The Elusive "Blow Off"

By: Henry To | Thu, Jun 30, 2005
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Dear Subscribers and Readers,

We switched from a 50% long position to a completely neutral position in our DJIA Timing System on the morning of June 13th at DJIA 10,485. Over the next three to five months, I still don't believe the probability favors the bull's side - there's just too much bullish sentiment given the overbought condition in the markets, the slowing global economy, and high oil and copper prices. A more immediate concern would be, of course, the statement released by the Fed tomorrow after their quarterly point hike in the Fed Funds rate. Remember, the market can do anything in the short-term. I believe our readers should continue to monitor the Philadelphia Bank Index, as a better insight over the long-run can be gleaned by keeping track of the Bank Index and its movements after the Fed meeting.

First of all, I encourage our readers to read this Economist's piece on housing if you have not already done so. No doubt, you have heard a lot about the wealth effect of rising housing prices, the "virtues" of refinancing at lower rates, and home equity loans, etc. But did you know that (according to the Economist) fully "two-fifths of all American jobs created since 2001 have been in housing-related sectors such as construction, real-estate lending and broking?" And according to this article from the NAHB - during the first quarter of this year, "the housing production component of GDP (residential fixed investment) grew at a robust 11.5% pace and directly contributed 0.64 percentage point to the overall GDP growth rate (that's a lot)." Make no mistake: Once the housing market cools down and given the lack of a growth sector/country besides the housing sector and the U.S. economy, it looks like we are definitely in for a significant slowdown by the end of this year or early next year.

Without further ado, let's begin our commentary:

Like I have said many times before in our commentaries, this cyclical bull market is now maturing - and like the good investors or traders we are (or attempt to be), we should be conscious about this and plan accordingly. I will attempt to summarize my thoughts and plans on what we should do going forward - in Q&A format. Please bear with me as I explore our options for the rest of this year and most probably into early next year.

Q) Okay, Henry - you mention that the bull market is now maturing and therefore the top of the major indices may be near. Does that mean we are to lay off long positions and probably even start thinking about short positions?

A) On the surface, this would seem logical. However, the market is anything but intuitive. Think of the many money managers that have outperformed by adopting contrarian analysis (in essence, value investing is somewhat similar to contrarian investing, as value investors tend to buy stocks that other investors do not want). Now, consider this: Before the end of every significant cyclical bull market in modern history, there has always been a "blow off phase" - said phase being a time when the market sucks in all the potential retail investors - producing a final run-up in prices in the most speculative issues. I am going to use the June 1962 to February 1966, October 1966 to December 1968, the May 1970 to December 1972, the August 1982 to August 1987, and the December 1994 to March 2000 cyclical bull markets as examples. One of the best ways to illustrate this final run-up is to look at the increase of the amount of equities held by households as a percentage of their total financial assets during the final months of the bull market. Following is a chart I have shown a few times before:

Equities and Mutual Funds as a Percentage of Total Household Financial Assets (1Q 1992 to 1Q 2005) - 1) The 'blow off phase' in late 1999 and early 2000 saw the equities and mutual funds as a percentage of total household financial assets ratio topping out at 34.97% - with a concurrent increase in this percentage of over 3% in just one quarter! 2) Equities and mutual funds as a percentage of total household financial assets bottomed at 23.79% in the third quarter of 2002 in the recent 2000 to 2002 cyclical bear market.  The current bounce of 3.54% so far in this percentage is mediocre (at least on an absolute basis) - suggesting that the current rally in the equity markets is not over yet - especially given the fact that we have not had a final 'blowoff phase' so far - a phase which has historically meant an increase of at least 2% in this percentage in just one quarter. 3) Bottom line: The 'blowoff phase' is yet to come!

Please note the huge jump in this ratio during the last few quarters of 1999 - thus capping a historical bull run to the December 1994 to March 2000 cyclical bull market and the 1974 to 2000 secular bull market. My contention is this: As this cyclical bull market comes to an end, the potential for making money on the long side increases if you are a good stock picker, especially if you can anticipate the popular stocks among retail investors (think stocks that may appear on the IBD Top 100 listings) going forward. As retail investors with limited time to spend on the stock market, you should start preparing for this period RIGHT NOW.

Q) That was a long answer to my question. Henry, you have mentioned in the past that we have always had a significant correction (both in stock market action and in the popular sentiment indicators) before we can have such a "blow off" period. So in the meantime, should I take advantage of this correction and short some stocks?

