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This is a guest post by Wayne Whaley (CTA):
The S&P made a low on March 9th 2009, reversed, and is coming into the final week of the year up 24.7%, having recovered almost exactly 50% of recent bear markets loss. Since 1950, all three years (1974, 2002, 2008) that were down at least 20%, have been followed by plus 20% years. The S&P will finish the first decade of the 21st century down close to 24.2%.
I am inclined to position myself with those who feel a correction is in order in the first half of the year, but that the market will post better than average returns by year end. The following is a summary of a few of the key factors swaying my outlook.
The Significance of a Selling Capitulation
One of the primary reasons I think the market should exceed expectations in 2010, is because of the importance of the selling climax that was put in place in October of 2008 and the impact that such events historically have for several years thereafter. I have studied market bottoms in the S&P 500 index going back to 1970 and found that most can be identified by a sharp climatic sell off near the end of a bearish cycle that usually last about one week. The vast majority of market bottoms over the last 40 years have at least one of three characteristics that I look for in price, breadth, or volume. That would be a five day 12% sell off in S&P 500 price, a five day Adv/(Adv+Dec) ratio of less than 21%, or an Upvol/(Upvol+Dnvol) ratio of less than 17%. These three levels are not simply drawn from thin air to fit the data, but represent a one in 1000 occurrence in each of those 3 measures.
The table below shows the nine market bottoms that occurred since 1970 that met at least one of these conditions. And yes, I realize this scan failed to pick up the 2002 bottom. If you wish to include it in the mix, it would support the bullish argument for 2010, as well. But focusing on the nine bottoms that met my criteria, the first two columns show the Date and S&P Price that the climax was established. By all three criteria, we had a classic selling climax in October 2008, followed by a couple of retest and the eventual price low in March of 2009. The middle set of columns show the performance of the S&P in the year after the selling climax, which is the sweet spot of the rally with a nice 26.59% average return.
But more importantly in regards to 2010, the last pair of columns in the table show the results for the second year after the selling climax and is bullishly significant (16.83%), as well. The average year since 1970 is up 8.0%. And it is important to note as well, that selling climaxes are normally spread out by at least a decade and the closest ones observed since 1970, occurred within four years of each other, suggesting that a major bear market in 2010 would be from a tape evaluation, historically uncharacteristic.
I have written (Mother of all Momentum Thrust Years) in the last year about the significance of breadth thrust (for more, see Marty Zweig & Ned Davis Research), and in particular, the bullish implications for at least the following 12 months for those rare occasions where the number of advances as a percentage of advances plus declines over a ten day period exceeds 0.660 (or almost 2 to 1). For the first time in my 40 year database, the NYSE experienced three such signals in one calendar year in 2009. Two of those (July 22 and September 16), occurred in the second half of 2009 and per historical precedent, should provide momentum well into 2010. The combination of the selling climax in October of 2008, followed by the three breadth thrust in 2009 are the two primary factors pivotal to my outlook.
It has often been a source of humor that the Conference Board’s Index of Leading Indicators (LEI) has correctly called 12 of the last 7 recessions, but whether it is from sheer luck, or revisions that have reportedly been made to the index, I thought one of the best untold stories of the latest economical cycle was the job that the (LEI) did in first predicting the downturn in the economy in mid 2007 and then the turnaround in early 2009. The LEI peaked at 104.6 in July of 2007 and declined steadily until bottoming at 98.0 in March of 2009 and has since had 8 consecutive strong monthly increases (November 104.9).
The trend in LEI, suggest that earnings should continue to improve over the next couple of quarters. The earnings forecast by Standard & Poor’s shows that in spite of the encouraging economic guidance provided by the LEI, they, along with most analyst, have vastly underestimated earnings for three straight quarters. Earnings that exceed expectations have been shown to be conducive to higher equity prices. I see no reason to assume the pattern will change in the next 12 months. I expect 2009 S&P earnings to come in near 50 (Is This Market Cheap after 50% Rise?), putting the 12 month trailing P/E at 22ish. My studies indicate that this is a reasonable P/E given extremely low levels of interest rates.
The 2004/2010 Comparison
Although there are obvious differences in the economic setting, the end of 2009 has some similarities to the end of 2003 that are worth noting. At the end of 2003, we were 15 months from the market bottom set October 9th, 2002, that followed a 28 month selloff that was 49% in magnitude. The 3 month T-bill was yielding 0.91% and the 30 year bond was 5.07%, resulting in an abnormally wide 416 basis point spread, all somewhat similar to today. The market was up a respectable 9% in 2004, and although I acknowledge that we are further off the bottom than at the end of 03, we also had positive years in 2005, 2006 and 2007 on our way to retesting the old highs.
