With a long holiday weekend upon us and just four months left in the year, we thought it might be a good time to take a step back from the blinking screens and do a thorough checkup of the really big picture. In short, we want to summarize where we stand on the macro issues, the economy, what we expect to see next, and our current general investment strategy. And since this represents an awful lot a lot of ground to cover, let's get right to it.

Our Macro Themes

Before we get started, let me say that some of this will sound familiar as we have discussed many of the issues in prior reports. However our goal here is to create one succinct report to let you know where we stand. First, let's look at our macro themes.

There are five major themes in our macro view of the stock market at the present time:

• Current Secular Trend: Bear Market in U.S. Stocks
  
• Current Rally is a "Mini Bull"
  
• U.S. Recession Ending
  
• Go Global
  
• Manage Risk at All Times

Secular Bear Market in U.S.: We've touched on this topic several times in the past, but to review, a secular bear market is a multi-year (think 10 years or longer) period of negative returns in a market. Unfortunately, most investors have never heard of this concept, let alone experienced it, as the last secular bear market in the U.S. stock market ended in 1982. The exact starting points of such market cycles usually require a healthy dose of hindsight. Examples of prior secular bear market periods in the U.S. (as defined by Ned Davis Research) include: 1966 – 1982, 1929 – 1942, and 1906 – 1921. And for a more recent example, one needs look no further than the Japanese stock market since 1989.

Some analysts argue that the current secular bear in U.S. stocks began in 2000 while others point to the 2007 top as the starting point. The charts of the S&P and NASDAQ make both arguments fairly well. We'll agree that the secular bear in the NASDAQ definitely started in 2000. However, we can see both sides of the argument in the S&P 500.

S&P 500 - Monthly Prices:

NASDAQ Composite - Monthly Prices:

If the charts don't convince you, perhaps a quick review of the total returns for the S&P, NASDAQ, and the Lipper Growth Fund index will. Below are the cumulative returns of each index since the new millennium began (S&P and NASDAQ results employ price only index returns):

Cumulative Returns From 2000 Through 8/31/2009   S&P 500 -29.73% Lipper Large Cap Growth Fund Index -42.31% NASDAQ Composite -60.20%

 

No, that's not a mistake. If you had plunked $100,000 into the Lipper Large Cap Growth Fund Index on New Year's Eve 1999, you're account value would be something on the order of $57,690 as of the end of August. And for those tech aficionados out there, you will still need to see the NASDAQ run up +151.27% from Friday's close to get back to the 2000 high of 5048. In short, THIS is what a secular bear is all about.

The mutual fund industry would have you believe that you should invest for the long term and "stay the course" through thick and thin. However, we're going to suggest that 9.5 years IS long-term. And since investors are still sitting with a fairly large loss over that period, it might be a good idea to admit that the concept of buy-and-hold is something best suited for secular bull markets.

It is our opinion that when you find yourself in a secular bear you need to change horses. Forget buy-and-hold and instead, consider implementing a buy-and-sell approach. In addition, it is vital for investors to understand that you MUST manage risk. Remember, there is no law that states you need to remain fully invested during bear markets. Thus, we'll suggest that investors may want to have an exit strategy at all times during a secular bear market environment.

However, don't despair because although this is a secular bear, there ARE great opportunities for profit available. It's just that this type of environment requires a different approach than blindly buying and hoping for price appreciation.

It's a Mini Bull: Speaking of profit opportunities, we've also spent a fair amount of time in our weekend State of the Market reports opining that this is likely a "mini bull market." To review, in light of the fact that we define the primary market cycle as a secular bear, we will classify the countertrend moves within the big cycle as "mini" market cycles. This is due to the fact that the "mini" moves are shorter in duration and eventually give way to the overriding major market cycle.

There are a good many analysts who suggest that the U.S. has not entered into a new bull market. For example, Paul Tudor Jones, who is a legendary hedge fund manager, told clients this week that the current run for the roses is simply a bear market rally. In addition, Lowry's – a well respected technical shop with a long and enviable record – also refuses to label the current fun in the summer sun as a bull market.

From our perspective, this is simply a matter of semantics. In our humble opinion, it is hard not to classify a blast of +52% in the S&P 500 over a 5-month period as at least some sort of a bull market. Hence our incorporation of the term "mini" bull market.

History shows that there have been several "mini bulls" that have occurred within the scope of a secular bear market. From studying such periods (1929-30, 1938, 1970-71, 1974-76, 2002-07), we can glean that the average gain seen in these "mini bull markets" has been +65.3%. We also note that the average duration of the four mini bulls (we're excluding the 2002-07 case here) has been just under a year at 343 calendar days.

However, we should also point out that in light of the fact that the market has advanced at such a rapid rate over the first 5 months of this "mini bull," we should expect the rate of the ascent from here to moderate. So, in short, the so-called "easy" money has probably been made during this cycle.

U.S. Recession is Ending: Actually, this statement should read: The recession in the U.S. has ended. As we reported in June, all nine of the economic indicators we follow have signaled an end to the economic downturn.

