We are at a wonderful ball where the champagne sparkles in every glass, and soft laughter falls upon the summer air, we know at some moment the black horsemen will come shattering through the terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time, so everyone keeps asking, ‘What time is it?’ But none of the clocks have hands.—The Money Game by Adam Smith
I met Jerry Goodman, whose nom de plume was Adam Smith, late in my career. He was working at my friend Craig Drill’s money management firm along with another icon in this business, from an era gone by, namely Al Wojnilower. I have had many conversations with all three of these Wall Street legends around the conference table at Drill Capital Management. Jerry wrote The Money Game (1968), Powers of Mind (1975), Paper Money (1981), and The Roaring ‘80s (1988), but unfortunately we lost his wisdom on January 3rd of this year (https://blogs.wsj.com/totalreturn/2014/02/17/remembering-adam-smith/). Well, that is not entirely true for as Terry Pratchett wrote, “Do you not know that a man is not dead while his name is still spoken?” More to the point is that much of Jerry’s wisdom can be gleaned from his books. Obviously, Jerry still lives in the minds of those who have read those books and continue to speak his name. This morning, I invoked his name with the aforementioned quote. I find the quip particularly timely following the 38-month upside skein we have experienced without a 10% correction on a closing basis. That’s a long time considering that a 10% correction comes along on average every 18 months! Of interest, it was the April through June of 2011 decline that lopped 19% off of the S&P 500 (SPX/2088.77), but since then we have not seen a true 10% pullback. Granted the April/June 2012 timeframe recorded a 9.9% slide, as did September/October 2014, but while they came close they were not true 10% declines based on closing prices. That makes this rally long of tooth, but not historic because, according to my notes, the longest run without a 10%+ correction came between October 1990 and October 1997.
I revisit the 10% correction theme as we approach the New Year because the timing models I use have again targeted the January/February timeframe as potentially a difficult period for the equity markets in the New Year. Recall, it was at this time last year those same models were calling for a 5% – 7% pullback in the first three months of 2014; and, we got a 6% decline. Of course the models also called for a 10% - 12% decline sometime in 2014, but, as stated, all we got was 9.84% on an intraday basis between mid-September and Mid-October. Still, I have come to respect my models over the decades and I am not going to ignore them this time. So what are investors to do?
Well, it was last July when I suggested that if you have stocks in your portfolio that have not participated in the 50%+ rally by the SPX we have seen since June 2012, you might want to consider selling some of them and raise some cash. I would use that same strategy as we head into 2015. In looking at which sectors are expensively valued, and therefore might be right for a rebalance in portfolios (read: trim back on select stocks), Healthcare is historically expensive with a price-to-earnings ratio (P/E) of 23.01x. Consumer Discretionary is next with a P/E of 21.50x followed by Consumer Staples (20.93x). The “cheapest” macro sectors on a P/E basis are Energy (13.41x), Telecommunications (13.66x), and Financials (14.76x).
Last week, however, raising cash was the last thing on investors’ minds as the Dow danced higher, and in the process breached 18000. Subsequently, my phone lit up with the ubiquitous question, “Jeff, you said earlier this month on various TV and radio shows that you thought the Santa rally would carry the D-J Industrials (INDU/18053.71) above 18000, and so what is the significance of 18000?” My response went like this, “I did expect 18000 to get exceeded before year end and I have been pretty adamant the Santa rally was going to accomplish that. But, 18000 is a non-event just like 11000, 12000, 13000, etc. The numbers that capture the public’s attention are numbers like 1000 (December 1972), 10000 (March 1999, where they broke out the hats on the NYSE), 20000, etc. If 18000 was a legion number, where are the hats?!” Speaking to Dow Theory, while the Industrials made new highs last week, the D-J Transports (TRAN/9199.65) did not, yet they are not very far away. For the Transports to confirm the Dow’s new high would require a closing price above the November 25, 2014 close of 9202.84. It will be interesting to see if that happens in a week where “champagne sparkles in every glass.”
Plainly, the drivers of last week’s “win” were the various reports. Consumer sentiment tagged a seven-year high, the Commerce Department reported consumer spending beat expectations at up 0.6%, and the third revision of 3Q14 Real GDP was a breathtaking +5%. The GDP report was the “cork popper” since expectations were clustered around +4.2%. It was the strongest quarterly reading in 11 years and has the U.S. economy growing at 3.5% in four of the past five quarters. On the negative side, the housing numbers disappointed and the durable goods report was terrible. The stock market, however, is turning a deaf ear to bad news and that’s good news. Hopefully, that trend will extend this week. But for those courageous enough to buy aggressive trading positions on our “fat lady sings” advice of December 17, 2014, I would either push up stop-loss points or shed those positions. One thing Andrew and I got right was the cup-and-handle formation in the Russell 2000 (RUT/1215.21), which we suggested was going to cause an upside breakout. That upside breakout occurred last week. As the eagled-eyed Jason Goepfert, of the insightful SentimenTrader, writes: “The Russell 2000 index of small-cap stocks closed at its first multi-year high in more than six months on Friday. The momentum that carries it to a new high has tended to continue over the next several weeks, as it added to its gains three weeks later all 15 times it has occurred (see chart).”
If Jason’s observations prove correct, this would foot with my timing work that shows the equity markets becoming increasingly vulnerable into mid-January.
The call for this week: While investors’ attentions were focused on last week’s economic reports, new highs in various indices and Christmas, the proverbial tree in the forest fell and was not heard. Verily to a cornered Vladimir Putin, who is feeling the pressure of a crude oil and Russian ruble collapse, last week’s Ukrainian parliament vote to become an “unaligned” nation is likely the first step toward becoming “aligned” with NATO. That may just prove to be the final straw that broke Premier Putin’s back. If so, things are getting ready to heat back up in the Ukraine, which may provide an unsettled news backdrop for the equity markets. Indeed, with the McClellan Oscillator overbought, as well as many other “finger to wallet ratios,” there is nearly a full charge of internal energy available in the equity markets to give us a move either on the upside or the downside. This week should be instrumental in determining the near-term direction. This morning Greece failed to elect a president, threatening the international bailout program. Russia has suffered its worst economic contraction since 2009. And Air Asia flight 8501 is still missing.
