 happen  every  year,  but  it  is  what  has  happenedmost  often.  It’s  just  like  the  old  advice:  “The  race  may  not  go  to  thestrongest and swiftest, but, young man, that is how you bet them.” Thishas been a distinct and predictable occurrence that gives way to the all-important stock market rally at this time of the year.
Besides  the  thesis  that  stocks  rally  when  interest  rates  decline,  onecould  add  additional  timing  signiﬁcance  to  investment  decisions  made  inOctober  by  investigating  what  bond  prices  have  been  doing.  In  otherwords, if bond prices have bottomed and/or ﬁrmed up during October (theFederal  Reserve  is  taking  positive  action)  then  one  could  be  even  morebullish or use this as conﬁrmation to enter into the stock market.
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THE AMAZING OCTOBER EFFECT
Figure 3.3 October Rally in Bonds
One look at the bond market seasonal pattern and we can see it is nowonder stocks have had such trouble in the ﬁrst part of the year. The sea-sonal  tendency  shows  that  starting  in  April,  the  bond  market  has  beendown, usually for the ﬁrst four months of the year. There is rhyme and rea-son as to why stocks do what they do. I would like to point out there is avariable lag effect between what the bond market does and what the stockmarket does. Usually bonds need to rally for a while, say a month or so,before this bullish consideration pulls up stocks.
By the same token, stock market highs do not occur precisely when thebond  market  reaches  its  peak  but  sometime  thereafter.  By  and  large,  thelead time for this warning from the bond market of potential stock markethighs  has  been  anywhere  from  six  weeks  to  six  months.  That’s  the  badnews—there’s no precise time when stocks will crack because interest rateshave started to increase. But I can tell you that every single bear market Ihave lived and traded through since the 1960s has been preceded by higherinterest rates and by a decline in the bond market.
To  a  large  extent,  as  bonds  go  so  goes  the  stock  market.  History  isclear on one point: Bonds have most often rallied in October. It is no won-der, then, that the best buying opportunities in the stock market have comeat this time.
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PUTTING IT ALL TOGETHER
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PUTTING IT ALL TOGETHER
Stop  and  think  for  a  moment  about  what  we  have  learned  so  far:  On  along-term basis the majority of important buying opportunities have comein  years  ending  in  a  two  or  a  three.  We  can  combine  the  four-year  phe-nomenon  with  this  to  load  the  odds  even  more  in  our  favor.  Hence,  weknow the ideal buy points would be in years ending in a two that coincidewith the four-year cyclical buy point. In the past these years have included1932 and 1942, both of which were phenomenal once-in-a-lifetime buy-ing opportunities.
The next opportunity came in 1952 when another up move began witha pullback into the ﬁrst part of 1953. What began then was a straight-upmarket  for  the  rest  of  1953,  1954,  and  1955!  By  the  time  1962  rolledaround  you  would  think  investors  would  have  woken  up  to  this  doublepunch  combination  of  the  four-year  phenomenon  and  the  decennial  pat-tern.  Unfortunately  few  had.  But  1962  acted  as  the  another  springboardfor  one  more  straight-up  market  to  the  record-shattering  1966  high  thatput  the  Dow  Jones  Industrial  Average  over  1,000.  What  a  beautiful  ridethat was!
The year 1972 was not a particularly optimal time to buy stocks; butthen again it was not in synch with the four-year pattern, which had calledfor a low point in 1970 and in 1974. We had to wait until 1982 for thenext ideal buy. That combination seemingly had a tremendous inﬂuence onprices, as the ultimate bull market began running almost straight up from1982 all the way to 1999. Historians now tell us that this was the greatestbull market ever. They didn’t tell you to be a buyer at that time, though.Yet the historical record was very clear, as 1982 offered our double punchfor a knockout of the bears.
Again,  that  was  why  I  wrote  How  to  Prosper  in  the  Coming  GoodYears. It was for that reason I went so far out on a limb and risked my en-tire reputation.
Now  that  we  have  seen  how  2002  played  out,  and  we  note  this  ﬁtswith  our  four-year  phenomenon,  certainly  the  bells  of  bullishness  shouldbe clanging.
Finally, we can bring in the October effect knowing that the majorityof bear markets have ended in October. Of importance is that the end of abear market means a bull market has begun at that time. Thus, I think it issafe to assume that 2002 presented investors with a wonderful opportunityto buy stocks.
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THE AMAZING OCTOBER EFFECT
When I began this book in the summer of 2001 I thought it would besafe to make another logical conclusion about the future. It was that be-tween then and October 2002 stock market prices would go into a tradingrange with a downward bias. Would there be a signiﬁcant bear market? Ididn’t really know, but there was a little expectation for a substantial moveto the upside—until of course we come into our triple whammy buy zoneof October 2002, with the four-year phenomenon in a year ending with atwo. The historical record of the past suggests there would be some type ofsigniﬁcant sell-off between 2001 and our buy point. That would not be outof character, but it was not mandatory that it take place. My study of thepast afﬁrms—above all—that our double whammy combination is a pre-lude to great bull markets. Sometimes these have been set up by signiﬁcantdeclines and sometimes not.
