“Under­cut Low?”
Octo­ber 10, 2011

“What do you mean by an under­cut low?” was a ques­tion I received in numer­ous emails after last Tuesday’s ver­bal strat­egy com­ments. Well, for the past few months I have been talk­ing about the sim­i­lar­i­ties to the declines, and sub­se­quent bot­tom­ing sequences, of Octo­ber 1978 and Octo­ber 1979. Yes, I know that back then the econ­omy was bet­ter, the inter­est rate envi­ron­ment was dif­fer­ent, pol­i­tics were more set­tled, Europe was sta­ble, etc., but I am ref­er­enc­ing just the pric­ing action of the D-J Indus­tri­als (INDU/11103.12). As often stated, those afore­men­tioned declines were just as severe, and just as quick, as what we expe­ri­enced from the 7/27/11 intra­day high of 12751.43 into the sell­ing cli­max lows of August 8th and 9th. Fol­low­ing those extreme over­sold lows the major indices have pretty much mir­rored the 1978/1979 pat­terns by trad­ing in a fairly tight range, ral­ly­ing a few ses­sions and then declin­ing for a few to the point where par­tic­i­pants needed Dra­mamine! In those late 1970s sequences the INDU vio­lated the sell­ing panic lows twice with an under­cut low so often ref­er­enced in these letters.

An “under­cut low” is when a much watched level, like the panic low of early August (1101.54 basis the S&P 500), is vio­lated on the down­side just enough to get every­one really bear­ish and cause them to sell out their port­fo­lios. Sub­se­quently, the indices turn up and rally, “lock­ing in” a low. And, that was our bet last Tues­day when in that morning’s ver­bal strat­egy com­ments we rec­om­mended buy­ing the index of your choice on the belief we were going to expe­ri­ence an “under­cut low.” To be spe­cific, I said to buy the trad­ing vehi­cle of your choice and if we ral­lied into the after­noon hold on to that posi­tion for a trade. The quid pro quo was that if we were not ral­ly­ing late in the day to sell said posi­tion and live to “play” another day. In ret­ro­spect, at least so far, the 1970s pat­tern con­tin­ues to track. Now one par­tic­u­larly obser­vant finan­cial advi­sor (FA) asked last Fri­day if I thought last Tuesday’s low (1074.77) could be retested over the com­ing weeks. My response was, “Yes it could and that would still be in keep­ing with the Octo­ber ‘78/’79 expe­ri­ences.” A num­ber of other FAs asked if last week’s col­lapse below 1101.54 meant we are going into another whole new “leg” to the down­side toward minor sup­port at 1050, or major sup­port at 1020 – 1030.

Speak­ing to that ques­tion, we have always said a “deci­sive” break below 1101.54 was needed on a clos­ing basis to con­sti­tute the rais­ing of even more cash than we already have. By deci­sive we have repeat­edly stated 5–10 points on the S&P 500 (SPX/1155.46) was what was meant by “deci­sive.” More­over, it has to be on a clos­ing basis to be valid. There­fore, last Monday’s close of 1099.23 wasn’t enough; and, Tuesday’s intra­day low of 1074.77 didn’t count because that day’s clos­ing level was 1123.95. Yet another FA wanted to know if last week rep­re­sented another Dow The­ory “sell sig­nal.” Asked and answered I replied, “By my pen­cil a Dow The­ory ‘sell sig­nal’ was recorded on 8/4/11 when the INDU broke below its March 16, 2011 reac­tion low, thus con­firm­ing a sim­i­lar break by the D-J Trans­porta­tion Aver­age below its March reac­tion low.” At the time we wrote about the sig­nal and have spo­ken of it numer­ous times since then. To get another Dow The­ory “sell sig­nal” would require a close below the July 2010 reac­tion lows of 9686.48 for the Indus­tri­als and 3906.23 for the Trans­ports, at least by our method of inter­pret­ing Dow The­ory. Regret­tably, to get a Dow The­ory “buy sig­nal” under my method­ol­ogy would require a close above the May 6, 2011 high of 12807.36 by the Indus­tri­als with a sim­i­lar close from the Tran­nies above their July 7, 2011 high of 5618.25. Of course, some Dow The­o­rists would sug­gest a close above the August 2011 clos­ing highs of 11613.53 and 4683.96 would do the trick, and I cer­tainly hope they are right.

Who­ever is cor­rect, we have been pretty cau­tious over the past two months, except for last Tuesday’s bull­ish trad­ing “call,” believ­ing that if we are going to err it is going to be by being too cau­tious. That’s why we have made very few trad­ing rec­om­men­da­tions and why we have con­cen­trated on dividend-paying stocks with strong fun­da­men­tals that have favor­able rat­ings from our ana­lysts. All but two of those stocks hope­fully made their respec­tive “panic lows” back in early August. The two excep­tions are LINN Energy (LINE/$35.21/Strong Buy) and The Williams Com­pa­nies (WMB/$24.97/Outperform), both of which made new reac­tion lows early last week before recov­er­ing late in the week. Again this week we offer these names for your con­sid­er­a­tion. One of the rea­sons for the “painful ups and downs,” and new reac­tion lows ref­er­enced in last week’s let­ter, is that ana­lysts are whack­ing for­ward earn­ings esti­mates. For exam­ple, accord­ing to our friends at Bespoke Invest­ment Group:

“Over the last four weeks, ana­lysts have raised fore­casts for 276 com­pa­nies in the S&P 1500 and low­ered fore­casts for 780. This works out to a net of –504, or –33.6% of the index, and rep­re­sents the low­est level since April 2009.”

