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Newsletter December 31, 2005 Recipe for a Happy New Year Market & Sector Review (Outlook 2006) Largest Changes This Week This Week's Economic Reports Recipe for a Happy New Year Author Unknown To leave the old with a burst of song To recall the rights and forgive the wrong; To forgive the thing that binds you fast To the vain regrets of the year that's past; To have the strength to let go your hold Of the non-worthwhile of the days grown old; To dare to go forth with a purpose true; To the unknown task of the year that's new, To help your brother along the road To do his work and lift his load; To add your gift to the world's good cheer, Is to have and to give a Happy New Year. Market & Sector Review Outlook 2006 Hope everyone had a wonderful Christmas and that each of you is looking forward to a very Happy, Healthy, and Prosperous New Year! Now it's back to work. This week we will look at the very big picture and see if we can get some good hints as to what we might expect in this coming New Year. It is important to note that while today's analysis will look at some of the major averages, individuals stocks, groups, and sectors will be not only resistant to the prevailing trends but will in all likelihood go there own way regardless of what the averages have in store for us. Keep that in mind. To begin with let us take a look at history and see if it has a story to tell. The chart below is a 105 year history of the Dow Jones Industrial Average (courtesy of stockcharts.com), the only index that we have such a long history. Outlined on the chart are the very big secular (lasting many years) cycles that occurred over the last 100+ years. The important thing to notice is that after a major high is made during a secular bull trend, it has between 1 and 2 decades, that's right decades, before that previous secular high is exceeded. The correction of the secular bull trends have been in one of two forms: Either a very sharp correction (Crash) as occurred in 1929 - 1932; or a long lasting wide range sideways consolidation as occurred in the 1970's. Also keep in mind this is a chart of the Dow Jones Industrials, only 30 blue chip stocks, not the S&P-500, or the NASDAQ composite, both of which suffered more serious declines during the 2000 thru 2002 bear market. What causes these major secular cycles, in my humble opinion, is a shift in perceptions and hence investment attitudes from one asset class which is perceived to be expensive to another asset class perceived to be inexpensive or cheap. Remember most people are not traders they are investors seeking to take advantage of what they perceive to be major trend shifts, either developing or already partly developed. The above chart suggests that basis the Dow Jones Industrial Average, the market has already seen or will certainly soon see it's high point for a decade or more, if the cycle turns out to be 20+ years (right translated) instead of the current block of 18 years. For what it's worth, I do not see a crash like 1929 that many bears seem to be looking. In fact here is an interesting exercise for each of you to look at, on your own to appreciate it more. Take a chart of the NASDAQ composite from lets say 1998 through 2002 and overlay the Dow Jones Chart from 1928 through 1932, they are almost identical, in other words, basis the NASDAQ, the crash has already happened, just not basis the Dow Jones. The similarities as well as the degree are astonishing! That being said, what I do believe, is we are in for a period just like the 1970's (see outlined period above) where financial assets remain in a wide, perhaps very wide trading range until such time as financial assets are once again perceived to be cheap relative to other assets. Relative is the key word here, not what those values are. While on the surface this outlook seemingly does not bode well for investors, it can be an extremely profitable period for traders. To illustrate the asset shift to which I refer, in the early 1940's (Dow about 100) financial paper assets were perceived as bargains. There was a shift from tangible assets and cash into stocks. In 1960 the process began to reverse with the Dow at about 1,000 financial assets were perceived expensive and overpriced and the money flow found its way into tangibles - commodities, real estate, and collectibles, in fact BARRON'S, in the 60's contained a section each week on antiques. Then once again in the early 1980's (Dow about 1,000 first hit in 1966) financial paper assets were again perceived to be undervalued, the shift went back the other way, yielding what was arguably the greatest secular bull market in history. These facts and the above chart seem to point to a very rough 20-year major secular cycle, which may be left or right translated since nothing is exact. Peter Eliades in a recent newsletter points to a 25-year cycle between major lows. Look once again at the above chart: 1907-Major Low; +25 = 1932; +25 = 1957; +25 = 1982; +25 = 2007? This is the very big picture. Now let's bring things in a bit in time and look at the 4-year presidential stock market cycle, which I have referred to in the past. In 2004, Marshall D. Nickles, Ed.D., Professor of Economics, Graziadio School, Pepperdine University studied and published an academic paper