Many investors believe that the most important part of their investment strategy is being right about what will happen next in the market. However, while being right can be an incredible boost to the ego and make you very popular at cocktail parties, as an observer of the markets since 1980, I can say one thing with absolute certainty; nobody is right year in and year out. And as Ned Davis is famous for saying on the topic, “It isn’t about being right, it’s about making money.”

Thus, if you want to be successful in the markets, you’d best figure out a way to deal with failure. I know it’s an overused cliché but as is the case with professional baseball players, failure is just part of the game. So, just as baseball’s best hitters will fail to reach base more than 60% of the time, a money manager knows that he will have positions that are “wrong” each and every day he walks into the office.

So, this weekend I wanted to spend a couple minutes objectively asking the question: “What if we’re wrong?”

The Premise

If you’ve read any of our weekend missives over the past three months, you probably know that we’ve taken a pretty strong stance about what we believe is happening in the market and also about what we expect to see happen over the course of the next 6 months or so. And frankly, I’m fairly confident that many are growing tired of hearing about the idea of a “mini” bull market occurring within the context of the secular bear market that has been going on since 2000.

However, what we haven’t spent a lot of time talking about is the “why” behind our market premise. And as anyone who knows me at all will attest, I’m very big on understanding why things happen the way they do in the stock market.

So let’s review. For starters, we believe strongly that the final leg down in stocks that occurred from early January through March 9th was the market’s way of discounting the potential for financial Armageddon. There was fear that the banks would need to be nationalized and a run on both the banks and money market funds was a single headline away. Thus, traders knocked stocks down to levels not seen in more than a decade in response to the uncertainty of what might come next.

However, everything changed once bankers reminded us that they were making money with the yield curve set up to borrow at 0% and lend at 5% and the mark-to-market rules were modified. Suddenly, Armageddon was off the table and the talk turned to the “green shoots” of recovery.

Thus, the next part of our premise for what has transpired is that the rally from March 10th through early the end of April was the removal of what we’ll call “the Financial Armageddon discount.” One look at the charts makes it very clear that the rally into April simply took the Dow and S&P back to the levels seen during the late-October through December 2008 period.

From there, traders, economists, and analysts alike stopped focusing on the banks and turned their eyes to the economy. And with some signs of improvement beginning to show up in April and May, the idea of the recession ending became the common theme of the day.

The big rally from the March low into early May pushed the indices up enough to trigger a bunch of very long-term and very reliable buy signals. Thus, by May, we were looking at a new bull market of sorts. However, based on the debt levels in the economy (which are still off the charts!) and the likely change in consumer attitudes in the wake of the dive in home values and 401(K)’s turning into 201(K)’s, we felt that this was not 1982 revisited. Thus, we got behind the “mini bull” concept. I.E. a strong rally within a longer-term bear market.

Although there have not been a great many instances in the U.S., there HAVE been periods where mini bull markets existed within the context of a secular bear market. And while we won’t bore you with them all, the best examples include the 1966 – 1982 period in the U.S. and the 1989 – present period in Japan.

The Next Leg Higher?

So, with the “Financial Armageddon discount” fully removed, a new bull market underway, and investors focusing on the economy, our premise then suggested that stocks would head higher once the data began to indicate the recession was ending. With all the doom and gloom out there, we felt that the vast majority of investors may not be able to see the positives that were beginning to develop – which would lead to higher prices once the more upbeat data began to flow.

You will probably recall that on May 17th we wrote a report entitled, Is the Economy Rebounding Now? in which we detailed a handful of indicators already pointing to an end of the recession. In that report, we highlighted five indicators designed to call the end of recessions. There were actually a dozen indicators we were watching and the good news is that as of two weeks ago, all twelve have now signaled an end of the recession.

Thus, we felt the next leg higher in stocks would likely be triggered by the reality that the recession had ended. And given that the stock market almost always overshoots in both directions (think tech in 1999 and then the March 9th lows) our thinking was that there might be some buying when signs of actual improvement showed up in the market.

Please keep in mind that the mind games being laid out here don’t necessarily drive decisions to buy are sell on a daily basis. But from a big picture standpoint, remember that mutual funds had obviously raised cash last winter to cover redemptions and an improvement in the economic picture might cause funds to put some cash back to work. Remember, it is really tough for a big fund to outperform during a bull run if it is sitting with 15% on the sidelines.

As an example, we found that the American Funds Growth Fund of America has been busy putting cash to work and had cut its cash holdings by about 4% from the end of March through the end of May. However, it is important to keep in mind that the fund still has 13.6% in cash. So, if the economy looks like it is going to improve…

The Revenge of the Bears

Looking farther into the crystal ball, our thinking was that once the mini bull matured (remember, the average gain for a “mini bull” is +65% over a 12 month period) the bears were likely to return. We figured that stocks might overshoot to the upside but that as the momentum from the not-so stimulative stimulus package wore off, reality would set in.

Given that the consumer isn’t likely to return to “normal” (meaning the free spending ways of the last 15 years) any time soon and that Corporate America won’t be able to leverage up their balance sheets anymore, our thinking is that the recovery in the economy will be subpar – and remain that way for a fairly long time. And because of this, the bears would likely begin to growl again at some point in 2010.

Could We Be Wrong?

Returning to the theme of this week’s missive, the question is: How can we be wrong here?

After some spirited debate, we believe the most likely fly in the ointment lies in the concept of the next leg higher based on an improvement in the economy. In light of the fact that the stock market is a discounting mechanism and that investors are very good at planning for what just happened, we feel there is a decent chance that the end of the recession may already be “baked in.” Therefore, the focus may already be shifting to the weak recovery. And if this is the case, the upside from here may be limited.

We should keep in mind that a rally of 40% in a little over three months is NOT normal and that regardless of the reasons behind the rally, the move has left the bulls vulnerable to disappointment.

So, what if we’re wrong and we don’t see another leg higher? What if we’re wrong and the “mini bull” has already run its course?

In short, THIS is why we employ risk management techniques. THIS is why we write the Daily State of the Markets – to try and identify the drivers of the action on a daily basis. The goal is to try and avoid any and all surprises. Thus, THIS is why we don’t manage money based solely on our premise! Because nobody – repeat, nobody – gets it right all the time.

So, as Ned Davis says, this game isn’t about being right – it’s about making money. Therefore, we will continue to watch the action closely and we will not hesitate to take defensive action when it is again warranted. And while we could be wrong on this idea also, we feel pretty strongly that there WILL be a need to manage risk again within the next year.

Wishing you all the best for a profitable week ahead,

David D. Moenning
Founder TopStockPortfolios.com

Positions in Stocks Mentioned: None

 

The Week in Review   Week Month YTD Dow Jones Industrial Average -1.19% -0.73% -3.85% S&P 500 Index -0.25% 0.03% +1.73% NASDAQ Composite +0.59% +3.60% +16.56%

 

TSP Chart Review
S&P 500	NASDAQ

 

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