2016 – 1st Quarter Letter – Technical Analysis
March 29th, 2016
Dear Friends and Clients,
What just happened?
Believe it or not, the markets have been less volatile in the last 5 years than in the last 10…less lumpy as we like to say. As per usual, there’s something interesting going on. The price action we’ve seen over the last 12-15 months has set up a number of textbook patterns: lower highs, higher lows, a double bottom, potential pennant….just about everything but the inverted Batman pattern. I promised myself early on that I wouldn’t populate these letters with a lot of graphs. They don’t work for everyone, but sometimes it’s a little better when a picture tells a story (apologies to Rod Stewart.)
Above is a daily graph of the Dow Jones Industrial Average from 1/1/15 to 3/29/16. Kind of looks like a cross section of the Rocky Mountains doesn’t it? P&A would consider the volatility described by this graph to be “light to moderate.” Nonetheless, this kind of see-saw action has been known to drive clients batty. The simplest remedy for being financially sea sick is Nowledge (you know, like the “N” on the helmet?) Fundamentals are important and knowing if the market is going up or down is one of them. Believe it or not, this is a skillset in itself and is often the source of argument amongst professionals. We have found that if nothing else, understanding the origins of these lumps is often enough to keep nervous investors long term…..the only term.
Technical research is a method of projecting future market movements by studying historical price action. We do not hold ourselves out as technicians, but have maintained more than a passing interest in the subject for the last 46 years. Most technicians concentrate on the short term, looking for trades that create quick profits in order to sell newsletters and hotlines. The technical work we covet the most is long term trend following….the direction of the market. Surprisingly hard to do, we liken it to reading uphill and downhill putts. It’s a lot easier once you’re able to recognize the presence of a hill. This became less challenging for us when we accepted the fact that based on calendar year results, the market goes higher 67% of the time and lower the other 33%….currently under repair on our website.
Is There a Correction in the House?
As mentioned earlier, the lumps the market has generated since last May provide an interesting setup. We don’t know how things are going to resolve themselves but we haven’t gotten bucked off yet. Events have been orderly, we did some loss trading during the correction, as well as point out some advantageous entry points for our cash-heavy clients. Hardly fiddling while Rome burns.
The graph on page 1 describes the Dow Jones over the 12 months prior to the date of this letter. At this writing it describes what looks like a typical market correction. The market starts at a high water mark and then makes two very similar lows. As we explain P&A’s technical take on a scenario like this, keep in mind that we are long term investors and firmly believe that the market always wants to revert back to that 67/33 mean. Since we eat our own cooking, the following numbers have been real time condiments for all of us:
5/19/15 Recent & all-time high 18,312.39
8/25/15 The next low 15,666.14 -14.5% from all-time high
11/03/15 The next high 17,918.15 +11.4% off the 8/25 low, -2.15% from the all-time high
2/11/16 The next low 15,660.18 -12.5% from the 11/03 high, -14.5% from all-time high
3/29/16 Recent close 17,592.09 +12.3% off recent low, -3.9% from all-time high
- Bear markets are followed by bull markets which eventually give way to new bears. The space between a bear and a bull is called a trough and is characterized by a low or a bottom. The space between a bull and a bear is called a peak and is characterized by a top or a high. For the last 120 years this bear/trough/bottom/bull/peak/top routine has been moving from lower left to upper right across the X/Y axis of a price/time graph. Quoting our friend Jack Schannep, “when a market rallies 19% off a previous low, it can be expected to rise 93% of the time, generating an average return of 29%. Likewise, a 16% retreat from a previous top generates a -24% bear in 70% of those events.” Our own experience has confirmed this +19/-16 phenomena.
- During periods of higher stock prices, the market holds more risk but for some reason will still attract emotional buyers….excitement and greed are the main culprits. Short term players adding to positions at market peaks can find themselves “high centered” when the market crests and then retreats. These high water marks eventually become areas of resistance.
