More support for the August 9, selling climax-induced bullish position?

More support for the August 9, selling climax-induced bullish position?
David R. Kotok
August 24, 2011

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So far, the August 9 intraday S&P 500 Index trading low has held. It was 1100. It has been tested twice in the futures market. In each case a sharply down futures price was reversed and the market closed up. Thus, those two tests do not appear in the trading records in New York. They do appear in Asian and European market trading.

We have remained fully invested through this turmoil and continue that way. We believe that the US stock market had a peak-to-trough bear selloff that lasted from the April 29 top of 1363 to the August 9 low of 1100. Those 263 points are about 20% of the S&P 500 Index.

The selling-climax issue is important but not enough by itself to make a fully invested decision. The reason is that we do not know if the climax was an interim climax or the final one. We will not know that for another few months.

Another indicator gives us some additional comfort in our bullish position. We give specific credit to First Trust for reporting it.

This approach measures the results of the US stock market after it has experienced a down day of over 6%. Since 1950, there have been 16 episodes in which the S&P 500 sold off by more than 6%. We had episode number 16 on August 8. The S&P was off by 6.66%.

Of the 15 other episodes, only two did not result in higher stock prices after one year. One of those was the selloff after Lehman-AIG on September 29, 2008, when the market lost 7.62%. The other was the selloff on October 13, 1989, when the market fell 6.12%.

In every other case, the stock market was higher one year after a 6% down day. The average gain was 21.25%, and that is after averaging in the two loss experiences. The higher gains were in the 34%-to-45% range, and there were four such gains among the 15 episodes.

So what does this mean for 2011 and 2012? History would argue that the stock market is headed higher, and maybe much higher. Some of the valuation metrics we use suggest the same. Others compare stocks with bonds (Ned Davis) or gold (Ritholtz) and argue the valuation disparity.

Our view is that stocks are mostly washed out. This is especially true of the financial sector. My email runs 10 to 1 against banks, bankers, and other financial professionals and their enterprises. They are the target of nearly universal disdain.

At Cumberland, we think it is time to be adding weight to the financial sector. We do it with selected ETFs. We are doing that and are taking up the weights. For us it is the first time since 2007 that we are raising weights in the financial sector instead of lowering them.

Was August 9 the final selling climax? We will not know for a while. Nevertheless, every day increases the odds that it was. That said, Friday’s Bernanke speech and any other event could send the market in any direction. That is how it works when uncertainty is so high.

We are fully invested in our US stock market ETF accounts. We are terrified bulls but still bulls. We think the market (S&P 500 index) has a chance to reach 1350-1400 by yearend and over 2000 by the end of the decade. It is 1165 as this is written.

We look forward to discussing this outlook with Tom Keene on Bloomberg TV tomorrow, (Thursday) between noon and one. And again on Bloomberg radio with Tom Keene and Ken Prewitt between 7 and 9 AM on Friday morning. This assumes another earthquake does not derail the travel plans.

David R. Kotok, Chairman and Chief Investment Officer