The Trend is Your Friend; Until it Isn’t.
Each January, I participate in a roundtable discussion with about a dozen professionals from different sectors of the financial community. The roundtable is sponsored by the premier San Diego business journal, with the executive editor serving as the moderator. Before the roundtable comes to a close the prognostications for the economy and the markets come out and are debated quite vigorously. At our last roundtable the market call that caught most everyone’s attention was the suggestion that the Dow Industrials would do as well or better in 2010 as they had in 2009, and could even possibly eclipse the 2007 high of Dow 14,100.
As I tried to fathom what I had just heard, I noticed that heads were starting to nod with agreement. When my opportunity came to opine on the subject, I suggested we should all hit our knees in a prayer of gratitude if the markets did nothing more than to remain flat for the year.
When pressed for an explanation of my opinion, I told the group that it was important to understand two concepts: Trends; and, Time and Price. Using the simplest definition, a trend is the general direction of a market or the price of an asset. Trends can vary in length from short, to intermediate, to long term. The most often used analogy is to visualize the action of the ocean: the tide is the major or primary trend; the waves are the intermediate or secondary trend; and the ripples are the short-term or tertiary trend.
The current major or primary trend was established in 2000 with the onset of the bear market. In October 2002, the markets reversed into the secondary or intermediate trend, which is always a counter or corrective trend, until the primary trend reemerged in November 2007. In March of 2009, the markets reversed once again into another counter or intermediate trend, which is still in force today. Unless all past market history is stood on its head, however, the primary trend will reemerge one more time until it is fully expressed and exhausted.
This is where understanding the concept of Time and Price is important. Markets are like many other natural phenomena; they move in ebb and flow. Using the simplest definition, this ebb and flow is both in time and price; i.e. it takes X amount of time to move Y amount in price. Additionally, when a trend covers X amount of time and price, the counter-trend will typically take place within a fairly repetitive and predictable amount of time and price.
What is difficult for analysts to adjust for is that exogenous events, generally geo-political or economic, can alter the behavior patterns of individual market participants acting en masse, i.e. as a crowd, and can extend or shorten trends beyond repetitive and predictable mathematical points.
That being said, all primary trends are eventually fully expressed and realized, which means it is highly unlikely, albeit not impossible, that the Dow will surpass its 2007 high before it establishes its final bear-market low. In short, this is a market you want to rent, not own.
For some this may seem a contradiction to the Dividend-Yield Theory of buying stocks when their dividend-yield is at a historically repetitive high area and holding it until the dividend-yield reaches its historically repetitive low area. To those I would say you are missing an important point.
Understand that the primary trend is down and has not yet been fully expressed. Therefore, at some point, the current counter-trend will end and the broad market will head lower. When this happens, some stocks that are well into their Rising Trend (the area that is 10% above the historically repetitive low-price/high-yield Undervalue boundary) but not yet at Overvalue (the historically repetitive high-price/low-yield area), will succumb to the force of the primary trend; in other words they will retreat with the tide.
The question for each investor then will be this: Based on my investment time-horizon and my personal goals, objectives and sensitivity to risk, do I hold my position or sell it and buy back again at Undervalue?
To be sure, there are stocks that have always bucked the tide and acted independently of the primary trend of the market. Some of those stocks have been in down-trends during this entire counter-trend rally and are only now showing signs of bottoming. Counter-intuitively, those are stocks that should do well even when the rest of the market is retreating and one should consider whether those aren’t better positions to hold as opposed to current positions that may surrender substantial portions of their gains.
Whichever choice you ultimately make, you don’t have to make it today. I believe the current counter-trend rally will continue into the fall, the last two weeks trading action notwithstanding. The time will come when you do have to make a choice, however; most likely when sentiment is very bullish and the spring and summer sell-offs have become a distant memory.
To illustrate this point I have attached two graphs: The bear market from 1966 through 1974; and, the bear market that began in 2000. Note the five legs of the ’66 to ’74 bear market; three down legs interspersed by two profitable counter-trend rallies. Now look at the 2000 through 08/25/2010 graph. As you can see there have been two down legs and we are currently in the second counter-trend rally. The fifth leg, therefore, lies ahead of us. The trend is your friend until it isn’t.