- As prices decline, emotional sellers will appear. This is a phenomenon common to all markets but catches a lot of publicity in the stock market. Certain that an abyss is ahead, investors flee, or in some cases become short sellers as prices decline and risk is removed from the market. Why lower prices should frighten long term investors has always been a mystery to me, but it happens. Think of the trough sellers as shipwrecked….eventually these levels become support. We all look at life through our own lenses and since I am surrounded by long term thinkers at P&A, weak hands that dread holding through a full cycle seem very odd to me….think fear and anxiety.
- Eventually, nouveau sellers will exhaust themselves and more committed investors will emerge. Both sides consider their counterparts foolish and find solace (think smug) in their own actions. Like water seeking its own level, buyers and sellers try to find equilibrium along this 67/33 move towards higher prices. Pundits call a market like this “range bound,” and it is not unusual for prices to zig-zag between support and resistance for extended periods of time. That’s probably what’s going on currently.
- We view the current market action as a short term correction, a 10-15% price change contained by a long term bear or bull (a bull in this case). Our 67/33 relationship forms a probability. The complement of a probability event is all the outcomes not defined by the event. If you roll dice and get a 5 and 6, the complement is 1,2,3, and 4. Together the event and its complement make up all possible outcomes… 67 & 33 are complements. If you could roll dice and achieve event probability of 67%, the world would be your oyster. A bear -16 and a bull +19 are reciprocals. 100 x (1.00– .16) = 84. 84 x (1.00+ .19) = 100. Technicians would have us believe that the knowledge of these numbers is all we need to achieve success. The reality is modestly different. What we have is a significant long term probability, governed by an easy to understand set of reciprocals. Unfortunately, it is constantly being attacked by investor emotions and the media…..nattering nabobs of negativism as Spiro Agnew and William Safire would say. So, let’s apply this paradigm to our current market’s most recent defining price action:
05/02/11 Recent high 12,807.36
08/10/11 Bear -16? 10,719.94 -16.3%….birth of a bear?
10/03/11 Trough 10,655.30 Not much of a trough
02/03/12 Bull +19? 12,816.65 +19.6% off Bear -16, a new bull?
05/19/15 Next & all time high 18,312.39 +42.0% off bull market threshold
- As you can see, the trough associated with the 10/03/11 bear was a bit of a dud….fine with us. We are dealing in probabilities and averages, both art forms not sciences. Using our -16/+19 thresholds, the average bull market lasts about 3 years and delivers gains in the +111% range. The average bear hangs around 16.5 months generating a -33% in price pain. Once again, investors get about 2 – 3 times as much bull as bear (dig it). During this recent trough we had a pretty good sense of what was going on and used the opportunity to rebalance, loss trade, encourage clients to fund their accounts and stay put long term. Those of you that got nervous (there weren’t that many) were encouraged to relax and stay the course. We didn’t lose very many during this period and it’s a good thing, because the ensuing bull was pretty good, an 18,312 top off a 10,655 low….up 72%. We’re not clairvoyant, but since probabilities favored being fully invested we stayed put. “Dance with the one that brung ya,” Darrell Royal and Shania Twain would say….both more interesting than Agnew and Safire. So far, the volatility that has been gnawing at your gut since 1/1/15 is a short term correction in a bull market. The price action that put the bovine in control was completed on 2/3/12 and we haven’t had a bear sighting since.
The educated reader will notice that these highs and lows along with the -16/+19 and 67/33 moves are elements of the Dow Theory, originally penned as a series of Wall Street Journal editorials and published by Charles Dow in the late 1890s. He likened repetitive market activity to the wave actions generated during high and low tides. His work has survived the test of time and we thank him for it. If you would like to know more about the Dow Theory, feel free to Google or give us a call.
One More Wrinkle….
In the grand scheme of things, all these numbers are a lot less important than a technician might think. Our task is to build your net worth and fulfill your goals and objectives. In order to do so we need to stay long term in our vision and keep you from getting bucked off when things get lumpy. So let’s take a look at how market activity is reported to you and how it impacts your pocketbook. There are some surprising differences between the two.
