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Is it a bull? Is it a bear? A strategy for making the best of a market that's both
02/23/2010 8:30 am EST
All right Sherlock, navigate that one for me and my portfolio.
The strategy is actually pretty simple. But the execution…
Well, it shouldn’t be too hard for anyone who combines the self-confidence and iron nerves under pressure of a Stonewall Jackson, with the sensitivity to rhythm and emotion of a Martha Argerich with the psychic powers of the three witches in Macbeth. (While I’m wishing can I have a flying horse and a dragon too, please?)
For the rest of us executing a strategy that can navigate a relatively short-term bull and a relatively long term bar might be a bit of a challenge.
A challenge. But not impossible. Let me start off by laying out the nature of such a strategy so that the challenge becomes clearer.
In my post of last Friday, I argued that we were still in a secular bear market—one that began in Mach 2000—and that could still have as much as another ten years to run even though we are currently in one of the great cyclical bull markets of all time. How else would you describe a rally that produced a 70% gain from the March 2009 low to the January 2010 high?
But I don’t want to rehash that argument here. In that post I promised that today I’d take my best shot at telling you how to navigate this bullish bear (or is that bearish bull?)
This is new territory for almost all of us. If you started investing anytime after 1982, until 2000 you’d only been an investor during a bull market. And one of the great bull markets at that. One that produced a 1309% gain. Despite such setbacks as the great crash of 1987 when the Standard & Poor’s 500 fell 20% in one day.
You’d have lots of useful experience—and the scars to show it—if you’d been an investor from 1968 to 1978. That was the heyday of the last secular bear market. On November 27, 1968 the S&P 500 topped out at 107.76. It wouldn’t see that level again until September 22, 1976.
And even then that bear wasn’t done with investors. It took yet another nose dive to 87.04 on February 28, 1978, rallied again and then fell one again to 98.68 on March 26, 1980, and then one last time to 102.42 on August 12, 1982.
The S&P 500 didn’t climb above its November 27, 1968 close, for good, until August 18, 1982.
That secular bear added up to 14 years of going nowhere. Puts the 10 years of going nowhere that we’ve been through since March 2000 in perspective, no?
Not that there weren’t some great rallies in that bear market along the way, though.
For example, there was the rally from September 16, 1975 to September 22, 1976 that took the S&P 500 up 31% in almost exactly a year.
There was the rally from October 3, 1974 to July 9, 1975 that took the S&P 500 up 52% in about nine months.
And biggest of the all there was the rally from May 29, 1970 to January 8, 1973—roughly two years and seven months—that produced a 57% gain for the S&P 500.
Turns out that the kind of rally that we saw from March 2009 to January 2010 isn’t quite as unusual as you’d think.
Even in retrospect—maybe especially in retrospect--it’s easy to see that how you did during the secular bear of 1968 through 1982 depended on what you did.
If you simply stood pat and didn’t make any buys and sells during the whole 14 year bear you would have finished the bear at no worse than even—plus the 2%-3% a year in dividends you would have collected on the S&P 500.
If you had held on and then sold at the bottom in 1973, you would have seen a loss of 42%.
Ouch. But you actually could have done worse.
If you had ridden the bear down from 107.76 on November 27, 1968 to 89.48 on July 30, 1969 and then sold. And then stayed out of the market until the rally that began in 1970 convinced you to buy in again at 90 and then sold again in disgust at the bottom of 62.28 on October 3, 1974, and then stayed on the sidelines until the market had rallied to 90 and then bought in again only to ride it down to 82.09 on September 16, 1975, you would have been looking at an even deeper 53% loss by 1975. And you would still have had another five to seven years of failed rallies to buy into at the wrong time.
You think there’s any chance that an investor who had been burned like that would have been too traumatized to jump into the great secular bull market that began in 1982 until, say, 1992?
Okay, so what are the lessons from that decade and a half of bear market pain? And can we build a simple strategy from them?
I think so even without the 20/20 hindsight that would have allowed an investor to buy at every temporary bottom and sell at every temporary top.
Let’s try on these three rules for size as a foundation for our strategy.
First, long cyclical bull rallies in secular produce gains of so large that they are too important to miss. Sitting them out all of them leaves a lot of money on the table. And at least some of the biggest rallies last long enough so that most investors should be able to catch part of the profit. So for example, while I was late to the party with Jubak’s Picks in 2009 and never did get fully invested, I still managed to catch enough of the rally to produce a 20% return for 2009.
Second, almost no one is going to catch all the cyclical bull rallies in a secular bear, especially if the bear is really, really deep. And most investors shouldn’t try nor should they kick themselves if they miss one or two or whatever. Remember that in a bear staying on the sidelines sure beats buying high and selling low repeatedly in an effort to catch the next rally. If the bear is really, really deep, rallies off the bottom can be very explosive and very quickly over. The 52% rally from October 1974 to July 1975 was over before most investors recognized it was taking place.
