What do politics and Santa have in common?

In spite of recent end of quarter (q3) volatility and ~10% correction, I have been telling investors to expect a good ending to the year for US stocks (and likely early part of next year too).  Its not that I can see into the future, rather there is a 2-pattern seasonality alignment which provides investors a high probability bullish outcome for US stocks over the next quarter or so. The first pattern is the traditional year-end (“Santa Claus”) rally that customarily begins sometime in October of each year. This is caused from sentiment changes the joys of the holiday season brings and optimism that typically abounds as the year winds down and a new one is christened. The chart below is a historical look at performance on the 3 major US stock indexes by month during the period of 1950-2012 and clearly reflects these year-end rallies. 

The second pattern is that the sixth year of 2-term presidents have traditionally been very good for stock market returns, but typically don’t manifest until the 4th quarter. The chart below which represents the SP500 US stock index returns by month since 1950 unmistakably reflects the historical out-performance during this time.

Two patterns aligning up at the same time (the 4th quarter of this year) provides a potential huge edge for investors (successful investing is all about investing at times when the odds/probabilities are in your favor).  This edge combined with the fact that stocks just recently endured an ~10% have gone on to put it in the rear view mirror in very short order, should be the impetus for investors to stay the course and for those who may have reduced their risk, to consider adding some. There are of course no guarantees and only time will tell if this year-end will turn out to be as bullish as I expect but until proven otherwise I am looking to take advantage to what appears to be a short-term very favorable investing environment.

Charts courtesy of Stocktradersalmanac.com

Looking Under the Hood

It’s been an unbelievably crazy, hectic and demanding last 6 months for me and the old voltmeter is telling me it’s time to recharge my batteries. So this will be my last post for a few weeks. I was going to just signoff this week but after doing my weekly check-in with those few trusted technicians I trust and follow, I felt compelled to leave you with a very thin slice of an excellent article “The 2014 Stealth Bear Market – A Transition or a Top?” written by Chris Puplava of financialsense.com.  He has some compelling statistics if you look under the hood of today’s market that confirmed what I believed was happening.  The market has a way of not only challenging even the most experienced but humbling us too.

Looking Under the Hood

While the small cap space is feeling the pain of this transition from high liquidity and low growth to higher growth and low liquidity, the Dow Jones Industrial Average and the S&P 500 aren’t showing the same level of volatility. While the Russell 2000 was down 4.4% through the third quarter, the Dow was up 4.6% and the large cap S&P 500 Index was up 8.3%; the NASDAQ as well was up 8.6% on a total return basis. However, the headline numbers don’t tell the full story for there is greater deterioration beneath the surface than what the major indexes performance numbers tell.

For example, the S&P 1500 is up 4.96% year-to-date (YTD) as of 10/23/2014 while the median stock in the index is down 0.15%. The NASDAQ Composite is up 6.61% YTD while the median stock within the 2557 member index is down 5.65%. The Russell 3000 comprises roughly 98% of the entire U.S. market capitalization and is up 4.55% YTD while of the 3000 members within the index the median stock is down 1.96%.

Looking at the figure above clearly shows that 2014 has been a rough year as the markets grapple with a less accommodative Fed and the prospect of rate hikes in the coming year on the back of an improved economy. Transitional years are difficult to navigate and the performance numbers from large cap active managers bear this out as nearly 85% of active managers are under-performing the S&P 500. Again, this comes down to stock picking and when the median stock is down 1.96% in the Russell 3000, while the index itself is up 4.55% YTD, beating your benchmark is hard to do.

This was made evident by a recent study done by The Leuthold Group in their October “Perception Express” in which they measured the percentage of stocks within the S&P 1500 beating the S&P 500 over a trailing 12-month basis. As of the end of Q3, only 30.2% of the 1500 stocks in the S&P 1500 were beating the performance of the S&P 500, indicating active managers had a 70% chance of under-performing the S&P 500; this was the worst reading since the technology bubble burst in 2000.

If you would like to read Chris’ entire article (which I would highly recommend) you can go here.

I look forward to seeing you back here in a few weeks fully recharged, enthusiastic and as always, ready to go.

The Dow Theory

As I sit getting ready for my exam, one of the areas I will be tested on is the Dow Theory, one of the cornerstones of technical analysis.  It is one of the oldest and best known methods used to determine the major trend of stock prices derived from the early 1900 writings of Charles H. Dow.  If the name doesn’t ring a bell, Mr. Dow is the founder of The Wall Street Journal and who created the first index/averages such as the Dow Jones Industrials, Transportation and Utilities. 

Even in today’s volatile and technology-driven markets, the basic components of Dow Theory still remain valid more than a century later. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow Theory addresses not only technical analysis and price action, but also market psychology. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did a 100 years ago.  It’s not about the market it’s about the people who make up the market.  The market may change but the people don’t.

Without going into the depths of the Theory as it would require an entire book to cover, one of the major values it provides is market buy and sell signals. While I am no Dow Theory expert, my interpretation is that a sell signal triggered last Monday.    

While there is no foolproof and perfect indicator, the Dow Theory included, it does have a very good long term track record.  The website thedowtheory.com compiled some excellent data regarding the success/failure of the Dow Theory past market signals and I would highly recommend those who would like more detail to check it out as I believe it is the premier source.