Here’s a numerical graph of the Dow Jones Industrial Average during my lifetime….a good long frame of reference. The X axis spans time while the Y axis describes changes in the value of the index. Although price weighted, the Dow does not move in dollar increments. The index is the price sum of all the components divided by a factor which adjusts for corporate actions (splits, stock dividends, spin-offs, etc.) This is the index and daily change reported to you on the internet, neon signs, and TV.
Now comes the same graph using relative instead of numeric changes. Once again, the X axis describes time while the Y axis reports changes in percentile or logarithmic increments. We can produce this graph using the S&P 500 (market cap weighted) or any other popular index; it will look virtually the same. This graph is a much more accurate description of what happens to your pocketbook and net worth during short term market fluctuations and over long term holding periods. This presentation is much less sensational and enjoys no popularity whatsoever. You have probably never seen it before and unless reproduced by us, it is unlikely you will see it again.
There are a couple takeaways here. First of all, let’s agree on the utility of an index. The Dow is price weighted and the S&P used to be market cap weighted (float weighted since 2005). Both are benchmarks….nothing more, nothing less. They do not describe how anyone manages money and offer their best utility in detecting market direction….you remember, uphill or downhill? Secondly, accumulating net worth is a long term process and has little to do with short term market vagaries. Thirdly, fulfilling long term goals and objectives is much easier said than done and P&A telling you to stay the course may not be enough incentive to do so. Take another look at the above graphs. All of our preaching notwithstanding, they both move from lower left to upper right across the page. This is an engine all of us must harness in order to be successful. If we haven’t convinced you yet….stay tuned, we’re not done trying.
What If We’re Wrong?
Our careers have spanned at least seven legit bear markets. The worst started in 1972 and ended in 1975. I was green behind the ears and didn’t know sick’em about market behavior at the time. My clients said they lost money but they really didn’t lose a dime. I worked for a bank in those days and we didn’t sell stocks…just bonds. The only way to really lose was to sell and hide the money in a tin can but nobody wants to hear that from a long haired kid. I got the point…. people don’t like seeing the market value of their securities drop.
I added technical analysis to my arsenal of weapons and learned more about my trade. The next bear arrived in 1976 and lasted until July of 1980. Timing is everything, I started my Dean Witter career in January of 1976. The bull market of ’82 gained 345% until it hit the wall in 1987 featuring a true catharsis…..a climactic 508 point down day. For some reason we didn’t get fired by many people….I was curious. Most of our business was still fixed income and our equity investors seemed to understand business cycles. There’s a good chance they were better at what they were doing than we were. It’s interesting that even in those double digit interest rate days, the equities held a moth to flame attraction. I bought books and watched as much financial TV as I could. Those were child rearing years and life was pretty much home, church and work….plenty of time to study. My after-tax portfolio wasn’t doing too well but my retirement accounts grew like weeds.
Dan left NBC and came to work with me at Dean Witter in 1985. We were part of Dean Witter’s institutional bond department and our job was to cover institutions and high net worth individuals. Muni bonds sported 12% yields and Treasuries peaked at 17%; we could miss-dial and sell bonds. Dan was full of hustle, on his first day he opened two or three new accounts as well as one for himself. I’ll never forget the first investment he made in his own account, he asked me for a stock ticket and bought Cat Tractor.
“Why are you buying Cat?”
“Great company, P/E of 8, always wanted to own it and now I get paid to sell it to myself.”
Pretty good answer. I bought some Cat myself and began mentioning it to my individual clients….we all made money. Owning stocks has always been more fun than owning bonds but the returns were lumpy (did I mention that?). In the late ‘70s, I’d figured out how to do bond swaps but didn’t have a similar routine for stocks. Commission rates were too high, ETFs hadn’t been invented yet, and individual stock returns weren’t as linear as bonds. Interestingly enough, our equity business continued to grow. At the time, we were comfortable with bonds but didn’t feel like we offered clients any unique expertise with stocks. Dean Witter sent us to schools and we both pursued CFP designations….our business grew and our retirement accounts were busting at the seams….I continued to scratch my head.
