Jeffrey Saut: "Calm Down 2"

Calm Down 2

by Jeffrey Saut, Chief Investment Strategist, Raymond James

September 8, 2014

In last Friday’s Morning Tack I referenced some sage advice from the legendary Dow Theorist Richard Russell of Dow Theory Letters fame. The opening verbiage was (as paraphrased):

Calm down: nothing created by the mind of man has ever equaled the stock market in terms of its sheer ability to frustrate people. Why is this? The answer is the stock market frustrates because millions of traders and investors across the face of the U.S., and the world, are all trying to make money out of the market. Now when millions of people are trying to make money in the markets, you know that it is difficult to do. Many people are just not fated to make money doing anything, much less beat the stock market. “It’s not fair” you complain, “why can’t all these nice people make money trading and investing?” There is one simple fact that makes this difficult. Throughout history there have always been a small number of financial winners and a larger number of financial losers. So when you say the markets are “frustrating,” the question becomes frustrating for whom? And the answer again is that the stock market is frustrating to the great number of participants, but highly rewarding to a smaller minority of informed, hard-working, intelligent winners.

And with those words I was inundated with queries of, “What do you have to do to be one of the investment winners?” Dick Russell responds:

You have to work hard. It’s an ironic fact that people are willing to work hard and put in long hours in their own businesses, or on their jobs, buy then they think they can turn around and make easy money in the stock market. Beating the markets is one of the hardest endeavors in the world and these optimists believe that with a modicum of knowledge, a little study, and a large portion of luck they can make money “playing the market.” It doesn’t work that way, never has, and never will. Here’s what I am talking about. The great Dow Theory writings were done by Charles Dow, William Hamilton, Robert Rea, and George Schaefer. How many analysts, professionals, strategists, etc. have read the works of these men? How many pros have ever studied Dow Theory, which is the basis of ALL technical market studies? Frankly, I think I could count on the fingers of both hands the analysts I know who have read, and are familiar, with the works of these men.

Now, there are certain pundits that will tell you Dow Theory does not work anymore because there have been so many changes to the components of the D-J Industrials (INDU/17137.36) and D-J Transports (TRAN/8601.80). I will tell you there has only been one false signal from Dow Theory (DT) over the past 15 years and that was a false “sell signal” generated by the Flash Crash in May of 2010; and, that was quickly reversed with a “buy signal.” Indeed, there was a DT “sell signal” in September 1999, a “buy signal” in June 2003, a “sell signal” on November 21, 2007, and a DT “buy signal” in the 2Q09. Since then, except for the Flash Crash, there has been nothing but “buy signals.” So what constitutes a DT signal?

Well, it’s not very complicated. When the Industrials, and the Trannies, make new reaction highs, that’s a DT “buy signal.” Importantly, the indices do not have to do this simultaneously. For example, in January 2013 the Trannies made a new all-time high, but it wasn’t until March 2013 that the Industrials did the same. It is worth noting the closer in time each index confirms the other, the stronger the signal. The reciprocal action is what constitutes a DT “sell signal.” Of course that begs the question, “Did we get a Dow Theory ‘buy signal’ last week? The answer is, “Close, but no cigar.” While the TRAN made a new high, the INDU did not. Still, the miss by the INDU was only 0.84 basis points. For the Industrials to confirm would require a close above the July 16, 2014 all-time closing high of 17138.20. It would seem appropriate during the week of 9/11 for such a confirmation to occur. While the S&P 500 (SPX/2007.71) has absolutely nothing to do with Dow Theory, it is worth mentioning the SPX did make a new all-time last week. Interestingly, however, less than 30 of the S&P 500’s components made new highs as well. If we get a Dow Theory “buy signal” this week it would be just one of many that have been registered since March 2009 and only reaffirms we are in a secular bull market; and that’s all you really need to know. As Curly (Jack Palance) said in the movie City Slickers, “Just one thing!” In this case the “just one thing” you need to know is that we are in a secular bull market, which reminds me of a story I have written about before.

Back in the 1920s there was a particularly shrewd stock operator named Mr. Partridge, often referred to as “Old Turkey.” Many Wall Street wags constantly asked him, “What do you think I should do in the stock market?” Old Turkey would cock his head to one side, contemplate the question, and with a fatherly smile he would say, “You know it's a bull market.” It was as if he were giving you a priceless talisman wrapped up in a million-dollar accident-insurance policy. Indeed, “just one thing” because in secular bull markets all of the surprises come on the upside. Well that’s not entirely true; in the 1982 to 2000 secular bull market there was a pretty big mishap in October 1987. Still, in retrospect, that mishap was a great buying opportunity.

As for the question “What do you have to do to be one of the investment winners?” – while Richard Russell’s advice certainly rings true, most individual investors do not have the time, or are unwilling, to do the due diligence to be big investment winners. Therefore, it is paramount to have a good financial advisor. Ever since the turn of the century I have opined that the 1970s was the decade of the product. My generation graduated from college and bought the first car, the first house, etc. The 1980s was the decade of the image. We bought the house on the golf course in a gated community and a Mercedes Benz. The 1990s were experiential. We went to Europe and brought back experiences, not things. The new millennium is all about the relationship. When our cars break we don’t need the cheapest price to fix them. What we want is someone we trust to do the job right and charge us a fair price. And, we want the same relationship with a doctor, a lawyer, and especially a financial advisor. Our mantra is, “Please take stewardship of our money and try to give us a decent return. We don’t need a spectacular return, but above all don’t lose 58% of it in the October 2007 to March 2009 decline.”

The call for this week: “Close, but no cigar” was the call on the Street of Dreams Friday as the Industrials failed by less than 1 point to notch a new all-time high and thus confirm such a move by the Trannies. But while all eyes were on the major indices, the Advance/Decline lines for most of the small-cap indexes remained well below their respective all-time highs. In fact, Lowry’s list of domestic common stocks dropped to a new 26-week low. Adding to the divergences, while the NYSE All-Issues Advance/Decline Line is at a new all-time high, the Operating Company Only Advance/Decline Line (it leaves out ETFs, closed end funds, etc.) has not registered a new high. Further, the SPX is at the topside of its 3% trading band, and therefore overbought on a trading basis, and there was a traders’ speculative short-term “sell signal” last Thursday when the 14-day Stochastic Indicator fell below its moving average. However, despite these near-term trading calls the “just one thing” investors need to keep in mind is that this is a secular bull market, so consider this. Since 1989 the S&P 500’s earnings have grown by 6.15% annually. Extrapolating that into 2020 implies earnings of $183.36 (see chart on the next page). Using the historical median P/E ratio of 15.5x yields a price target of 2842 in 2020. This morning the preopening futures are marginally down on worries about what might happen during the week of 9/11.