Market results after “SELL” signals were as follows:

Original (Traditional) Dow Theory SELL Signals and the further S&P500 Loss to the final Bear Market Lows*:

What their data shows is since 1953 the Dow Theory provided 25 Sell signals and 24 were followed by market declines, the average loss being 14.3%. The one signal that did not decline, that being in 2012, ended exactly where it started.

In today's uniquely managed markets, Dow Theory signals may be of little or no worth, but considering its past performance (yes, yes I know past performance is not indicative of future results) investors should heed at their own risk. As a minimum it should be used in conjunction with other analysis to determine a course of action based upon the weight of all the evidence. Right now the evidence is piling up for the bear camp. 

Royal Dutch Shell

I had an annual review meeting with a client a few weeks back and as we were wrapping it up he asked me what I thought of Royal Dutch Shell as an investment.  I commented I didn’t have an opinion but would provide one once I looked at the chart. He went on to say he was watching CNBC and (Jim) Cramer was promoting the stock.  I went on to tell him that the evidence supports that you would have had a better chance of making money by flipping a coin than following in his calls. In fact, you would have made more money if you had done just the opposite of what he said. Without skipping a beat my client said “he can’t be wrong all the time can he?” 

There have been many studies done that show that “experts” (I prefer not to get into a debate on whether Mr. Cramer is an “expert”) as a whole don’t provide better recommendations than flipping a coin.  An example of such a study is where they initially asked 3 groups to predict the future price of a security initially given 6 pieces of relevant information.  What they found was all three groups (experts, a computer and those deemed “financially unsavvy”) all performed equally, none better than a coin flip. The second part of the study continued to progressively deliver more and more relevant information about the security until they were given 20 pieces in total. What they found was quite interesting. The computer improved its ability to forecast (increased to more than 60%), the financially unsavvy had no change (stayed at 50-50) but the “experts” ability fell from 50% to near 20%. There are reasons why this happen and for the sake of brevity it’s not relevant to this post.  What is relevant is anyone listening and then acting on forecasts or predictions of the financial future will likely be disappointed.

The CXO Advisory Group (you can find more information here) provides a great service (some free some is subscription) where they deliver objective research and reviews to aid investing decisions. The thing I found most interesting is their “guru grades” (this section is free) where they assess the forecasting acumen of stock market “gurus” as a group and rank them as individuals according to their accuracy. In the paragraphs following this one, I have cut and pasted the results from their webpage. I am sure you have heard of some of the names covered but most will likely be recognizable only to industry insiders. Please keep in mind, there are always risks in drawing conclusions about individual results, especially those with small sample sizes.  What their results do illustrate (and reinforce from numerous studies) is there are a few that get it right more often than not but on the whole, you would be no better off than if you flipped a coin.  Forewarned is forearmed when it comes to listening to the noise on the financial networks and those who consistently attempt to forecast the future.

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Individual Grading Results

The following table lists the gurus graded, along with associated number of forecasts graded and accuracy. Names link to individual guru descriptions and forecast records. Further links to the source forecast archives embedded in these records are in some cases defunct. It appears that a forecasting accuracy as high as 70% is quite rare.

Cautions regarding interpretation of accuracies include:

Forecast samples for some gurus are small (especially in terms of forecasts formed on completely new information), limiting confidence in their estimated accuracies.Differences in forecast horizon may affect grades, with a long-range forecaster naturally tending to beat a short-range forecaster (see “Notes on Variability of Stock Market Returns”).Accuracies of different experts often cover different time frames according to the data available. An expert who is stuck on bullish (bearish) would tend to outperform in a rising (declining) stock market. This effect tends to cancel in aggregate.The private (for example, paid subscription) forecasts of gurus may be timelier and more accurate than the forecasts they are willing to offer publicly.

And in case you are interested … Royal Dutch Shell is down more than 10% from the day I had my client meeting.

The Trouble with Triangles

I know I lured in some unsuspecting geometry haters but this week’s blog post has to do with the chart pattern rather than the geometric shape.

The chart below is a 5 year weekly look at the Chinese Stock market ETF, FXI.  You can see while price has swung up and down as much as 30% from its mean, it really has gone nowhere over the entire 5 year period. Also, you can see since the 2010 high, price has traded within a triangle bounded by the blue trend lines. Triangles are consolidation patterns and while we try and avoid consolidation zones they should not be ignored because eventually they lead to a breakout.

Breakouts are what every investor dreams to find because they can be the start of a new trend. And trends are where investors make money, not areas of consolidation.  All patterns in technical analysis have probabilities associated with their outcome. Technicians look for the patterns with the highest probability as that logically improves investing success. The higher the probability the higher the success. Now, here is the trouble with triangles they have no edge.  They provide no statistical probability greater than flipping a coin. Because of their 50% probability of breaking either up or down, you should wait for the breakout before entering a position.  To make things even worse, if you buy the breakout, there is an equal  probability it will reverse back in the other direction.

My chart of FXI is a perfect example of what I tried to explain above and why I hate triangles.  Price broke out to the upside (bullish breakout) which pulled in new investors thinking this was the start of a new bullish trend. After a 10% rise, almost up to the prior late 2010 high, price immediately reversed and fell right back into the triangle where it sits today. Those who bought the breakout and were not prepared with an exit strategy are likely now sitting with a loss. Those who were familiar with triangles could have entered with a tight leash and may have been skillful enough to have eeked out a small gain or better yet, have avoided this investment altogether.

Now you know the troubles with triangles