What does this means for investors? History (and the computers at Ned Davis Research) suggests there is usually about a six month window of opportunity before the stock market fully discounts the economic recovery. And it is for this reason that stocks can advance in the face of ongoing bad news such as Friday's report showing the unemployment rate hitting a 26-year high.

A primary argument for this window of opportunity has to do with inventory restocking. With the economy improving, businesses are beginning to restock their shelves in preparation for better times ahead.

However, once this cycle plays out, it will be up to the consumer to carry the bulk of the load for economic growth. So, the consumer has a quarter or two in order to get in a better mood. But if the shop-till-you-drop game has indeed ended (many economists are predicting a secular shift amongst consumers from free spending to an era of thriftiness and savings), this is where the bears could start to make a comeback.

Looking strictly at history, the folks at Ned Davis Research tell us that following the end of recessions, the stock market has been higher six and twelve months later in nine out of ten cases, with average gains of 9% and 14% respectively.

Go Global: It is also important to recognize that the current "mini bull" market is global in scope. In fact, of the 42 global stock markets, every single one is currently above their 40 week (or 200-day) moving averages. Talk about a "global market!"

We also believe that while a global bull market is tough to achieve without the United States participating, current and future bull markets may not be driven by the U.S. alone. As such, we need to recognize that countries such as China, which has positive economic growth and no real exposure to the credit crisis, will be the world leaders going forward. Therefore, limiting one's investment exposure to just the United States would mean ignoring some of the best opportunities around the globe.

Another argument that favors global markets in general and the emerging markets in particular is that many emerging markets remain in secular bull market trends. Thus, the recent bear was really more of a "mini bear" within the context of a secular bull.

It is for these reasons that we want to be sure to develop portfolios that are global in scope whenever possible.

What To Watch For

Given that we see the current rally as a "mini bull" and that such trends usually give way to another trip to the dark side, this is no time to be complacent. Remember, on average, this type of bull market cycle lasts about a year. However, it is important to realize that since our sample size is small, the use of averages can be dangerous. For example, the mini bull that occurred from November 1929 through April 1930 lasted just 5 months. Then the mini bull of 1938 was only 7.5 months long in duration. Whereas, the 1970-71 affair was 11 months in length and the 1975-76 version lasted 22 months.

The point here is that now is the time to start thinking about your exit strategy. No, this does NOT mean that we think we're heading lower from here or that it is time to sell. However, it DOES mean that you should have a strategy for leaving the party.

Our basic game plan for the current market is to make as much money as we safely can and then get the heck out of the way! So, here are some of the things we're watching for which could lead us to start becoming concerned about the bears again.

• Overvaluation: This is obviously a controversial topic, but we'd look for a "normalized P/E" near 22 to be a sign that it might be time to start looking for the car keys. (This would be somewhere in the 1200 to 1320 range on the S&P 500)
  
• Extreme Optimism: Also hard to measure, but remember, "The crowd is right in the middle and wrong at both ends." Thus, we will be watching our sentiment gauges carefully for signs that investors have become fully invested.
  
• Tape Deterioration: Market tops are usually accompanied by divergences between the internals (A/D line, new highs vs. new lows, etc.) and price. This means that although the indices continue to rise, the technical health tends to deteriorate at important market tops.
  
• Rising Interest Rates: The cliché "Don't fight the Fed" really means to avoid fighting the tape when interest rates are rising. The bottom line here is that interest rates will rise at some point in time for a myriad of reasons. And when this starts to happen, we'll want to ask someone to pull the car around.
  
• Resumption of Credit Crisis: Remember all those "toxic assets" that put the banking system on the brink of collapse earlier in the year? Well, they are still out there. And now we're seeing problems in both the commercial mortgage and prime mortgages markets. Suffice it to say that if defaults start to rise, the banks could go back into a downward spiral. In which case, we could very well see déjà vu all over again.

A Quick Review

To sum up, we believe that we're seeing a "mini bull" rally within the context of an ongoing secular bear market. It is likely that the bulls could run for a while longer but that the pace of the advance is likely to be slower from here. We believe that the recession has ended in the U.S. and that stock prices are currently discounting better days ahead. However, if the consumer doesn't step up in a reasonable period of time, the economy could languish, which could lead to a resumption of the primary cycle. We believe that investors need to look beyond the shores of the U.S. for investment opportunities as there are many countries that ARE growing and did not get into the mortgage derivative game. Next, given our premise that this is NOT the start of a new secular bull market, we need to have an exit strategy in place and we have laid out some things to watch for. Thus, our current game plan is to make as much money as we safely can during this phase (i.e. we are not terribly concerned about keeping up with the indices at the moment) and then get the heck out of the way when the bears return.

Wishing you all the best for a profitable week ahead,

David D. Moenning
Founder TopStockPortfolios.com

Positions in Stocks Mentioned: None

 

TSP Chart Review
S&P 500	NASDAQ

 

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