Third, the most reliable guide to telling when a long secular bear is over is the same guide that can tell you when you’re in one—fundamentals. I don’t mean to denigrate technical analysis, not in the slightest. But reading the difference between a recovery rally inside a bear market and the rally that really ends a bear market using purely technical tools is so difficult that you should also look at the fundamentals of the economy and the stock market. Take help anywhere you can find it, I say.
Looking at the steady upward climb of interest rates during the 1968-1982 secular bear—5.64% on the 10-year Treasury in 1968, 7.99% in 1975, 9.43% in 1979, 13.92% in 1981—should have made any investor doubt the staying power of any bull rally during the period.
(The potential for interest rates to follow a similar course over the next decade that they did in 1968-1982 is one reason that I put the odds of a secular bear lasting another five to seven years so high.)
What kind of strategy do I propose building on that foundation? One that pays attention to both short-term bull rallies and the long-term bear by realizing that whenever either of the two trends, long-term or short –term, runs to an extreme, it opens up opportunities to buy into the other trend at a good price. And then to hold until the attention of Wall Street and the great majority of investors switches to the other trend and sends prices there toward an extreme.
Essentially the strategy oscillates between going short and going long—only in this case we’re not talking about short-selling and its opposite—but about switching our thinking from short-term to long-term and back again as one perspective or the other gets over or undervalued.
So, for example, in the latter stages of the current cyclical bull market in 2009 and into 2010, gold and other hedges against inflation got relatively cheaper as stocks continued to soar.
Inflation? Who was worried about inflation? If it is a problem, it’s a problem so far down the road that it’s certainly not worth investing money in hedging against the trend or to make money from the trend.
But, I’d argue that it’s when everybody is focused on making money in the short-term cyclical bull that you ought to be thinking about putting some money into positions that will do better—or maybe just relatively better—in the long-term bear.
I’ve posted repeatedly in the last few months (most recently on February 18 http://jubakpicks.com/2010/02/18/my-thin-reeds-say-the-first-half-of-2010-will-be-surprisingly-strong-in-the-u-s/ ) laying out my reasons for believing that this cyclical bull could well continue through the first half of 2010. I hope it does.
But if the correction is indeed over (see my post http://jubakpicks.com/2010/02/17/so-is-the-correction-over-already/ ) and the rally resumes, then I think the time to be adding new positions to take advantage of the short-term bull is just about over. Let your money ride, by all means. But start to watch valuations and take some profits. And start to put some money into the under-loved long-term bear view.
In the coming weeks, if the rally heats up again, I’d be looking at gold and commodities. They’re both likely to be increasingly overlooked, especially if the Federal Reserve’s February 18 move to raise the discount rate, the interest rate the Fed charges banks for borrowing overnight, adds even more strength to the U.S. dollar.
The same will be true for defensive stock market plays. Stocks backed by recession resistant revenue streams like Procter & Gamble (PG) or stocks with solid dividends such as du Pont (DD) move to the top of investors’ buy lists when the market is falling and then they fall out of favor when a rally resumes. It’s when they’re out of favor that you want to add to positions in these kinds of stocks to prepare for the days when the bear is back in control.
Same with dividend stocks in general. When stocks are climbing in price, dividend stocks get over-looked and become relatively cheap. But you’ll want to own them if the rally ends and the bears regains visibility. The time to buy them is before you start to hear every guru in the blogosphere recommending dividend stocks.
I think there’s a similar short-term/long-term play on emerging market stocks. If you hope to have any chance of avoiding a lost decade or more, you’ll have to add stocks from the world’s fastest growing economies to your portfolio. (See my posts http://jubakpicks.com/2009/11/24/how-to-escape-the-next-lost-decade/ and http://jubakpicks.com/2010/02/05/how-to-build-a-global-portfolio-what-countries-do-you-want-to-own/ )
Emerging market stocks are likely to go up—but even faster—when U.S. markets are rallying. A rally in the developed world’s stock markets usually convinces investors that it’s safe to take a flyer on the riskier (in their minds at least) markets of the developing world.
When the bear shows itself, developing markets are likely to fall even faster than their developed world counterparts as investors seek what they think is the relative safety of the U.S. and other developed markets. That’s the time to buy emerging market stocks.
The evidence of the last decade says that investors do indeed get more volatility when they buy developing market stocks but the excess returns—the gains above what developed market stocks achieve—make the volatility more than worth it.
Over the next couple of weeks I’m going to tweak the holdings in Jubak’s Picks just bit to see if I can get something closer to the best mix for the end stages of a rally that I expect will peter out somewhere near the middle of the year.
But then after those tweaks I’ll start looking for bargains that will let me build a portfolio prepared for the return of the bear.
Full disclosure: I don’t own positions in any stock mentioned in this column.
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