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The “Calm Rally”

Complacency is never a good sign in the stock market. The market climbs a wall of worry, for which fear is needed. So it’s reasonable that, after eight weeks of persistent upward movement, many investors and advisors are saying, “too good to be true.” And yet... the market keeps rising. Recently,...

Complacency is never a good sign in the stock market. The market climbs a wall of worry, for which fear is needed. So it’s reasonable that, after eight weeks of persistent upward movement, many investors and advisors are saying, “too good to be true.”

And yet... the market keeps rising.

Recently, this fear-complacency situation was eloquently addressed by Dan Sullivan, editor of The Chartist and The Chartist Mutual Fund Letter. Both newsletters have been recommending a fully invested stance since February 3, and they’re staying that way—for now at least. I liked the reasoning Sullivan gave for staying fully invested after an eight-week rally and the data he backed it up with—so I thought I’d share it with you today:

Clear Sailing Ahead

“It’s true that stock market participants have settled into a complacent mode in recent days. The American Association of Individual Investors now has 44.51% in the bullish camp versus 26.83% bears. This marked the tenth consecutive week in which bullish sentiment was above its historical average. According to Investors Intelligence, 51.1% of the advisory services they track are bullish versus only 25.5% bears. This worries many analysts. Since the market frequently moves in the opposite direction of majority opinion, they feel that a correction is in the cards. We disagree. In our opinion, there is nothing wrong with complacency in a rising market and majority opinion can be right for extended periods of time. It is only at pivotal turning points that majority opinion is inevitably proven wrong.

“It is our feeling that the contraction of volatility we have been witnessing in recent sessions bodes well for the market. To get a handle on this volatility, consider this. It has now been 43 trading sessions since the S&P 500 has recorded a loss in excess of 1%. The last time it occurred was back on December 28th. Since that time, the S&P has rallied an impressive 9.96%, close to 70% on an annualized basis.

“Patrick Chu, a full time trader, recently came up with an interesting concept concerning this lack of -1% days when he put all of the numbers into a spreadsheet going back to 1980. Over this period, he found 18 previous occasions in which the S&P 500 had gone at least 41 trading sessions without a single -1% day. He then tracked the subsequent performance after the first -1% day had occurred. As you can see by the chart, the initial rallies lasted from 41 to 112 trading sessions. When the rallies ended, the average subsequent gain after 20, 60, and 120 trading sessions was 0.8%, 3.7%, and 6.7%, respectively. This is without taking dividends into consideration.

“While the overall gains did not match the initial rally, what stands out is how well the S&P held up over the periods. The worst performance was -3.9% after 60 trading sessions and -3.1% after 120 trading sessions. If history repeats, a correction in the foreseeable future is not in the cards. Chu refers to the period in which there are no -1% days as a ‘calm rally.’ In the chart he does not begin tracking the S&P’s performance until after the calm rally has ended. By definition, it will be over when the S&P loses 1% or more in a single session. Note: The average calm rally lasted 69 days. We are currently in Day 43. What we have here is a bullish scenario going forward if history is any guide. Add to this the fact that our models are highly bullish. Our advice to stay fully invested remains unchanged.”

You can read Patrick Chu’s original analysis and article on Seeking Alpha by clicking here. One interesting point not addressed in Sullivan’s analysis is that the current period is the first calm rally since the end of 2006—over 1,300 trading days ago. This is the second-longest “drought” between calm rallies in his study period; the only gap longer was 1,798 days of volatility between the end of 1996 and the beginning of the next calm rally in October 2003. He also looks specifically at the other two calm rallies following long periods of volatility, writing:

“Our current calm rally comes after a drought of over five years, so the calm rallies starting January 1985 and October 2003 can serve as ‘key races’ (as they say in horse handicapping circles), since those calm rallies also came after droughts of over five years.

“Those drought-ending calm rallies returned 11% to 13%. The 2003 calm rally lasted 65 days, and the 1985 calm rally lasted a whopping 112 days. Both rallies came after the market recovered from very volatile periods in the stock market. In each case after the drought was broken and that calm rally ended, another calm rally started less than a year later.”

Predictions and Analysis for the Current Calm Rally

“It appears that, except for periods of very low volatility in the mid-1990s, most calm rallies can easily generate double digit returns. ... Absent earth-shattering news, we could easily be in for another month of low volatility and creeping upward prices.

