NOTE: Every week or two I write a Client Note for my clients. For a limited time, I am allowing non-clients to sign up and receive it at the same time as my clients. You can sign up at the top right hand corner of the website. I will also be posting the notes on my blog with a time delay from time to time.
Originally sent to clients February 8.
When everybody thinks alike, everyone is likely to be wrong.
- Humphrey Neill, The Art of Contrary Thinking
Last Friday’s positive Jobs Report and the resulting breakout to new highs has led to a bullish capitulation.
Bull market sentiment was on full display on CNBC on Tuesday. On Street Signs, Paul Hickey of BeSpoke Investment Group and Josh Brown of Fusion IQ – two investors who also write excellent and well trafficked blogs – could hardly contain their enthusiasm. Later on Mad Money, Cramer compared the current market to the great bull market of the 80s and 90s.
In this context, we shouldn’t forget that the current rally is almost identical with one that occurred during the same period last year. Starting December 1, 2010, the market took off on a euphoric 12 week joy ride carrying it from 1180 all the way up to 1343 on Friday February 18. That was followed by some chopping around, nominal new highs on the last day of April and the first day of May, followed by the August plunge.
This year, the current run began on November 28 at 1159 and has carried us all the way to 1347 as of Tuesday’s close (Feb 7). The rally is currently in its 11th week.
On Tuesday February 15, 2011 after the close I wrote “Get Ready For A Nasty Correction”. On cue, the market peaked 3 days and 15 S&P points later. It’s deja vu all over again.
During bull stampedes like this, certain perennial market platitudes are inevitably espoused as justification. One is that the market is telling us that the economy is strong. This is false. The market is not a true reflection of economic reality but of the views and actions of market participants according to their weight. The great Bernard Baruch said it best more than 50 years ago: “What registers in the stock market’s fluctuations are not the events themselves but the human reaction to these events, how millions of individual men and women feel these happenings may affect the future. Above all, the stock market is people” (Baruch: My Own Story (Henry Holt & Co: 1957), pgs. 84-5).
The other market cliche that is always mouthed at times like these is to invest according to what the market is doing not what you think it should be doing. This is the philosophy of the short term traders, the intellectually narrow lemmings who dominate the current market. However, the truly great investors know that sometimes you have to be contrarian and go against the crowd. Wayne Gretzky famously said: “I skate to where the puck is going to be, not where it has been.” That’s what the great Michael Steinhardt did when he bought treasuries in the early 1980s and it’s what John Paulson did when he shorted the housing bubble.
One important clue of a growing divergence between the stock market and economic reality is the weakness of 4th quarter earnings. Net profit margins excluding financials and utilities declined from a peak of 8.95% in the 2nd quarter of 2011 to a blended 4th quarter estimate of 8.23%. Because much of the profit growth during the current bull market has come from cost cutting and not revenue growth, margin deterioration calls into question future profit growth. Second, the blended earnings beat rate so far is 60% – the lowest since the last two quarters of 2008 (“Profits Showing Weakness”, Jonathan Cheng, The Wall Street Journal, February 6, C1).
Enjoy it while it lasts because this bull run’s days are numbered.
Now is a good time to report our recent returns because I am sure many will assume that the above is the product of sour grapes from someone who has been left behind. Nothing could be further from the truth.
At the start of the 4th quarter I wrote what turned out to be one of the best calls of 2011: “The Case For A 4th Quarter Rally” (October 3, 2011). We were long in late September and early October and perfectly positioned for the October reversal. While I ratcheted down my bullishness after October, we were still net long through year end. As a result, 4th quarter returns were as follows:
Top Gun: +6.60%
DJ Total: +11.36%
Even though I was bearish heading into the new year, we still managed a good January:
Top Gun: +4.82%
DJ Total: +5.03%
While these returns might not seem notable compared to the market return, it is important to remember that I was bearish in 2011 and we were mostly unscathed by the August plunge. The proof of this is our returns since the current bull market highs at the end of April/beginning of May. Returns for May ’11 through Jan ’12 are as follows:
Top Gun: +11.38%
DJ Total: -4.59%
THE BOLDEST OFFER IN INVESTMENT MANAGEMENT HISTORY:
Starting now I will guarantee at least the return of the S&P 500 in 2012 after fees to the first $1 million in new investor money.* That is, for those investors, I will make up out of my own pocket any deficit between the performance of your account after fees and the performance of the S&P 500 this year. I will sign a contract with you to this effect. You will thereby be guaranteed at least the return of the S&P 500 and any upside to it will be yours as well.