The ‘90s were a great decade for stocks and tough sledding for bonds. The Dow grew from 2,500 to 10,000 while interest rates fell from 17% to 5%. This was the dotcom craze and the stock market was likened to the roaring ‘20s. Business was great, but almost overwhelming. Operationally, Wall Street was still in the ‘60s and it was really hard to keep track of an investment portfolio. I felt like we were holding the hose about 10 feet from the end. The Baby Boomers were hitting the ball out of the park and their parents were in definite need of investment savvy. We always worked on Saturday mornings, posting our sales logs and researching securities. One of those mornings our collective light bulbs went off. All of us have a sixth sense; we applied ours to sizing up our clients. We didn’t do too well with the flashy types but the bib overall and Dockers crowd recognized us for what we were….long term straight shooters. We noticed that when the short term got lumpy, our clients had a tendency to tail us up…a phenomenon that was a little puzzling and didn’t occur within our peer group.
It took us awhile, but we finally figured out that our lack of short term sizzle was not considered a minus by our clientele. Eventually we became introspective and took a look at the difference between us and what Dean Witter wanted us to be. It was pretty stark. Instead of short term trades and high commission packaged products, we were fashioning long term portfolios and generating fractional sales credits. P&A was waiting in the wings for us although we didn’t know it until 1994. The roller coaster rides over lumpy markets finally taught us it was silly to work in a 67/33 environment and not capture the 67. We broke the retirement account code when it finally dawned on us that those accounts were always fully invested and long term. We probably will be wrong short term but it is unlikely we will be wrong long term. I can see clearly now, the rain has gone (thank you Johnny Nash). Taking the long view isn’t the stuff that genius is made of, but it compliments probability and reduces emotions. It has worked for us for a long time and we wish we would have found out why earlier than we did….we’d have a lot more money.
The World According to Pitt and Dan….
At the current time, interest rates are historically low with overnight money worth nothing. In Japan and Europe, the central banks are charging their constituents for holding deposits. Dividend yields exceed the returns on five-year corporates. Inflation is less than 1%.
Flat market or not, this is a very expensive time for equity investors to be sitting on the sidelines. Picture yourself as the portfolio manager for a large mutual fund….$100 billion or so. When overnight rates were 5% you could go to cash with 20% of your fund and still earn $1 billion while hiding from the market. Today that option is not available. Being behind the 8-ball by that amount of money is not a pleasant experience. The bravest of the brave, hiding from the market in this fashion, will be spooked back into stocks during fairly minor rallies.
P&A would fit in the mold of a “long-only” manager. We prefer to be fully invested at all times and take what the 67/33 market will give us. All our scars are real. Over the 46 years we have been in this business we have tried to make it to the altar with long/short funds, timing disciplines and alternative investments….no joy. Each time our love affair with common stocks and investment grade bonds has prevailed. Still, the technical analysis we have been sharing with you helps us answer the trend-following questions that are always creeping into investor minds. Remember those uphill/downhill putts…the first thing you have to do is recognize the hill.
Here comes the punch line. We think the market will continue to trade higher over time. It is a market of individual stocks, not a monolithic index. Consider it a collection of living and breathing companies that employ people who have pride in their work and want to leave things better than they found them every day. We look for companies with world class management, best of breed products, established lines of distribution and competitive advantages that form a protective “moat.” None of these holdings is exempt from volatility, but most generate their own gyros… kind of like a bicycle wheel or a spiraling football. That being said, the growth cycle of a stock is not forever so when our holdings start to disappoint we are open to culling them from the herd and finding replacements. Our strategy is not “buy and hold.” It is however “fully invested and long term.” With any kind of luck we will find the bullet proof, rock star, tough guy stocks that fit John Cameron Swayze’s old saw about Timex watches… ”They take a licking and keep on ticking.” At the current time we really like equities.
James S. Pittenger, Jr, Dan Anderson