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Bull Markets Do Not Die From Old Age

The last five months have been great ones for the market, with all the major indexes powering relentlessly upward, and many individual stocks doing even better. For most of that time, everyone was happy just to hang on and make money—after all, that’s the goal of investing. But sometime in...

The last five months have been great ones for the market, with all the major indexes powering relentlessly upward, and many individual stocks doing even better. For most of that time, everyone was happy just to hang on and make money—after all, that’s the goal of investing. But sometime in the first few weeks of January, things started to look a little too good … and analysts collectively seemed to think, “If it looks too good to be true, it probably is.” Every day, our Digest contributing experts were urging caution:

“I have never been one to complain when my screen turns green, but I’ll stick to what I said last week. I’d feel quite a bit better about things if the market would just make a healthy pullback here. Admittedly, this rally looks great on the outside, but as usual I am suspicious. I mean is this really what the market has become? All green all the time? If so, then it defies everything I know about the market because my 25 years of experience screams something otherwise. Like them or not, the red days have their purpose. Besides, what I’m seeing in the charts just doesn’t jibe with what I’m seeing in real life.” (The Wealth Advisory, 1/14/11)

And, four days later:

“As long as the major indexes can hold above their 50-day moving averages the primary trend remains solidly in the bullish camp, and that may be as simple as it gets, but this rally is very long in the tooth.” (Stealth Stocks, 1/18/11)

And then eight days later:

“I don’t normally get bitten by the bear bug ... but this market can’t keep up its current trajectory. I’ve conversed with technical analysts and lifelong students of market history, and this is the most the Dow has ever gone up in a 22-month period. Ever. It’s up more than 90% since March 2009. Normally, the Dow goes up 10% per year. So you can see the reason for concern. Now, I’m not complaining about a bull market. I love making money as much as everyone else. What I’m worried about is getting burned when someone blows on the house of cards. Of course, I’m not going to sit around and sulk as the market ticks higher. There are a few plays I think we can squeeze gains from before the legs are kicked out.” (Alternative Energy Speculator, 1/26/11)

As you know, the correction everyone was anticipating still refused to show. Analysts were forced to adjust their predictions to account for the bulls’ tenacity, but most were still predicting some kind of correction. On January 27, Argus Director of Research Jim Kelleher wrote:

“Much as we think a 3%-5% correction would do well by this market, the technicals are not exactly cooperating. The gentle ascent in equities and those two selling spates we discussed have prevented a dangerous and frothy overbought condition from developing. On sentiment, we have been on the lookout for VIX readings below 15. But skittishness about a few EPS reports (C, JNJ, BAC) sent the VIX back up to 18 and the VXN above 19.

“Long story short, we think this winded bull, running since early July, needs to take a breather before he trips over his tongue. But we may need some headline earnings disappointment, rather than a classic technically unbalanced market, to cause an optimal correction.”

And markets did tumble the next day, rather dramatically. But it wasn’t the breather most analysts were waiting for; the indexes recovered, and then went on make more gains, in the ensuing days.

Fast-forward to today: It’s February, and the bulls are still holding the reins. Of course, that doesn’t mean the correction-callers were wrong. As Gregory Spear presciently wrote in The Spear Report back on January 14, “The shorts will be right in the end, but timing is everything.”

So how to get the timing right? Simple: Listen to the market. Or said another way, respect the trend. Only change your strategy once you see concrete primary evidence that the uptrend has been broken—like multiple weak days in the market. Waiting for that can feel like you’re hanging on to a sinking ship, but the ship may stay afloat for much longer than you think. In the meantime, it’s best to stay dry.

Momentum Strategies Report Editor Clif Droke concluded as much on January 10:

“A market contrarian might be tempted to conclude that this extended run in bullish sentiment bodes ill for the stock market outlook in the months immediately ahead. It would do well to remember, though, that a similar increase in bullish sentiment was seen during the extended run-ups of the late 1990s and in the year or so preceding the 2007 stock market top. When the stock market gathers a head of steam as it has since bottoming in early 2009, a steady increase in buying from the retail sector can actually help sustain the market’s uptrend, at least so long as inflows remain strong and the key cycles are still up. It’s only after everyone has become convinced that the bull market is here to stay and the early birds in the market—namely hedge funds and institutional buyers—have decided to cash out that you have to worry about a major reversal of the uptrend. We haven’t yet arrived at that point and investors are advised to avoid the urge to short this market just yet.”

