Kaeppel's Corner: Recession Starts Next Tuesday at Noon
December 11, 2007
I’ve been waiting to read this headline somewhere so I decided that I might just as well go ahead and write it myself before someone else beats me to it. It seems like a logical headline because it appears to be a foregone conclusion among investors, commentators, men, women, children, dogs, cats, etc. that the economy is either:
A. Already in a recession;
B. On the cusp of a recession; or
C. Within a matter of months, lapsing into a recession.
So I figure what the heck, who needs all of this drama and angst, right? Let’s just say, “It’s starting next Tuesday,” and get on with it. And why not throw one helluva “going away” party for the economy while you’re at it? Good way to break up the week. Well, it’s a thought anyway.
Fear and the Markets
Fear is one thing that causes investors to fail to generate as much profit as they might otherwise in the long run. The fear of losing one’s hard-earned money has a very powerful influence on investors. There is fear involved in contemplating the thought of working for x-hours or days or weeks or even years to earn a certain amount of money—and then seeing that money vanish in a short period of time. How does this happen?
- A company comes up 2 cents short of “street expectations” for earnings.
- The Fed:
- Raises rates triggering fears of recession.
- Cuts rates triggering fears of inflation.
- Leaves rates steady triggering fears of continued uncertainty.
3. The unemployment figure is:
- Too high, triggering fears of recession.
- Too low triggering fears of future rate hikes by the Fed (see above for
appropriate fears to be spawned by this event).
- About in line with expectations, thus triggering fears of stagnation in the
economy, etc.
4. The U.S. dollar:
- Plunges, thus creating terribly negative implications for the U.S. economy.
- Advances sharply, thus creating terribly negative implications for the U.S. economy.
- Remains unchanged, leaving pundits to argue about which direction the
dollar will go next and what the terribly negative implications to the
economy of that move will be.
5. Of our preferred scenario that the economy is either:
- Already in a recession.
- On the cusp of a recession.
- Within a matter of months of lapsing into a recession.
You get the idea. If you read or listen to the business news you will likely come away thinking that you should be afraid of just about everything. Even news that is typically considered as good news for the stock market—lower interest rates, robust economy, full employment—is spun as just a lead in to the next disaster. In essence, the message seems to be that we have everything to fear including fear itself.
The combination of all these issues is the reason that so many of us spend countless hours looking at indicators. If only we could find the indicator, or group of indicators, that accurately tells us when to be in or out of the stock market (preferably with “uncanny accuracy”). Having spent a “few” hours studying a “few” indicators myself, I can confirm that there are some pretty useful indicators out there. That unfortunately, is the good news. The bad news is that there are none that always work. Therefore, no matter how “locked down, airtight, sophisticatedly quantifiable” your trading method may be, the fact remains that there will be times when you will be in the market and the market will start to decline. Likewise, there will be times when you are not fully invested in the market and the market will go up. And regardless of the amount of confidence you have in your approach, there will always be that doubt in the back of your mind that maybe, just maybe “this time” will be that “six sigma” aberration. The one where you either get your clock cleaned before your “sophisticated” methods tell you to cut bait, or the one where you sit and watch the rest of the investing world make tons of money while you sit on your hands. Allow me to sum this up as succinctly as possible with two simple maxims:
Maxim #1: Reality sucks sometimes.
Maxim #2: Deal with it.
Okay, I admit that that it’s not the most eloquent thing I’ve ever written, but sometimes you’ve got to call a spade a spade. In the end, you cannot control the market. Just as importantly you cannot allow the market to control you. The bottom line is that you must utilize an investment approach or method that puts the odds as far into your favor as possible and then “ride the wave” to the best of your ability. No retreat. No surrender. No regrets. Okay, maybe a stop-loss order now and then…
Moving on, this week we’ll look at two thoughts on putting the odds in your favor right now: the 40-week cycle and large-cap vs small cap stocks.
