By
Tom Dyson, publisher, The Palm Beach Letter
Monday, February 2, 2009
On March 15, 2006, we passed a small milestone in stock market history.
If you'd been paying attention on this date, you might have avoided the 50% stock market decline last year... or made 647% gains by betting on a rise in volatility.
Before March 2006, this landmark event had only happened three times in the previous 110 years. Every time it occurred in the past, the stock market collapsed soon after.
I documented this pattern with the help of Jason Goepfert of SentimenTrader. The signal is a three-year episode of complacency. I define an episode of complacency as a period without a fall of 10% or more in the S&P 500, marked from the highest point of the previous six months.
Ten percent corrections are very common in the markets – even in bull markets – and you can expect to see one about every two years. To go three years without one of these corrections implies a market that's so calm, you have to check its pulse to make sure it's still alive.
Usually, such a long period of calm ends quickly and painfully. Take a look:
Date
Months without a correction
Result
Feb 1966
39 months
-24% over the next 9 months
Aug 1987
37 months
-35% over the next month
May 1994
36 months
-10% over the next 3 months
Starting in March 2003, when the U.S. and its allies invaded Iraq, the market went almost five years (57 months) without a 10% correction – the longest stretch in stock market history.
"It is the complacency... that creates the trouble," Goepfert said at the time. I concluded this "fourth episode" would end in trouble because investors had never had become so lazy and complacent toward risk.
Complacency in the stock market is a bit like the weather at sea. You have long periods of blue skies and calm days interjected with fierce storms. The longer the calm weather lasts, the more cargo the shipping companies dare to load on their vessels. After five years of uninterrupted fine weather, some ships carry so much cargo, their railings barely rise above the water.
No one knows when the storm will hit, but after five years of calm weather, it's a certain bet many ships will sink when it comes.
This time, it took more than 18 months for the market to collapse after the signal flashed. But when the storm finally hit, there was a catastrophe at sea. The VIX volatility index rose 647% from 11.98 to 89.53 between March 2006 and October 2008. And the S&P 500 fell 53% between October 2007 and November 2008.
We just had the longest spell of stock market blue skies in 110 years... so it may be a long time before we see this signal flash again.
But the next time you notice a three-year period without a 10% correction in the stock market, you should bet there's trouble around the corner. Don't forget about it. It could save you from huge losses some day.
Good investing,
Tom
P.S. Jason Goepfert's website, www.sentimentrader.com, is a fantastic source for monitoring stock market sentiment. Steve Sjuggerud and I use it all the time. If you like to trade against the crowd, you should check it out.
StemCells (STEM)... biotech
CV Therapeutics (CVTX)... biotech
Myriad Genetics (MYGN)... molecular diagnostics
Brink's Home Security (CFL)... security
Scopus Video Networks (SCOP)... video networks
NEW LOWS OF NOTE LAST WEEK
Fossil (FOSL)... watches
Aflac (AFL)... insurance
Novartis (NVS)... Big Pharma
FedEx (FDX)... freight delivery
Southwest Airlines (LUV)... airline
Capital One (COF)... credit cards
Steinway Musical (LVB)... pianos
Dow Chemical (DOW)... chemicals
San Juan Basin (SJT)... natural gas trust
Black & Decker (BDK)... tools
Boston Beer (SAM)... Sam Adams
optionsXpress (OXPS)... brokerage
Eastman Kodak (EK)... photography
Cash America (CSH)... pawn shops
Lindsay Corp (LNN)... irrigation equipment
Caterpillar (CAT)... construction equipment
CNH Global (CNH)... construction equipment
Thor Industries (THO)... recreational vehicles
International Paper (IP)... paper products
U.S. Lime & Materials (USLM)... lime & materials
Portfolio Recovery Associates (PRAA)... debt collection
Zions Bancorp (ZION)... bank
Porter Bancorp (PBIB)... bank
Privatebancorp (PVTB)... bank
Home Bancorp (HBCP)... bank
First South Banc (FSBK)... bank
Jacksonville Banc (JXSB)... bank
Wintrust Financial (WTFC)... bank
Capital City Bank (CCBG)... bank
Lean hogs, Natural gas, Lumber
Over the past year, Jeff's timing has been better than mine... and anyone else I know. He called the top in oil last summer, the bottom in gold last fall, and the beginning of this whole bear in early 2008. So this time, if anyone's timing is right, it's likely to be Jeff.
Friday night, I was in the Gaslamp district of San Diego. The streets were packed with kids... fashionably dressed kids, everywhere, partying away, blowing their money (or their parents' money).
You should never invest again without doing this. This technique is something Warren Buffett knows, Sam Zell knows, Bill Gates knows, and Peter Lynch knows. It works for bonds, currencies, stocks, real estate, and the money in your bank account.
Right now, it's easy to be bullish on gold. In fact, it's common sense. But if you want to make money in the metals market, then you have to wait until it's hard to be bullish...