A) You are absolutely right - prior each of the final "blow off" phases of the stock market, investors were relatively pessimistic, as evident by very low readings in our popular sentiment indicators during the third quarter of 1999. In fact, I have constructed a table illustrating this - showing the range of the three popular sentiment indicators during the third-to-last quarter of each cyclical bull market that I listed above - along with the run-up in the equity percentage (as a percentage of total financial household assets) in the final two quarters of those cyclical bull markets:

A 'Blow Off' Study - Equities Accumulation and Sentiment Prior to the End of Recent Cyclical Bull Markets

It is unfortunate that we don't have more historical data of the three popular sentiment indicators that I have listed above - but you get the point. During the many corrections we have experienced over the last 18 months, we have seen readings in both the AAII survey and the Investors Intelligence Survey that resemble the above readings (focus on the low readings instead of the high readings) - with the only exception being the readings of the Market Vane's Bullish Consensus. This is a point that I really want to make - that in order to have an upcoming "blow off" phase, we will need to see a more significantly oversold reading in the Market Vane's Bullish Consensus. The low of 56% that we have seen in the last 18 months just does not cut it. Please also note that while the run-up in the equity percentage was not reflected in the second and third quarter of 1987, one could have seen it in the many other indicators - such as valuation and the divergence among tech and other sectors.

Okay, a long answer yet again. So should we or should you, as a retail investor, short stocks? I do not believe so. Shorting stocks is a very difficult business and it takes away an immense amount of your time as well as energy in order to manage your short positions. This amount of time can better be spent in preparing for the upcoming "blow off" phase - in picking long positions that you think can pay off well. Again, please keep in mind that the real money - virtually all the time - is made by going long. Please also note that if you did not make money during the March 2000 to October 2002 period, then you can forget about shorting stocks.

Q) So in general, I should not short stocks?

A) Most probably not - unless, as a retail investor (and this is very important), you are devoting all your full-time energies into the stock market. Please remember that you are competing against thousands of very intelligent professionals who are spending 100 hours a week each on analyzing the stock market and different strategies. With all the long-short equity hedge funds out there today, you definitely do not want to be shorting stocks as a retail investor. Just imagine Darth Vader on the other side of your transaction in time you want to initiate a short position.

More importantly, I believe this is a key for many intelligent retail investors - retail investors who have the passion for the stock market but who have limited time (said time being less than 40 hours a week). That you can beat the professionals and the hedge funds. How? First of all, you have to realize your own strengths and weaknesses. For example, if you're an emotional person, then do not try to look at the computer screen on an intraday basis. Secondly, you have to focus on your strengths. Buy five to six stocks instead of ten to twelve. Moreover, instead of using your time to find both potential long and short positions, focus on trading long positions. For example, if my thinking is correct and that we will continue to have a stock market correction in the next two to three months, then use this time to prepare for the upcoming rally off of this correction. That means that in the next two to three months, you should be in cash (if you are a trader) - and you should be doing a significant amount of analysis and research instead of using this time to try to find short positions. Remember - over the long-run, the amount of stock market returns you receive is positively correlated to the amount of time you do research. This would also save you an immense amount of stress.

Q) So Henry, how should I go about finding these potential long positions?

A) I can name many different ways but in the end, you will have to find a strategy that you are comfortable with. For the novice, I will start by reading Bill's guest commentary from last Thursday morning. Remember, successful investing over the long-run requires tilting the probabilities in your favor in each of your trades. As Bill outlined, value investing has been very successful over the long-run. I concur with that, but I also want to add that there is a time for everything and we are quickly approaching the time when retail investors will be sucked into the stock market - a.k.a. the "blow off" phase. In this final phase, momentum reigns - and one can most probably do very well by finding stocks that will appeal to the retail investor, such as the next TASR or TZOO.

Q) I am sorry, could you give us a little more details?

A) No matter what your investing style is, I will begin with one of the many mechanical "screens" that financial websites such as Yahoo!, MSN, and IBD offers (when will it be Google's turn?). This is only the beginning; however, as the real leg work just comes ahead. I still believe in evaluating a company's industry, business, and financial statements, but the initial screen will really pare down the work. For investors who are looking at more "kick," Reuters have many preset screens that are very intriguing. Of particular interest is their Reuters Contrarian Opportunities Screen - which has returned nearly 1,200% since the end of January 2000 (this assumes a monthly turnover) - an out-performance of over 800% on the second best returning screen. You can also frequent our discussion forum, as I will be devoting more of my time to studying individual stocks in our discussion forum going forward (moreover, the activity of our discussion forum has also grown significantly over the past couple of months).

In short, the intelligence investor will need to be patient, and to be prepared to seize the moment. Think of Sir Winston Churchill - who really did not start his "career" until 1940 when he was elected as Prime Minster of Great Britain at the age of 65. Sure, Churchill had played many significant roles in the British Military and British politics, but his role as Prime Minister of World War II was what elevated him to greatness and who will be remembered for centuries to come.

Signing off,


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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