What Happens After a Flat Market Year?
A Potential Leader Getting Ready to Move
Seeing as this is my first Wealth Advisory since 2012 began, let me first wish you and yours a terrific, healthy and prosperous New Year. With the New Year comes a clean slate for investors--mentally, it's a lot easier to ignore the tedious up-and-down action of 2011 and look ahead toward a year full of possibilities. Personally, I am optimistic that 2012 will be a good year, but as always I'll take my cues from the market itself.
If you haven't done it already, now is a good time to make a few New Year's investing resolutions. Don't worry--I am not going to bore you with another edition of "cut losses short, let winners run" talk (even though that is vitally important). Instead, I want to chat about avoiding being your own worst enemy ... something that brings the portfolios of the majority of investors down.
As someone whose professional life is dedicated to the stock market, I can tell you that it's tough enough to outperform the market when you don't make any mistakes (it's like playing a good football team (go Pats!) mistakes make every play hard to execute. So if the team also turns it over and has a bunch of dumb penalties--beating itself--it's nearly impossible for them to win the game.
Here are the most common mistakes I've seen investors make:
Owning too few stocks (having a ton of money tied up in just one or two names) or way too many stocks (so that a big winner or two doesn't do them much good). A corollary would be that they own a bunch of stocks in the same sector, which is somewhat pointless and can lead to big losses when that group turns down.
Concentrating only on "fastballs"--the very volatile, relatively thinly traded stocks that can do great for a while, but have huge corrections during their advance and eventually fall off a cliff. It's hard for even disciplined professionals to handle these types of stocks, so most "average" investors tend to get burned.
Playing to their biases when picking stocks. Whether it's a stock that was good to them before (I still get questions about First Solar, Research in Motion, Green Mountain Coffee, you name it), or, conversely, avoiding groups they view as ugly (many investors still hate to touch commodity stocks, for instance), they end up focusing on a select group of names instead of letting the market tell them where it's best to put their money.
Chasing stocks, getting emotional that they'll miss the boat. I don't care how many years you've been in the market, this is a very common fault that we all fall for. But, while chasing stocks can work out at times, over the long run you're better off either buying on a huge breakout from a multi-week (or multi-month) range, or just buying a strong stock after two or three days down.
Not tracking their performance, so they really don't know how they're doing.
Finally, they vary from their plan based on the recent past. If an investor loses on three straight trades, but then the fourth one is off to a good start, guess what? He sells it quickly to book the profit so that he doesn't lose a fourth in a row. Sounds good, except that eventually one of those he sells early turns into the big winner he was waiting for!
There are other missteps out there, of course, but these are the biggest ones I see in my conversations with other investors. If you've struggled in stocks during the past year or two like so many have, your best move is to eliminate these mistakes first; they'll automatically help you out. After that, you can focus on learning some new tricks of the trade ... which I'll write about in a future Wealth Advisory!
On the topic of the current market, I wanted to relay some data from an interesting study we did last week. It answers the simple question: "What happens in the market during the year or two following a very flat year?" I really didn't know what we'd find, if anything, but the results turned out to be encouraging.
First, I looked for all the years when the S&P 500 finished the year with a return of between +3% and -3% (including dividends). As it turned out, there were only six years that fit that description since 1928, and that's if you included 1990 which returned -3.1%. So I broadened the search for results between +5% and -5%. Using that parameter, we got nine results (not including 2011, which was flat).
Then I looked at what happened during the year or two following those lackluster years. Here's what I found:
The year following a very flat year averaged a whopping 26% return, with eight of the nine years producing positive results. The only down year returned -10%, while all of the positive years returned at least 14%. So that was good to see.
Moreover, looking at the second year out from a flat year, it was still decent, with an average return just south of 14%. However, as you'd expect, the results were more mixed--two offered negative returns, and another two returned less than 10%, while the remaining five all returned at least 19%.
By the third year out, it was a coin flip, with an average return of just 1% for the S&P 500, which included three stinkers and another couple mundane gains.
What's my conclusion? First, the market tends to act relatively well after a very flat year, especially in the year following (which would be 2012). Second, and possibly more important, is that the market usually gets back to making some moves--the trendless chop of 2011 could continue a bit longer, but it should give way to some real trends in the near future, which provides opportunity for investors.
All that said, we wouldn't base your entire 2012 investing plan on this limited study. But history does rhyme in the stock market, and I do believe the odds favor some tradable trends emerging in 2012, possibly during the current earnings season.
NOTE: I took the study a step further because a hedge fund buddy of mine asked, "How were the results when you looked at flat years during secular bear markets, such as 1966-1982, 1929-1945 and 2000-the present?" Turns out four of the nine years occurred during these long-term bearish periods--1934, 1939, 1970 and 2005.
The results going ahead weren't as good, but were still solid. One year out, the median return was 15%, with three of the four returning at least 14%. Two years out the median return was 12%, with three of the four positive.
As for the current market, I am growing increasingly optimistic that we've turned the corner. It appears that the shakeouts seen around Thanksgiving and again in mid-December, and the mini-crash from mid July through early October were enough to wear out the weak hands. Interestingly, since that mid-December low, the major indexes have been moving higher in a well-controlled manner, and many potential leaders are tightening up.
The good news is that even if you haven't bought a share of any stock during the past month, it's not like you've missed the boat. To the contrary, my research shows just a handful of leaders have lifted off on big volume to this point, so if this move is the real McCoy, then I anticipate many, many more opportunities as earnings season revs up.
I think keeping it simple at this point is your best move--look for great growth companies with big stories and rapid growth whose stocks have set up launching pads. And then see if they can gap up on earnings! If they do, you buy them, if they don't, you leave them alone.
One stock to watch is MercadoLibre (MELI), which suffered a horrific drop during the market's plunge last year; in total, the stock collapsed from 93 in April to 48 in October! But then it began rallying, and it exploded higher on earnings (it was up 31% one day on eight times average volume), thanks to a much better-than-expected report.
However (and this is one thing you can keep in mind for the future), when a stock suffers a top-to-bottom retreat of more than 45%, and then comes all the way back in quick fashion, it almost always needs at least five or six weeks of consolidation near the top of the structure. In other words, it doesn't just bottom and go up forever; it needs a multi-week period of digestion to set the stage for a real breakout.
That's what I see now from MELI, which is in the sixth week of a new, proper, shallower base. A couple more weeks in the 80 to 95 range, followed by a big-volume move to new highs would be buyable in my opinion, with a stop about 10% to 12% below your cost. It's something to keep an eye on in the weeks to come, as MELI is acting like it could be a mid-cap leader of any powerful bull move that develops.
All the best,
Editor of Cabot Market Letter
Editor's Note: Mike Cintolo is the editor of Cabot Market Letter, our flagship publication. Combining top stock picking, market timing and portfolio management, Mike has bested the S&P 500 by more than 10% annually during the past five years--a period that encompassed bull, bear and choppy markets. With a new bull market on the horizon, now is a great time to get in Mike's program so you can take advantage of the leaders as they lift off. Click here to learn more.