the Contrary Opinion Forum in Vermont last weekend with Timothy Lutts–Tim’s been going for 22 years straight, while this is my fourth or fifth visit since I came to Cabot back in 1999–and it’s always a treat.  This year the foliage was breathtaking, and the weather couldn’t have been better.

In terms of the attendees, as well as the speakers, I would say there were two consensus opinions.  First, the market was likely near a low based on the degree of capitulation being seen (remember, this was last week, when the market was off 20% in a handful of days).  But second, that America’s longer-term future would be difficult.  The reason?  Government debt, interference in the markets, and worries that the current “de-leveraging” of the economy will last for years.

Now, you might think that, since this was a Contrary Opinion Forum, that the views of the crowd would be right on the money.  Usually, however, that’s not the case–the speakers and attendees are human, just like all of us!  And, when most of them think one way, the opposite often occurs.  I’ve seen it happen a few times, and Tim even more so.

But there’s more than just this anecdotal evidence to get excited about.  Consider some numbers from one of the speakers, Steve Leuthold, who manages a couple billion dollars.  When normalizing earnings (taking a moving average, which smoothes out the fluctuations), the S&P 500 dropped to about 13 times earnings last week, well below average and near the 25th percentile of all readings since 1957.

The upshot?  Historically, when valuations have been so cheap, the S&P 500 is actually on the verge of beginning a great long-term advance.  On average, in the 10 years following such readings, the S&P rises 14% to 15% per year!  (In the one-year period after such readings, the average advance is 18% or so.)  This is a historical fact, not opinion.

The reason is simple: Valuations have been generally compressing, from the exuberant bubble days of 2000 to the ultra-pessimistic worries right now.  All during that time, perception has been weakening, so investors have been willing to pay less and less for earnings.

I’m not suggesting that P/E ratios are going to turn around and head back to 2000 levels, but I do believe, given last week’s panic and the year-long bear market we’ve gone through, perception has a LOT of room to increase in the years ahead.  Other studies point to the same thing–the S&P, for instance, has returned just 3% annually (including dividends) during the past 10 years.  After such sorry returns, the subsequent five- and 10-year periods are often terrific.

Time will tell, but just keep these facts in the back of your mind when somebody who is only looking through the rear-view mirror (even if they’re an experienced investor) tells you America’s best days are behind it.

Of course, that is the long-term view.  Shorter-term, the market’s volatility has been insane–700-point drops, 950-point up days, intra-day swings of 5% … it’s hard to get a read on just what is going on.  But I looked back on some other market crashes and have formulated a rough road map.

Disclaimer: I never tell the market what to do, and that’s especially true these days, with what we have seen in the market and from world governments.  So if the market doesn’t follow the script, I’ll change my mind.

But as best as I can tell, here’s what you can expect to see in the aftermath of a mini- to large crash:

  • First, you get an initial rally of anywhere from two to eight days or so.  The market usually enjoys a sharp gain for a handful of days, with the worst-performing stocks during the meltdown being the best performers on the rebound.
  • Then, just as investors want to jump on board for “fear of missing the boat,” the market usually pulls back for a few days.  It doesn’t give up its entire rally–in fact, the market usually remains well above its major low during this pullback.  (This time has been a bit more severe than usual.)  But the retreat can be sharp, and if you buy in after the first few days of rally action, you can get hurt.
  • After that, the market often gyrates higher for a few weeks.  The sellers have been mainly exhausted, and pent-up buying pressures push prices higher.  Occasionally, you can get an early leading stock hitting a new peak during this phase, but for the most part, the market is still sorting itself out.
  • Finally, the market experiences some type of re-test of the initial, major low point; usually this occurs four to 10 weeks after the low.  Sometimes the market doesn’t pull back all the way to the low, settling instead a few percent above the low.  But it’s extremely rare to see no re-test at all.

Thus, a couple of thoughts.

  • First, don’t expect this market to fall through the floor.  Last week’s low is likely to stand for at least a few weeks, if not much longer.  Maybe this time is different, but I prefer to go with the odds.
  • Second, be wary of chasing the market, even if you’re a nimble trader.  Sharp upmoves will probably get sold after a couple of days, and the same with sharp pullbacks.  So if you’re playing the swings, it might be better to wait for a couple of down days before buying, and vice versa.
  • Third, keep the re-test scenario in the back of your mind–it’s easy to forget if the market rallies for a few weeks, but the odds do favor one happening.  So getting sucked in late can be harmful.