Similarly, on January 14, InvesTech Market Analyst Editor James Stack wrote:

“Bull markets do not die from old age. Instead, the demise is brought on by imbalances—both economically and monetarily. But the warning flags often appear well in advance, and in a variety of leading economic and key technical areas of the stock market. As we enter 2011 and approach the second birthday of this bull market, the most important question we can ask is, ‘Where are we on the Wall Street roadmap?’ So here is a brief updated perspective.

“In historical terms, this bull market might still be young. At 22 months of age, it won’t celebrate its second birthday until March 9. And 80% of the bull markets during the past 80 years have lived beyond their second birthday. Unfortunately, the survival rate starts dropping after that. Barely half of these past bull markets lived to see their third birthday, and only 33% extended much beyond four years. In size, this bull market is already approaching the ‘median gain’ of the past 15 bull markets since 1932 (+90.1% versus +101.5%). However, that does not necessarily worry us since this bull market followed the biggest bear market since the 1930s. Nonetheless, we must maintain perspective that this bull market has covered a great deal of ground in a relatively short time frame. When looking at the 12-month, 24-month, and 36-month gains of past bull markets, today’s +90.1% has already surpassed the 36-month gains of all but one bull market of the past 80 years.”

Personal Finance Editor Elliott Gue sounded a similar warning January 16:

“When the S&P 500 finally pulls back from its 52-week high, the move will be one of the most anticipated market corrections in recent memory. Practically every story about stocks these days, no matter how bullish, includes the caveat that the market is overdue a pullback. … Against this backdrop, [with the S&P 500 substantially above its 50-day moving average,] it’s hardly surprising that so many pundits claim the market is overdue for a correction; if you repeatedly call for a correction, you’re bound to be correct at some point. But these admonitions won’t help you time an imminent correction. For example, the S&P 500 traded at least 4% above its 50-day moving average for weeks before suffering a severe correction in May. Plenty of pundits also highlighted how overbought the S&P 500 was back in September and October, weeks before the index endured a modest 5% pullback.

“That so many investors are waiting for a correction to add to positions suggests that the eventual pullback may prove shallow and short-lived. It would be irresponsible to suggest that the broader market won’t pull back 5 to 10% at any time, but it would be even more irresponsible to claim that I can predict when such a retrenchment will occur. It’s possible the market will pull back in late January and touch its 50-day moving average of 1,235. However, it’s equally feasible that the market will surge beyond 1,300 before a meaningful correction sets in.” Personal Finance Weekly, 1/16/11

They all turned out to be right, of course, at least so far. The bottom line? Patience is a virtue.

Of course, that doesn’t mean you have to sit on your hands and wait for the market to wipe out all your profits. There’s nothing wrong with taking some defensive action, whether that’s by hedging part of your portfolio in inverse exchange-traded funds (ETFs), taking partial profits in your biggest winners, or simply selling your weakest stocks. Below are some of the best defensive suggestions from our contributors:

“Wow! Despite having a rather sizable position in the ProShares UltraShort QQQ ETF (QID) (an ETF designed to generate a return of twice the Nasdaq100’s in the opposite direction), the Aggressive Portfolio is still up over 20% in the five weeks since last month’s issue went to press (and the Model is up over 10% as well)!

“Unfortunately, while I think we should all take a moment to celebrate this sort of success and congratulate ourselves for being disciplined enough to hold a nice basket of stocks in our portfolios despite the amazingly volatile market we have seen over the past couple of years, once we’ve allowed ourselves a few minutes of excitement, I think we also need to remind ourselves that moves like the ones we have seen lately are not sustainable. In addition, they have historically been extremely reliable indicators that ‘the end was near’ for the bull markets that were underway when the ‘mega moves’ occurred.

“Of course, as pointed out many times before, rallies can (and often do) last longer than seems reasonable, and thus our job is to ride the current rally as long as possible before starting the process of taking our chips off the table in a more aggressive manner—in fact, history tells us that the final stages of bull markets often produce some of the largest gains for disciplined investors who are patient about locking in their profits.” (Nate’s Notes, 1/14/11)

“We initiated the first (of possibly many) bearish trades. We went long shares of The Direxion Daily Tech Bear 3X ETF (TZA), which benefits from a decline in the Nasdaq. I will keep it for a week, to see if the market does turn. If the market continues its bullish path higher, our current longs should have big gains and negate any loss incurred on TYP.

