Don't Bury the Bull Just Yet!

04/01/2013 10:30 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

This bull market is breaking records, but analysis shows it's far from dead, says James Stack of InvesTech Research.

Nancy Zambell: My guest today is Jim Stack with InvesTech Research. Jim, thanks for joining me.

Jim Stack: It's great to be talking to you, Nancy.

Nancy Zambell: I just read in your midterm bulletin that your company has actually been in business for more than 30 years. That is a lot of market cycles, isn't it?

Jim Stack: It is. And who would have guessed that many years ago that we would be going through things like the 1987 crash or technology bubble of the late 1990s or the financial crisis of 2007? It's been a very wild 30 years.

Nancy Zambell: It certainly has, and now we're in a pretty good market. Since the bottom in March 2009, for the most part, we've been going up and have recently been breaking records. And I see that you are still optimistic.

Jim Stack: Actually, we are still quite optimistic. I call it cautiously optimistic. We are close to 90% invested, but at the same time, our strategy is shifting to a more defensive, cautious stance.

One of the reasons is because we're in the fifth year of this bull market. The average bull market duration in the past 80 years is 3.8 years, so chances are we are in the latter half-if not possibly the latter third-of this bull market.

Nancy Zambell: For an individual investor, is your strategy just to be in certain sectors? To be in certain stocks? Or is it more of a combination of both?

Jim Stack: There are several important steps an investor can make to dial down the risk in their portfolio.

First, you reduce your invested allocation in those sectors that are what you call early bull market sectors. They do the best in the first early years of the bull market. But as a bull market ages-and not knowing exactly when a bear market will strike-you want to reduce your allocation in those sectors that become the highest-risk sectors.

Those sectors would include the financial, the consumer discretionary stocks, and a little bit of technology, although I think technology stocks still offer one of the better valuations out there today. But it is still going to be one of the sectors that is going to see the larger losses when a bear market strikes.

Nancy Zambell: You wouldn't be totally out of those sectors, because you still want to have a bit of speculation, and the ability for some pretty high returns in certain sectors-is that correct?

Jim Stack: An investment strategy-particularly one that is risk-averse-always needs a balanced portfolio. In other words, you look at the different sectors that you have, and you reduce the allocation in what might be termed the highest-risk sectors.

But you don't exit them completely-not if you have good stocks in them. In addition, you increase your allocation in those sectors that tend to become more defensive-including health care and consumer staples.

At this point, I think energy is just about in the middle. Energy is not necessarily one of the most defensive. But it's certainly not the highest risk, because we haven't seen the kind of run-ups that we have in, for example, consumer discretionary stocks.

Nancy Zambell: Are there any particular sectors in health care that you would avoid? We've had a lot of talk about Obamacare. Some people have been totally out of health care, and they missed some very good returns. So where in that particular sector would you like to be, where are you currently, and where would you definitely not be buying?

Jim Stack: Well, that's really a question that should go to our portfolio team, but I'll give you the guidelines that we're following.

We don't want to focus on any particular sector within health care. We want to focus on the individual companies. You want to look for the company that is not going to be impacted dramatically in a negative fashion by the implementation of Obamacare.

But at the same time, you need to make sure that there's not a great deal of uncertainty surrounding how that company is going to be impacted by the full implementation of Obamacare, which is coming in January 2014.

Nancy Zambell: Right now, you would have more in more conservative stocks, a little bit less in the speculative...but still keep a strategy so you are balanced?

Jim Stack: You always want to follow a balanced strategy. But at this point, you want to shift the balance a little stronger in favor of some of the more defensive sectors, and a little less in terms of those higher-risk, higher-performance sectors that are great to own in the first years of the bull market. But you don't want to have a high allocation in them when you go into a bear market.

Nancy Zambell: Now looking in your crystal ball, and I know with you that means an awful lot of research and charts, can you give us an idea of when you think this bull might finally die?

Jim Stack: I don't think anyone can look 12 months or even six months down the road and say, "I think that's when the bull market is going to end."

What you can watch for are warning flags, those characteristics that when they appear-particularly when multiple warning flags appear-indicate that a bear market is not very far off on the horizon.

Where we've really built our strengths over the past 30 years is in what we call risk-averse management-we are able to identify bear markets very early, and in most cases even before they start.

Some of the areas that we watch for are divergences in the number of stocks participating in the market. For a technician, that shows up in the advance-decline line. We also watch what we call "bellwethers," those leading stocks in those sectors that always-or in most cases-tend to peak ahead of the broader market.

We have our InvestTech Bellwether index, which has peaked ahead of the market in each of the bear markets over the past 30 years. Today, that Bellwether index is still hitting new highs, right along with the market, so we're not seeing the kind of divergences that would tell us to start battening down the hatches.

I think another key area is in leadership. You don't want necessarily upside leadership, but downside leadership-the number of stocks hitting new yearly lows.

We have a technical gauge called our Negative Leadership Composite. It's designed to tell us when we have a rapidly rising probability of a bear market ahead. And right now, it's still giving us an all clear signal. So even though I'm not wildly bullish, we are, as I said to begin with, cautiously optimistic on the outlook for this market.

The S & P was up ten out of the past 11 weeks. That kind of strength typically happens in the middle of a bull market, not at the end of a bull market. In fact, there have been only 23 instances when that has happened in the past 85 years, and all but two them saw the market higher over the next six and 12 months.

So what that means is that odds are, even though we may see consolidation in the second quarter this year, and more sideways action, I think, by the end of the year-barring, of course, any of those warning flags appearing-we are going to see higher prices.

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