You don’t have to look very far back to see examples.  In fact, we’ve seen two of these patterns play out this year.  Take a gander at the chart of the market during the January-April period, as well as the July-September period. 

In the first case, the re-test worked but the rally that followed was just a bear market rally–it failed, and we fell to new lows in July.  And in the second case, the re-test failed altogether, as we crashed into last week.  Yet studying those charts can give you a glimpse into the market’s pattern in the weeks ahead.

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The last thing I want to write about today is a simple topic, yet one that few investors grasp: Big moves don’t just happen out of the blue.  In the market, stocks (and the market itself, for that matter) take time to set up.  And that means that the market’s crash during late-September and early October was entirely avoidable.

Most investors, of course, will believe that such-and-such news item caused the crash, or they might comfort themselves by believing there was no way they could have avoided such a meltdown.  I talk to many people in that camp every week.

Really, though, it’s all about study and discipline.  I love the challenge of the market, and am glad to have a job that allows me to advise others how to do well in stocks.  But everyone should learn at least some of the tricks of the trade when it comes to identifying bull and bear markets.  My studies are based on how the market has actually performed in the past … not my opinions on what should or should not happen.

Basically, when the market’s trends are down (as determined by the indicators followed in our Cabot Market Letter) and just about every stock and sector is in poor shape, as was the case in mid-September, you know that the market is in trouble.  That is NOT to say that I predicted the crash–not in any way, shape or form.  But putting 1 and 1 together, I was able to stay heavily defensive, and keep 90%+ cash in the Cabot Market Letter’s Model Portfolio since early September.

Looking ahead, however, you should know that leadership stocks also do not just come out of nowhere.  They build multi-week launching pads, and within those basing structure they show signs of powerful accumulation.  And this time of year, such accumulation usually occurs because of a big earnings beat–a big positive reaction to a great earnings report can set the table for further gains in the fourth quarter.

One stock that did react well to earnings was Global Payments (GPN), which made its way into Cabot Top Ten Report two weeks ago.  Here’s what I wrote about it:

“Global Payments, making its Cabot Top Ten Report debut, is a nuts-and-bolts financial company that does the back office work for merchants, corporations, financials and government agencies. The company helps its customers issue credit cards, process their transactions, verify their payment checks and set check cashing limits for casinos. It sells, installs and services ATMs and provides money transfer services to U.S. immigrants through its nearly 800 retail branches in the U.S. and nearly 100 in Europe. But it’s the settlement arrangements with about 12,000 banks, exchange houses and retail locations worldwide that indicate its scope. Global Payments has no exposure to subprime mortgages, and investors see it as a way to play the global rebound in the financial sector once the current storm passes. A great earnings result last week, along with expectations for 20% bottom-line growth in 2009, has also bought in buyers.”

Now, the only problem was that GPN’s great earnings result propelled the stock for just one day … and then the market crashed last week, dragging shares down from 49 to 40, before the stock found high-volume support last Friday.  It’s now in the lower 40s, and I believe more time is needed.  But with business solid (sales and earnings were both up 30% last quarter), I believe it has a shot to be a steady advancer when the market turns up.  Give it a look.

And keep your eyes open for growth stocks that explode higher following their quarterly reports during the next few weeks–they could be revealing big upside potential for the next bull run.

All the best,

Mike Cintolo
For Cabot Wealth Advisory

Editor’s Note:  How did your portfolio do during the market’s crash?  Were you caught flat-footed, or were you safely on the sideline?  Subscribers to Cabot Market Letter, edited by Michael Cintolo, were nearly all in cash–thanks to his time-tested market timing indicators, the Letter’s Model Portfolio has been more than 90% cash since early September!  Mike knows how to spot bull markets, too (he outperformed the S&P 500 by 31% in 2007), and he’s now gearing up for the next upmove by honing his watch list and keeping a close eye on his indicators.  If you want to be in early in the next bull move–and be sure to avoid any future pitfalls–you owe it to yourself to give Cabot Market Letter a try.

http://www.cabot.net/info/cml/cmlim03.aspx?source=wc01

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