on the presidential cycle in the stock market. Here are his findings and reasoning behind the cycle: In 1936 John Maynard Keynes first presented his macro-economic theories. By the late 1950s, Keynesian theory was widely accepted in academic circles and was being taught at most major U.S. universities. The federal government began to embrace Keynesian economics by the early 1960s, and from that time forward, Washington has played an active role in influencing the direction of the economy. "Because of the consistency and predictability of administrative actions and campaign rhetoric and their anticipated influences on the economy, investors have come to assume better times for business conditions, corporate bottom lines, and stock prices in the period prior to a presidential election and a less robust period following those periods. Thus, a four-year stock market cycle seems to have become a part of the investment landscape since the mid-twentieth century. From April, 1942 to October, 2002, 15 stock market cycles have occurred, each averaging approximately four years' duration. " "Major market cycles usually have abrupt "V"-shaped bottoms with declines in excess of 10 percent. The following stock market recoveries are often created (as suggested earlier) by strong economic stimulus invoked by government officials in an effort to counter potentially unpopular economic recessions. Strong doses of fiscal and/or monetary policy stimuli unfortunately often result in creating inflation, which then must be addressed, thereby perpetuating the business and stock market cycles. Given the foregoing scenario, it is not at all surprising to find that the stock market often has made major bottoms about two years before presidential elections and has risen through the end of election years." Now switching to a broader based market average the S&P-500: Historical Stock Market Cycles for the S&P 500 Index (1942 - 2002) The table above shows that full cycles occur approximately every four years. Bull Markets averaged about three (3) years while bear markets averaged less than one (1) year. Stock market lows have occurred very close to mid-year congressional elections, or approximately two years before the next presidential election. Now let's take a look at when during presidential cycles the market has previously bottomed: Presidential Elections and Market Troughs This table clearly shows a clustering of bear market lows around the congressional election period, or about two years into the presidential term. As can be seen, three of the 16 bear market lows occurred in year one of the presidential term, 12 in year two, one in year three, and none in year four (the election year). To view the study in its entirety including alternative investment strategies visit: http://gbr.pepperdine.edu/043/stocks.html . Now that we have taken a fascinating (at least I hope you think so) look at history, does it portend anything for 2006? Remember as traders and/or investors there are no certainties, only probabilities, so let's look at all this from a probability or odds standpoint. 2006 is the year of congressional elections and two years into this president's term in office. Therefore according to the Pepperdine University study: Probability of a major stock market low in 2006: 75% or 1.3333 to 1, for you horseplayers out there this is the odds-on favorite. 5 of the 16 bear market lows occurred in October of the second year (which is 2006) or 5/16= 31% probability or 3.2:1, We’ve had 1 in March and 2 in April, so the March/April period would be 3/16 = 19% or 5.333 to 1; The next most likely period would be August with 2 bottoms or 2/16 = 12.5% or 8 to 1. If we look at the August through October period (a quarter year) the odds become 7/16 or 44% or a little better than 2:1. Basis this data the odds on favorite for this bear market low is late summer through fall. Next let's take a look at where that low might occur extrapolating from the above 60 year database. The average bear market decline has been 26.4%, recent S&P high ~ 1276 x 73.6% (inverse of 26.4%) = 993; Dow Jones Industrial Average recent high ~ 11,027 x 73.6% = 8,116. Now let's take this exercise one step further. Let us assume for a moment that I am correct, that we are entering a period very much like the 1970's where the markets trade in a very wide sideways fashion for a decade or so. Again pointing to the Pepperdine University study above, during the 1970's the average advance was 70% (range 62%-74%) and the average decline 32.5% (range 19%-48%). From the 2000 top to the 2002 through the Dow Jones declined 37.4% (well within that range) but the S&P-500 declined 50.4% (just a bit outside the range) but certainly within reason of the average 1970's type of decline. From the bear market lows through recent highs the Dow Jones advanced 53% (slightly below the range) while the advance in the S&P-500 was 66% (perfect fit). The S&P is obviously the more volatile of the two. The NASDAQ on the other hand declined some 78% during the same time frame which is very much in line with the 1929 stock market crash, basis the DOW, and has thus far rallied 105% from the 2002 bottom, which is about in line with the advance from 1932-1934 after the stock market crash. We will have to see if the NASDAQ continues to act as the DOW did in the 