The Cocktail Theory
by Jeffrey Saut, Chief Investment Strategist, Raymond James
February 14, 2011
I was on the West coast last week seeing institutional accounts and speaking at various seminars. The resounding question served up was, “Is this a rally in a bear market, or a new secular bull market?” The follow up question was, “How can you be sure that the pullback, you have wrongly been expecting, is for buying?” Speaking to the second question first, since 1940 there has never been more than one 10% or greater pullback in a bull move; we had a 17% pullback last year between April’s high into June’s low. Moreover, the retail investor is nowhere close to fully embracing this rally, which is typically what occurs around intermediate/long-term stock market “tops.” Consider this quip from Peter Lynch’s book “One Up On Wall Street:”
“If the professional economists can’t predict economies and professional forecasters can’t predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own ‘cocktail party’ theory of market forecasting, developed over the years of standing in the middle of living rooms, near punch bowls, listening to what the nearest ten people said about stocks.
In the first stage of an upward market – one that has been down awhile and that nobody expects to rise again – people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, ‘I manage an equity mutual fund,’ they nod politely and wander away. If they don’t wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque. When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely the market is about to turn up.
In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer – perhaps long enough to tell me how risky the stock market is – before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market is up 15 percent from stage one, but few are paying attention.
In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals takes me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they’re all discussing what’s happened.
In stage four, once again they’re crowded around me – but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up. When the neighbors tell me what to buy, and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.”
Manifestly, we are nowhere near stage 3 or 4; so yeah, I think any pullback is for buying. As for the first question, I have not wavered in the belief that since the first Dow Theory “sell signal” of September 1999 the major averages would do what they have done after every secular bull market peak – they would go sideways in a wide swinging trading range. My often mentioned example has been the trading range between 1966 and 1982 following the previous secular bull market that began on June 13, 1949 and ended on February 9, 1966. That wide swinging trading range market experienced no less than 13 swings of 20% or more (both up and down) during that 16-year range-bound environment. Interestingly, while the DJIA made its nominal price low in December 1974 at 577.60, the D-J Transportation Average refuse to confirm with a like new reaction price low (read: non-confirmation). That left the Dow’s nominal price low at 577.60, a level that would not be breached, or even retested, over the subsequent years. The Dow’s valuation “low” (the cheapest it would get in terms of price to earnings, price to book value, price to dividends, etc.), however, was not reached until the summer of 1982. Still, the senior index NEVER came anywhere close to its nominal price low of December 1974. Accordingly, for almost two years I have argued that the nominal price low for the current range-bound stock market came in March of 2009; I have also stated that I would be shocked if the major averages ever come close to those levels again. As for when the valuation “low” will occur is certainly a fair question, but my sense is it is still a few years away. Yet, that does not mean you can’t make money in the stock market, as has been demonstrated by our Analysts’ Best Picks list, which has outperformed the S&P 500 in nine of the past 10 years of a range-bound market.1
