Thinking About the Market Cycle
A Pre-Earnings Buy
Since today is Tax Day (ugh), I wanted to give you something to think about. Here's a quote from a speech Calvin Coolidge (the 30th President of the United States) gave back on February 12, 1924 where he discussed his proposed bill to slash certain taxes that was pending before Congress.
But this Cabot Wealth Advisory isn't about the politics of cutting tax rates--the speech really gave insight into the relationships of tax rates, the economy and Federal revenues. As a disclaimer, this is NOT a political talking point on my end; it's a reasoned economic argument that rarely gets mentioned these days. I hope you enjoy it!
"In taxation, like all else, it is necessary to test a theory by practical results. The first object of taxation is to secure revenue. When the taxation of large incomes is approached with that in view, the problem is to find a rate that will produce the largest returns. Experience does not show that the higher rate produces larger revenue. Experience is all in the other way.
"When the surtax on incomes of $300,000 and over was but 10%, the revenue was about the same as when it was at 65%. [Note: $300,000 back in 1924 is the equivalent of $3.8 million today.] There is no escaping the fact that when taxation of large incomes is excessive, they tend to disappear. In 1916 there were 206 incomes of $1 million or more; then the high rate went into effect. The next year there were only 141, and in 1918, but 67. In 1919, the number declined to 65. In 1920 it fell to 33 and the next year it was reduced further to 21.
"I am not making the argument with the man who believes that 55% ought to be taken away from the man with $1 million income, or 68% from a $5 million income; but when it is considered that in the effort to get these amounts we are rapidly approaching the point of getting nothing at all, it is necessary to look for a more practical method.
"I agree perfectly with those who wish to relieve the small taxpayer by getting the largest possible contribution from the people with large incomes. But if the rates on large incomes are so high that they disappear, the small taxpayer will be left to bear the entire burden. If, on the other hand, the tax rates are placed where they will get the most revenue from large incomes, then the small taxpayer will be relieved."
I like this speech because it's based on facts and figures and experience, not on political talking points. Incidentally, Congress did pass Coolidge's tax bill, reducing the top tax rate to 25%, and the economy and people's incomes indeed boomed during the roaring 1920s, before the Great Depression took hold. Just something to chew on!
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Now let's move on to my real passion, the stock market. We're about six to eight weeks from the point where the market confirmed its latest rally, depending on the method you use. At this point in the current intermediate-term rally, most of the best leading stocks have already lifted off, hit new price highs and made good advances. That doesn't preclude new leaders from emerging during earnings season (some always do), or some slow-to-get-going stocks from also gapping on earnings.
But for the most part, the leaders are extended from proper buy points. If you bought some of these names during early- to mid-March, you're likely sitting on solid gains. And yet you're also wondering what to do next--with earnings coming up, and with your stock extended to the upside, should you be booking your profit?
For guidance, I defer to another giant from history, Jesse Livermore. Technically, this isn't a quote, per se, as it comes from a fictional biography, "Reminiscences of a Stock Operator," but this is probably the most famous passage from that book, which is itself probably the most famous investment book ever written (and my personal favorite).
It comes just after a friend's chat with a trader nicknamed Turkey, who, despite the friend's efforts to get him to sell his stock and buy it back on weakness, was insistent on sitting tight with his shares. The reason he gave for such a decision? "Well ... it's a bull market!" And that's where we pick up:
"I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept telling other customers, 'Well you know this is a bull market!' he really meant to tell them that the big money was not in the individual fluctuations but in the main movements--that is, not in reading the tape but in sizing up the entire market and its trend.
"And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It was never my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! I've known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine--that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money.
"This is about all I have learned--to study general conditions, to take a position and stick to it. I can wait without a twinge of impatience. I can see a setback without being shaken, knowing that it is only temporary. I have been short one hundred thousand shares and I have seen a big rally coming. I have figured--and figured correctly--that such a rally as I felt was inevitable, and even wholesome, would make a difference of one million dollars in my paper profits.
"And I nevertheless stood pat and seen half my paper profit wiped out, without once considering the advisability of covering my shorts to put them out again on the rally. I knew that if I did I might lose my position and with it the certainty of a big killing. It is the big swing that makes the big money for you."
Now, I can't say that I adhere to this line of thinking in full; I personally do like to take a few chips off the table every once in a while, especially if a stock has become greatly extended above its moving averages, and looks out of trend on the upside. Some stocks look like that today, in fact.
However, reading this quote is something I advise doing from time to time--it reminds you of the importance of trying to hit a few homeruns when things are going our way, as they are today.
As for the current environment, we are seeing amazing strength in the marketplace. In fact, on Wednesday, when the Dow rallied more than 100 points, the number of stocks hitting new 52-week highs totaled 611. That was slightly higher than the 601 figure seen in mid-March and the highest in many years!
I've written about this before, but here's what such a strong reading usually means. In the short-term, it's a negative--the flood of new highs tells you that enthusiasm is reaching a crescendo, and that most investors who want to buy in have already done so. In fact, after the prior 600-plus reading in March, stocks basically meandered for two and a half weeks before spurting higher in April.
My guess is that, with earnings season getting underway, a pullback from this point is likely. And I think some pain will be dished out--the market is not a one-way street, and with investors having bought hand over fist for about two months now, you should prepare for some pullbacks.
But that's a good thing! Why? Because the odds are that many of the true leaders of this advance--the stocks that have made big moves and that have terrific growth prospects--are generally too extended to the upside to safely buy here. But I'm betting that a few of them will consolidate for two, three or even four weeks and allow their 50-day moving averages to catch up.
What are some names to consider? Many have been mentioned in these Cabot Wealth Advisories during the past few weeks. Names like Baidu (BIDU), Cliffs Natural Resources (CLF), Priceline.com (PCLN), Apple (AAPL), Lululemon (LULU), Cree Inc. (CREE) and Las Vegas Sands (LVS) could present good buy points on 5% to 10% retreats.
But I want to write about Amazon.com (AMZN), which has not been a leader during this advance--the stock is just now testing its peaks from December. However, for all the talk about Apple's iPad possibly killing Amazon's Kindle e-reader, business at Amazon seems to be doing great. Nearly all retail firms are benefiting of late, and Amazon, even before the latest pickup in the economy, was forecast to grow its bottom line 40% this year and another 30% in 2011.
Thus, when Amazon reports earnings next Thursday (April 22) after the closing bell, I'll be watching to see if it can react strongly and thrust to new highs; the bigger the upmove the better. I think buying a small (only small!) position here is OK, with the idea of buying more if the stock's first-quarter report brings the type of gap I'm hoping for.
Until next time,
For Cabot Wealth Advisory
Editor's Note: Cabot Market Letter subscribers are currently enjoying a solid 10% profit in Amazon and as Mike wrote above, he believes the stock has a lot more upside potential. To get all of Mike's top growth stock picks, as well as detailed market timing advice, try Cabot Market Letter. There's a reason Hulbert Financial Digest named Cabot Market Letter to its annual Honor Roll ... find out why! Click below to get started today.