The 40-Week Cycle
Since I first wrote about this cyclical phenomenon in an issue of Technical Analysis of Stocks and Commodities magazine, this cycle has garnered some notice. I have written about it often and Tom Gentile has developed a variety of methods to capitalize on this essentially unexplainable phenomenon in the stock market. In a nutshell, since April 21, 1967 (and no, I don’t know why it started then), the stock market has seemed to operate on a fairly regular 40-week cycle. The first 20 weeks are the “bullish phase” and the second 20-weeks are the “bearish” phase. I have since determined that the best use of this cycle is to attempt to maximize one’s profitability during the bullish phase.
The latest bullish phase began at the close of trading on 12/7/2007 and will extend through the close of trading on April 25th, 2008. Chart 1 below displays the growth of $1,000 invested in the Dow only during each 20-week bullish phase since April of 1967.
Chart 1: Growth of $1,000 invested in the Dow during the “bullish” 20-week phase of each 40-week cycle since 1967.
Looking at Chart 1, you can see a definite long-term tendency for the stock market to advance during the 20-week bullish phase. But does this mean that we can simply put aside all fears, leverage ourselves to the hilt and wait around for April 25th and then cash in our huge profits? Ah, there’s the rub. In reality, the so-called “bullish “ phase has shown a profit 40 out of 53 times, or about 76% of the time. So no one should get the idea that the stock market is a “lock” to rally between now and April. The best that we can say is that if a major bear market unfolds during this new 20 week bullish phase, it will mark the first such occurrence in the past 40 years.
Large-Cap versus Small-Cap Stocks
In the 2007 Stock Trader’s Almanac, there was a piece of research credited to Ned Davis Research, that suggested that small–cap stocks tend to outperform large-cap stocks between the middle of December and the end of February, and that large-caps outperformed small caps the rest of the year. Is there any truth to this theory? Seeing as how it is almost December 15th, now would be a good time find out. So let’s take a look.
Chart 2 displays the growth of $1,000 invested in the Russell 1000 Large-Cap Index (RUT) and the Russell 2000 Small-Cap Index (RUT) between December 15th and the end of the following February, starting on December 31st, 1988.
Chart 2: Growth of $1,000 invested in small-cap RUT Index (purple line) and large-cap RUI Index (blue line) only between December 15th and February 28th of following year since December 1988.
As you can see in Chart 2, there has been a definite tendency for small-caps to outperform large-caps between mid-December and the end of the February.
- $1,000 invested in the RUT only between December 15th and February 28th every year since 1988 would have grown to $2,736.
- $1,000 invested in the RUI large-cap index during the same time would have grown to only $1,638.
So there does appear to be a tendency for small-cap to outperform between mid-December and the end of the following February. Chart 3 displays the performance of each index during the rest of the year. The blue line displays the growth of $1,000 invested in the large-cap RIU Index between February 28th and December 15th of each year since 1989. The purple line displays the growth of the same $1,000 invested in the small-cap RUT index during the same time.
- $1,000 invested in the RUT only between February 28th and December 15th every year since 1988 would have grown to $1,931.
- $1,000 invested in the RUI large-cap index during the same time would have grown to $3,391.
Hence, it also appears that there is an advantage to being in large-cap stocks during the bulk of the year.
Chart 3: Growth of $1,000 invested in small-cap RUT Index (purple line) and large-cap RUI Index (blue line) only between February 28th and December 15th of same year since December 1988.
Chart 4 displays the growth of $1,000 invested in the small cap RUT index only between December 15th and February 28th and then switched into the large-cap RUI index the rest of the year. This chart also displays the growth of $1,000 that had simply been split between the two indexes on a buy and hold basis.
Chart 4: Growth of $1,000 invested in small-cap RUT Index between December 15th and February 28th of following year and in large-cap RUI Index the rest of the year since December 1988 (blue line), versus $1,000 split between the two indexes (purple line).
- $1,000 invested using our “switching” strategy would have grown to $9,279 between 12/31/1988 and 12/7/2007.
- $1,000 split evenly on a buy-and-hold basis between the two indexes (RUT and RUI) on 12/31/1988 would have grown to only $5,425 during the same time.
Summary
So, should we be bullish on small-cap stocks between now and the end of February based on the combination of a bullish phase in the 40-week cycle and the tendency of small-caps to outperform large caps during this timeframe? Don’t ask me. I’m too busy making my “Recession Party” preparations. (But I’ve heard worse ideas.)
Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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