“In addition, once a multi-year drought is broken, more calm rallies tend to follow. It’s possible that we could see another period later this year of low volatility, despite the rising price curve in later-month VIX futures.

“The cliche is that markets climb a ‘wall of worry.’ I’ve rarely seen this more the case than in this calm rally. [In] many posts here on SeekingAlpha and on, the bears, who far outnumber the bulls, are expecting a crash any day now. The talking heads on CNBC tell us that many funds and retail investors have missed this train. ...

“In any case, calm rallies of the recent past do not support a ‘crash’ scenario. Since 2000, the biggest rally ending day was a decline of -1.87%, on January 19, 2006. The other declines since 2000 were -1.36%, -1.36% and -1.12%. After recent calm rallies have ended, the subsequent monthly and quarterly returns were all slightly positive, and with quarterly returns of 3-5%, not too shabby either, on top of the double-digit gains from the calm rally itself.” (-Patrick Chu, Seeking Alpha)

For today’s recommendation, I looked for an investment that would be leveraged to a continuing rally. I found two.

Small-cap stocks tend to be particularly sensitive to bull markets. They hold the promise of big, quick profits, which are what investors chase in optimistic times. So it makes sense that the latest Investment Digest featured not one but two small-cap-focused funds. One is a mutual fund and one is an ETF, but both should be great holdings if the bull market rally keeps running.

The first recommendation comes from Ian Wyatt of Ian Wyatt’s $100k Portfolio. On February 12, Ian wrote:

“2011 was a lousy year for small-cap stocks. ... So far in 2012, however, small caps—along with emerging market and technology stocks—have been leading the market higher. I expect small caps to continue their outperformance, even if the broader market experiences a pause or near-term correction. After declining in 2011, history supports an increased allocation to small caps, which have averaged a remarkable 24.1% gain in the year following a loss. ... Moreover, profit margins for small companies aren’t as stretched as they are for most large caps. Cambiar Small Cap Fund (CAMSX) is one of the best investment vehicles for diversified small-cap exposure. ... Cambiar Small Cap is team-managed, following a bottom-up, relative-value investment process that favors undervalued companies that possess a catalyst for future growth, such as a new product or a management shake-up. It’s a concentrated fund, holding only 45-55 stocks. All new portfolio positions enter the portfolio with a 2% weighting in order to reduce excessive stock-specific risk. Cambiar’s portfolio has a forward P/E of 10.4, while the Russell 2000 Index commands a multiple of 13.8. At the same time, the portfolio’s EPS growth is 12.4% versus 10.7% for the index. On average, then, the stocks owned by Cambiar are substantially cheaper than the index but are growing much faster. That’s a recipe for success. Last year, Cambiar outpaced the Russell 2000, declining only 1.34%. Its trailing one-, three- and five-year annualized returns are 4%, 30.6% and 5.4%, respectively, placing it near the top of the category of all small blend funds tracked by Morningstar. ... Buy $5,000 of Cambiar Small Cap Fund.”

The second recommendation comes from Walter S. Frank, editor of MONEYLETTER. On February 24, Walter wrote:

Rydex S&P SmallCap 600 Pure Growth ETF (RZG)—Starting with the S&P 600, an index covering about 6% of the U.S. equities market, the pure growth and pure value style index series identify approximately one-third of the index as pure growth stocks and a third as pure value (with the remaining middle third considered to be blended stocks). ... Growth factors include three-year sales per share growth, momentum (12-month percent price change) and three-year change in earnings per share over price per share. ... Within the indexes, stocks are weighted by their style attractiveness. As expected, traditional growth sectors such as information technology and health care weigh most heavily in the fund. In fact, compared to its Morningstar small growth peers and the Russell 2000 Growth index, the fund is overweight in technology and consumer stocks, while underweight in energy and industrials. The fund holds 147 stocks with just over 11% in the top 10 holdings. So while it is slightly concentrated sector-wise versus its peers, it is well-diversified at the individual stock level. Each of the fund’s top four holdings are up at least 24% this year. Buffalo Wild Wings, a casual dining chain with restaurants in 38 states, and MWI Veterinary Supply, a distributor of animal health products to veterinarians, have both advanced 30% this year. [RZG] has outpaced its average peer in three of the past four years, and a 4.8% gain in 2011 put it in the top 1% of its category.”

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Investment of the Week

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.