February 22nd, 2012
The stock market has gotten off to a great start this year. Coupled with better than expected economic reports a surge of optimism has investors focused on how much higher the market is likely to rise, rather than whether it will fall. Various measures of investor sentiment reflect a disproportionate level of bullishness. As noted in our February 1 Special Update, we think the market is forming at least a short term high, and vulnerable to a 4% to 7% correction. Comparing investor’s bullish outlook to the actions of corporate insiders also provides a note of caution. According to Vickers Weekly, corporate insiders have been selling 8 times the dollar amount of their purchases. In late September, they were only selling $.80 forevery $1 of purchases. This suggests they think their stock prices have gotten ahead of where they think their businesses are going. This supports our view that the economy is likely to slow in coming months.
It is also interesting to note that corporations were big buyers of their stock throughout 2011, especially in the fourth quarter. However, the timing of corporate stock buy backs has not been good. They were huge buyers in 2007, just as the stock market was topping. At the bottom in 2009, their purchases were the lowest in 12 years.
As we discussed last month, dividend paying stocks consistently underperformed non-dividend payers since 1978, as investors were more focused on growth than dividends. The period of relative weakness ended in 2000, at the peak of the dot.com mania. Since then, dividend paying stocks have been gaining in relative performance, and now sport the highest relative P/E ratio in more than 30 years. A recent study by Alliance Berstein ranked 650 large cap stocks by their dividends, and grouped them into quintiles. Currently, the premium of high-dividend payers over low-payers is the highest in 40 years. This fact alone does not mean this trade cannot continue to work, but a measure of caution is advised based on contrary opinion. We suspect this trade has attracted a lot of conservative money that is focused more on the income than the potential downside risk. If the stock market experiences another 20% decline in the next year, a dividend of 3% won’t provide much solace if one’s nest egg has shrunk by 17%. As the chart below illustrates, dividend paying stocks closely tracked the overall market, and fell quite hard when the market sold off in August and September last year. If there are more episodes to the European sovereign debt crisis and the U.S. slows as we expect, the odds favor the stock market being down 10% or more from current levels at some point before year end. Dividend stocks require as much sound money management as non-dividend stocks.
Click on graph for larger image.
In a February 1 Special Update we suggested that our clients sell into strength over the next few days. On February 3 the S&P gapped above 1340 and hasn’t made a big move since then. Since institutional investors loath cash and are bullish, the market can hold up until more evidence of slowing in the U.S. economy emerge, and the expected resolution of Europe’s problems are challenged. A close below 1290 will increase the odds that a more significant top is in place.
Aggressive investors were advised in the February 1 Special Update to establish a short position in the S&P by buying the ETF SH, if the S&P traded above 1328, and to add to this position if the S&P traded above 1344. Last week we suggested the S&P might have one more pop left that would carry it above 1355. We suggested a further add to the short at 1364, using a close above 1374 as a stop on the whole position. For those following that advice the position would have been taken today (Tuesday 21 February) as the S&P reached 1367 before closing at 1362. Cover half of the position at 1325, and the other half at 1313.00.
Bonds - In our November letter we suggested buying TLT, which is the ETF that mirrors the yield on the 20-year Treasury bond. On February 9 it closed at $115.49, which is the only day it has closed below our stop of $115.80. We think it will trade above the October high $125.03 before year end. Buy one third now, one third on a close below $115.49, and another third at $112.85, where there is a gap.
Dollar - In our May letter we recommended going long the Dollar via its ETF (UUP) at $21.56, and in our July 31 Special Update, we suggested adding to the UUP position below $20.91. The stop at $21.90 was triggered on February 7, when UUP closed at $21.89 and the only day it has closed below our stop. Repurchase UUP, using a close below $21.70 as a stop.
Gold - We recommend selling 65% of GLD purchased at $154.00 on the opening on December 30, which was $155.48, and to sell the remaining third on the opening of January 17, which was $161.17. If gold closes above the November high at $1804.00, it will likely run to the September peak near $1925.00. Buy a one third position in GLD if it closes above $175.55, using $160.00 as a stop. We are more comfortable waiting for a pullback later this year for a larger position, especially if Europe’s sovereign debt crisis reignites as we expect.
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