What keeps me from having a “slap myself in the face” bullish epiphany is that the contrarian side of me is unnerved by the Investors Intelligence polls showing a current 3 to 1 ratio of bullish to bearish market newsletter writers. This suggest there is too much complacency. However, the retail investor is usually the last to show up at the party and I have taken solace in the fact that they have been net bearish for most of the year. Sentiment numbers from the Association of Individual Investors (AAII), show that individuals have just in the last couple of weeks turned net mildly bullish. And, although sentiment polls are important, a stronger indication of an individual’s perspective is what they do with their money, as opposed to how they answer a question in a survey. Mutual funds are the retail investors avenue into equities and there is statistical evidence that some $11 billion was withdrawn in 2009 from equity mutual funds. At the same time, investors plowed $357 billion into fixed-income funds.
Besides sentiment, there is the list of usual bearish suspects. I am fully cognizant of the housing collapse that exposed inept lending practices and led to the banking crisis, which then led to higher debt, which led to a declining dollar, all of which contributed to historically high unemployment. These concerns are legitimate. The bearish variables instigated by the banking crisis will eventually come home to roost, but can be mitigated for some time as the Fed continues to print money and push financial responsibility for current ills upon our children. The bulls tend to take refuge in these events as they provide the needed “wall of worry” that bull markets historically prefer to climb. I am inclined to agree with them and find myself embracing the previous observations that suggest that although the easy money has probably been made in this rally, we should be able to squeeze at least one more decent year out of the current upward trend.
The bullish sentiment numbers suggest that a shakeup is in order. We should get a double digit correction at some time in the first six months of 2010. This selloff will likely come at an unconventional moment, possibly earlier than many market timers expect. Given that the bear market of 2008-09 is still fresh on investors minds, this correction should lead to a swift shift in sentiment, shake out the weak hands, and lay the foundation for another push up in the major indexes. I believe that equities will have a normal market year in 2010 with 3-4 down months mixed in but a positive net conclusion, likely of the double digit magnitude.
Factors that Could Change my Outlook
- The S&P is currently up 25% for 2009. In years where the S&P is up more than 10% going into the last week of the year, the market has been up 27 of the those 29 last weeks (End of Year Seasonality after 10% Gain). The Nasdaq has never had a losing week (21-0, since 1971) in this situation. A weak end of the year, given such bullish tailwinds should be interpreted as a sign of potential weakness (ala,1973, 2007).
- A failure of Santa to arrive to Wall Street would be reinforced by a down beginning to the 2010 year. Although the January Barometer posted a major failure in 2009, the last 11 months of the year are 32-4, when preceded by an up January. January’s that are up at least 4% are 19-2 in forecast accuracy. If I’m long equities, I’ll sleep a little more comfortably if January finishes positive. As a side note with little significance, the last time we had three straight down January’s was 1969-1971.
- Since the economy is of primary concern for equities at this juncture, any indication from the LEI that the economy may possibly turn over again would draw my attention. The current LEI is 104.8 (revised). A move below 103.0 would give me reason for concern.
- Any signs from the tape that the market is confused. Short quick unified pullbacks are normal in bull markets, but periods where large percentages of stocks are going in different directions is concerning. For example, large numbers of stock making both new 12 month highs and new lows over a ten day period would give me reason for concern.
- Some of my recent research (What do Interest Rates Rising from Zero Mean for Equities), suggest that contrary to popular perception, when interest rates are extremely low, lower rates are usually symptomatic of deflationary concerns, which is a very nonconstructive environment for equities (1928-40, 2001-02, 2008. Given current trends in inflation, commodity prices, and company earnings, I am of the opinion that deflation is not in the cards for 2010, but if the current 30 year bond (4.55%) were to drop below 4%, I would start taking notice. Recall that in 2008, the 30 year bond got as low at 2.8%. Confirmation by a shift in CPI or commodities would be alarming as well. If I am long equities, I want to see interest rates, leave crisis mode levels, and slowly return to what would be considered accommodative (T-Bills 1-2%) levels.
- And last but possibly most important, if I receive almost unanimous comments agreeing with my outlook, I would have reason to consider reducing my equity exposure. Please, feel free to disagree.
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