Today’s article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends. You may find it useful to compare his market ideas in today’s article with those he shared here on September 1, in Why The Rally Has Been Sustained.
Topped Out?
by Dave Van Knapp
SensibleStocks.com
As the market was plunging from October 2007 until March 2009, I ran occasional articles, usually titled Are We There Yet? The question, of course, was whether the bear market was over — was it safe to come out of the woods and invest cash in the stock market again? A couple of these articles correctly identified false starts late last year as failing to demonstrate the end of the bear market. Finally, the bear market ended on March 9, 2009, replaced by a direct reversal and a strong bull market.
Now that bull market has lasted for more than six months and raised the S&P; 500 by more than 50%. Some people are getting nervous about it. Is it sustainable? Therefore, I am going to write occasional articles asking the old question in reverse: Has the market topped out? Is it time to take some profits off the table, or to go completely back into the woods where the bears hang out? This is the first of those articles.
Frequent readers know that I already have my exit strategy in place for my public Capital Appreciation Portfolio. There are three holdings there: SPY (the ETF that tracks the S&P; 500); QQQQ (the ETF that tracks the NASDAQ); and IBM, the only individual company. The first two holdings — SPY and QQQQ — are protected by 8% trailing sell-stops. I update the stops each weekend, sometimes in the middle of the week if the market makes a significant one-day jump. I have a 10% trailing sell-stop under IBM.
That’s my approach to controlling risk. Others may be protecting their profits with hedging strategies, or by using sell-stops placed at different values…5%, 10%, the 20-day simple moving average (SMA), the 50-day SMA, or “support” lines they have drawn on a chart. There are an infinite number of ways to select the level of a sell-stop.
However you are protecting your profits, these occasional Topped Out? articles will be asking a different question: Are we back in a bear market? I will let that term be vaguely defined for now. Let’s just say that I am asking whether we have entered a period where the market is likely to decline by 20% or more. That matches the rule-of-thumb definition of a bear market.
Of course, by definition, no one knows the future. So these articles will necessarily consist of conjecture. But I will base my conjecture on facts and sound reasoning to the best of my ability.
I have stated many times that this has been a sentiment-driven bull market. While it has been more powerful than most, in many ways it is a garden-variety recession bull. Of the previous nine recessions before the current one, the stock market has bottomed out and started back up several months in advance of the end of the recession. That’s what has happened here since March. Why does that happen? Stock investors look forward — the stock market is a leading indicator of the economy. So it often starts back up while the economy is still mired in recession, indeed while many elements of the recession are still getting worse.
But the market does not do that based on simple hope. I have coined the term “net news flow” to explain what positive-minded stock buyers have been reacting to during this bull market. They have been reacting to the so-called “green shoots”…signs that the economy might be pulling out of the recession. Early on (say, last March), most any sign that could be interpreted positively was a data point that was simply “less bad” than before. The perceived meaning of this was that the downward cycle of various indicators was slowing down and bottoming out — a necessary precondition to the indicators actually turning back upward.
Currently, most indicators have slowed their descent significantly, some have clearly reached a trough, and some have turned upwards. For example the Conference Board’s Index of Leading Economic Indicators has risen for four straight months. I track a few important indicators in my bi-weekly Timing Outlook reports.
One specific topic to end with: In the last earnings season, a majority of companies reported earnings that were “positive surprises,” meaning they exceeded the consensus expectations of stock analysts. All of these positive surprises contributed greatly to the positive net news flow that helped the market along. In most cases, the quarterly reports did not reflect growing revenue or earnings compared to a year ago. They simply reflected better-than-expected earnings, which in most cases were well down from a year before. Most of those positive surprises were based on companies’ fast cost-cutting, which meant layoffs and hiring freezes. That’s why we have the high unemployment rate that we do right now.
However, it did not go unnoticed that, while earnings surprised positively, revenue often did not. Not only that, many companies’ projections for revenue going forward were not encouraging. So here’s my thought: Last earnings season was a “free pass” on the revenue front in terms of how forgiving the stock market was in interpreting the news. The market forgave revenue misses and rewarded earnings hits.
We have a new earnings season coming up in a couple of weeks. If many companies do not show sequential revenue jumps (that is, quarter-over-quarter), and/or do not project positive revenue expectations going forward, then positive earnings surprises will not be enough to count as “good news” this time around. This will not help the net news flow, will not add to positive investor sentiment, and may herald a new bear market.