1930's, while the DOW and S&P-500 act as if we are in the 1970's. I think it's very possible. So far basis the Dow Jones and the S&P we are well within the confines of a 1970's type of market. If we are to see a bear market and a bear market low this year and the average length of the bear markets are 0.94 years or 11 and a quarter months, and if we are to see that low in late summer or early fall of 2006, it would auger well that we have already seen, or will soon see the high of this cyclical bull. Therefore caution and stock selection should be the byword. You may be wondering why I present this analysis in this form, probabilities and odds? I firmly believe that if we are to be successful in this business over time, you must attempt to put the odds in your favor, as much as is humanly possible. In fact, if you have read the Trader Vic books (if you haven't, I strongly suggest you do) you will note that Victor Sperandeo (author) attributes much of his success in the markets to his previous experience with poker. Editors Note: Victor Sperandeo, now an advisor to major institutions, has never had a losing year in the market, something to make note of and someone to listen to! He states: the skill sets for poker and for trading/investing are surprisingly similar. Poker and investing are both about good decision making. There are a number of similarities between poker and investing. To do well you have to be patient. Both deal with incomplete information. The tough thing: the amount of information that you don't know and don't control. You don't know what's going to happen for sure therefore you do enough analysis so that the probabilities are in your favor when you make a particular trade/investment. In poker, you weigh the odds in your favor by only playing those hands where you either have the best hand or have the best draw. Understanding human nature is the biggest similarity between these two activities. As an example of the use of probability from the poker realm: In a five card draw game, with a four flush (four cards to a flush plus one other card) is it correct to call a $10 bet with $50 in the pot? A flush, for those unfamiliar with poker, is simply a hand where all your cards(5) are of the same suit. You need to go through a mental process in considering this problem. If you have five cards in a draw game, there are 47 cards that you have not seen. If you are drawing to a flush, there are nine cards out of the thirteen in the suit that can help you and there are 38 cards that are of no help to you at all (13 cards in each of 4 suits, less the 4 you hold). Therefore the odds are 4.22:1 against making that flush. Do you call (meet the $10 bet required to stay in the game)? This is the same problem we as traders/investors face every day. Do you buy today at this price, or wait for confirmation (whatever that is), or lower prices, or just go away. Both involve careful decision making to survive and prosper! The same maxims that will save you money at the poker table will save you money in the trading/investment process. In poker, they say, "have the best hand, the best draw, or get out." In other words when the odds are in your favor you bet, when the odds are not in your favor, get out of the way. "Raise or fold," is another axiom used in poker. In poker, if you have a hand that's worth being in, then it's worthwhile to raise, if you have winner in the markets, it's probably worthwhile adding to. If it's not worth raising, or adding to, then it's probably not worth being in. You can save a lot of money in poker and in trading/investing if you know when to say adios. The thing that works against us is that people want to hope and they hate taking losses. They are willing to seek risk but wish to avoid losses. When people are thinking about money or gains or losses, they're quite often not making decisions on a rational basis. And obviously, "cut your losses and let your profits run," is the standard maxim in trading/investing. In poker and investing, you have to have a game plan and the patience and discipline to stick to it. You have to minimize your losses and maximize your gains. You must understand the math of the game-the probabilities. You must understand human nature, especially your own. And you must be able to control your own emotions. In fact let me suggest a great book, an easy to read fascinating true story: Bringing Down the House: The Inside Story of Six M.I.T. Students Who Took Vegas for Millions. What they accomplished was simply to take the only casino game where it is possible to put the odds or probability in their favor and not the casino's favor. While I guarantee you will love the story, what I really hope you will walk away with is the simple fact that in the market, as in this story, you can put probability and odds in your favor, not every time but more often than not. While this analysis is obviously bearish over most of the coming year, try and remember all stocks will not go down, in fact a select few will probably do extremely well. Which leads to one final old axiom, I will be addressing in future newsletters: "There is always a bull market somewhere!" Largest Changes This Week This Week's Economic Reports Wishing All A Very Happy, Healthy, and Prosperous New Year! Bill Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.