“We have four bullish positions in the portfolio. And while I predict a bearish turn is very near, sellers need to prove themselves before we switch our strategy. I am bullish on the market, but prudence must be taken on your open positions. I am again increasing stops for open positions all of which use closing price. These positions will only be sold if the stock closes below each stop.” (TradeMaster Daily Stock Alerts, 1/18/11)

“It is our contention that the bull market, which is approaching the two year mark, has several more months to run; however, with more and more market participants piling into the bullish camp it was becoming increasingly apparent that something had to happen to shake up the overwhelming bullishness. Over the past two days the high relative strength stocks and small caps have been the hardest hit while the high caps have given ground grudgingly. The obvious question—is this the beginning of a correction? Some of the tell-tale signs are there, which we’ll get to in a moment, but in our opinion the last thing you want to do at this juncture is to move to the sidelines. Corrections within the confines of bull markets are quite normal.” (The Chartist, 1/20/11)

“The market was near breakeven today, with the Dow falling three points and the Nasdaq rising two points. The major trend of the market is still up, but beneath the surface, we are starting to see lots of concerning action among leading stocks, including a few outright breakdowns and plenty of sloppy patterns. … There’s no reason to turn outright defensive, but it’s vital to watch your holdings closely and take action when appropriate.?“Tonight, we’re going to sell both Freeport McMoRan (NYSE: FCX) and our remaining shares of Riverbed Technology (NASDAQ: RVBD), both of which have broken down. If you bought along with us, you’re booking a decent profit in Freeport, and you’re taking the rest of your larger Riverbed profit off the table.

“The cash from these sales will bump our cash position up to 39%, which does feel a bit high given the still-uptrending overall market. But we don’t see many high-quality set-ups, so we’ll sit on this cash for the moment.” (Cabot Market Letter, 1/25/11)

Of course, an imminent correction is still possible, and some would even say likely. But hopefully investors who bailed out—or took large short positions—early in January have learned the value of being patient, and following the market’s lead. (On February 1, one of our contributors admitted, “I wish I had stayed 100% in the market instead of going to 20%-30% cash.”)

So, with the uptrend still intact, there’s nothing wrong with doing a little new buying now. Conservative investors might want to focus on low-risk setups, like value stocks, while more risk-oriented growth investors should focus on stocks showing definitive new strength—think decisive breakouts from strong base formations.

A perfect example of the latter situation is cardboard box-maker RockTenn Company (NYSE: RKT). Michael Cintolo recommended RockTenn in last Monday’s Cabot Top Ten Weekly, which recommends stocks based on momentum. He wrote:

“RockTenn is one of the biggest manufacturers of cardboard boxes in the U.S., boxes that hold everything from cereals to pizza, from dishwashers to diapers. And it’s a well-managed company, evidenced by the fact that revenues have grown every year of the past decade, with the exception of a tiny 1% contraction in 2009. Now, cardboard box makers are seldom great growth stocks, but RKT has three big factors in its favor. First is the statement by CEO James Rubright last week, on the announcement of fourth quarter results, saying, ‘RockTenn’s co-workers again produced outstanding results, with adjusted earnings per share up 36% over last year’s first quarter. … Our free cash flow generation exceeded our expectations for the quarter, and we see continued strong cash flow generation through the balance of the year.’ Second was the acquisition of peer Smurfit-Stone, which will create a dominant packaging player in North America. And third—and most important—is the powerful action by the stock last week, as big buyers swooped in after the earnings report.

“Until last week, RKT had been performing no better or worse than the market for the past six quarters. It was gathering potential energy. And now that energy has been let loose, visible as four powerful days of high-volume buying before

a little profit-taking set in on Friday. A typical consolidation from here might see the stock give up 50% of the advance, which would take it down to 63. If you’re interested, make that the midpoint of your targeted buy range.”

That was January 31; since then, RKT has continued to consolidate right around 67. It’s not the most interesting story in the world, but there is clear strength in the stock. If you have money to put to work, it’s a strong candidate for your portfolio or your watch list.

Wishing you success in your investing and beyond,

Chloe Lutts

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.