We have watched such shenani­gans for nearly 50 years. When stock prices are ris­ing ana­lysts tend to raise their earn­ings esti­mates. When prices are falling they lower esti­mates. Maybe a good cur­rent prism for investors would be to look at the 276 com­pa­nies where ana­lysts are rais­ing estimates.

As for the econ­omy, in last Monday’s mis­sive we noted that 14 of the 18 eco­nomic reports issued in the pre­vi­ous week came in bet­ter than expected. That trend con­tin­ued last week with 11 of the 16 releases show­ing bet­ter than esti­mated results. Of par­tic­u­lar inter­est were bet­ter than antic­i­pated num­bers on employ­ment, vehi­cle sales, vehi­cle pro­duc­tion, con­struc­tion spend­ing, and manufacturing/non-manufacturing PMIs. In fact, the com­pos­ite Pur­chas­ing Man­agers Index is con­sis­tent with +1.8% GDP growth for 3Q11. Addi­tion­ally, U.S. Machine Tool Orders have soared, same-store sales for the aver­age casual din­ing chain were up 2% in Sep­tem­ber (an accel­er­a­tion from August) and rail­car traf­fic trends for the past two weeks have been quite strong (par­tic­u­larly inter­modal). All of this is incon­sis­tent with an econ­omy enter­ing a reces­sion. As stated, we guess peo­ple could actu­ally talk them­selves into a reces­sion, but at the cur­rent time the met­rics actu­ally sug­gest the econ­omy is mar­gin­ally strength­en­ing. To be sure, cycli­cal sen­si­tive sec­tors, namely hous­ing, has been so weak it is dif­fi­cult to envi­sion how much more it can con­tract. House­hold bal­ance sheets have improved since the 2008/2009 “Finan­cial Fiasco.” The trade deficit is likely to improve due to slower import growth and a decline in energy and com­mod­ity prices. Said price declines should also check head­line infla­tion and lift house­holds’ pur­chas­ing power. As for ECRI’s (Eco­nomic Cycle Research Insti­tute) state­ment that a reces­sion is “immi­nent,” while the folks at ECRI are very smart, they did call for a reces­sion last year that never arrived.

The call for this week: Amaz­ingly, on Octo­ber 3, 2008 the SPX closed at 1099.23, the exact same level as on Octo­ber 3, 2011 right before “Turn­ing Tuesday’s” tri­umph. In observ­ing the data, one can make the case that the U.S. stock mar­ket is cheaper today than three years ago. Thanks to my friend Doug Kass for that insight. Also from Dougie, “The U.S. stock mar­ket, on a P/E mul­ti­ple basis, appears to be dis­count­ing 2011 S&P 500 earn­ings of about $78 a share, which I believe will turn out too low. (The cur­rent rate of earn­ings is annu­al­iz­ing at $100 a share in third quar­ter 2011). But, given risk pre­mi­ums (earn­ings yield less cor­po­rate bond yields), the mar­ket is dis­count­ing 2012 S&P 500 prof­its of slightly under $60 a share, which to me, seems ridicu­lous.” Some­thing else to con­tem­plate is that while the SPX briefly vio­lated its intra­day low of August 9, 2011, the Volatil­ity Index (VIX/36.20) did not breach its August 8, 2011 intra­day high of 48.00, nor did the num­ber of stocks mak­ing new annual lows exceed that of 8/8/11. Then too, accord­ing to Ned Davis Research, since WWII quar­terly losses exceed­ing 14% (3Q11 loss was 14.33%) have been fol­lowed by rebounds the next quar­ter 89% of the time. The aver­age gain dur­ing the next quar­ter has been +5.3%. More impor­tantly, since the 1920s there have been 24 quar­ters when the SPX declined by 14% or more. The aver­age rebound over the next 12 months was ~12%, while the aver­age 12-month gain since WWII has been ~23%. The real ques­tion for this week is fol­low­ing last week’s over­sized near-term rally, “Can the SPX sur­mount its 50-day mov­ing aver­age at 1177.87 that has con­tained every rally attempt since Sep­tem­ber 16, 2011?”

P.S. – A good exam­ple of a Brain Study: If you can read this you have a very strong mind – 7H15 M3554G3 53RV35 7O PR0V3 H0W 0UR M1ND5 C4N D0 4M4Z1NG 7H1NG5! 1MPR3551V3 7H1NG5! 1N 7H3 B3G1NN1NG 17 WA5 H4RD BU7 N0W, 0N 7H15 LIN3 Y0UR M1ND 1S R34D1NG 17 4U70M471C4LLY W17H 0U7 3V3N 7H1NK1NG 4B0U7 17, B3 PROUD! 0NLY C3R741N P30PL3 C4N R3AD 7H15. WE CONTINUE TO INVEST, AND TRADE, ACCORDINGLY, CONSISTENT WITH OUR RIGHT BRAIN, WHOLE BRAIN, INVESTMENT STYLE.

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