WHAT TO DO NEXT
An investor faces several challenges at this point, knowing what we nowknow. The ﬁrst, naturally, is to get ready for the next buy point . . . andknow what stocks to buy.
Let’s not forget that these forecasting techniques tell us we should havea signiﬁcant market rally in 2005 and another in 2006. That seems to be apretty  good  combination,  suggesting  to  me  that  we  will  have  a  great  upmove in 2005 and 2006. That time represents the next best potential for amajor buying opportunity after the one that occurred in 2002.
In either event, knowing this in advance, you should begin lookingfor  stocks  to  put  on  your  shopping  list.  The  rest  of  this  book  will  be devoted to selection techniques as well as investment strategies that canbe  optimized  at  these  superb  long-term  buying  points.  Yes,  these  tech-niques can be used at other points, but it strikes me as folly to use tech-niques at what is not an optimal time. Ultimately, I see speculators to belike  gambling  casinos.  Casinos  build  all  those  gargantuan  hotels,  golfcourses, and the like simply because they have a small percentage advan-tage in a game that ranges from less than two percentage points all theway up to ﬁve percentage points. With that slight advantage they rake inthe dough.
They play their game in an optimal fashion. They make money in theold-fashioned way: They ﬁnd an advantage in the game and never give you
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WHAT TO DO NEXT
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a break (a free room perhaps, but never an advantage over them in theirgame of choice).
Isn’t that what we should do? I sure think so. There’s no need to tradeevery day or even every year. A long-term investor seeks the times with thegreatest advantage in his or her favor. As a pilot friend once told me, “It isfar better to be on the ground wishing you were in the air than to be in theair wishing you were on the ground.”
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HOW TO KNOW FOR SURETHE BOTTOM IS HERE
Taurum per cernua prehende.(Take the bull by the horns.)
We’ve been able to isolate the times we expect to see the next major stockmarket lows, that of 2002–2003 as well as the 2005 (decennial pattern ﬁveyear) and 2006 (four-year phenomenon) buy points. Let’s also not forgetthe potential for a buy point somewhere in the latter part of 2007, the gen-eral time when we expect the last up leg in our decennial pattern to kick in,taking us up to the negative ﬁrst nine and second zero year of this century.While we clearly have the vision of those potential lows, that will notbe enough information to give us the conviction at the time to rush in andbuy. I think it will be helpful for us to study market buying points of thepast  to  better  understand  what  to  expect  and  what  to  be  looking  for  asthese potential buy opportunities unfold.
HOW TO TELL WHEN STOCKS ARE UNDERVALUED
There are several indicators I have used and found to be extremely valu-able  in  calling  major  market  bottoms.  While  there  are  several  ways  oflooking  at  what  forms  a  market  bottom,  one  would  be  the  fundamentalscenario.  There’s  a  great  deal  of  signiﬁcance  to  what  the  yield  is  on  the
41
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Dow Jones Industrial Average. The yield is the amount of cash return in-vestors get from companies in the form of dividends.
In  the  past,  stock  market  highs  typically  developed  with  the  yield of the Dow Jones Industrial Average somewhere under 3 percent. Thatwas an extremely good rule until the 1980s and 1990s, when, for what-ever  reason,  stocks  continued  churning  ahead  despite  the  very  low yield in the Dow. The yield is a measure of value or quality. Not payingdividends  is  usually  (not  always)  a  sign  of  a  lackluster  or  unproﬁtablecompany.
Major market bottoms in the Dow Jones Industrial Average have beenseen when the yield on the Dow was over 6 percent. In light of the factthat a 3 percent or lower yield no longer seems to stop stock market activ-ity to the upside (now undervaluation seems to be more in the 1 percent to2 percent area) it might suggest to us that the 6 percent yield factor willbecome an even more rare occurrence than in the recent past, or may notbe seen at all.
The 6 percent yield has called, without a doubt, the best major buyingopportunities  of  the  past  100  and  some  years.  That  is  a  long-term  trackrecord  that  I  don’t  want  to  neglect.  Nonetheless  I  am  concerned  that  wemay not see such a high yield at the next market low. There have been lowswithout such a high yield. An absolute ﬁxed rule of investments is that any-time the yield on the Dow Jones Industrial Average exceeds 6 percent oneshould mortgage the house, scrape up all the possible cash one can acquire,and  buy  stocks.  They  may  not  go  up  the  next  day  or  the  next  week  butthere is a gargantuan bull market ahead whenever stocks have had such ahigh yield. This has hardly ever occurred but the few instances have alwaysled to huge stock market rallies.
The spread between competing yields of stock and bonds is probablythe  best  way  to  look  at  these  value  numbers.  Stocks  always  competeagainst another investment. So if stocks yield 6 percent but bonds yield 12percent, clearly stocks are overvalued despite a high yield. In the marketsall things are relative.
It makes sense to me that if we can double the yield in the Dow from a
prior market high then we are in an area that we can call relative value.
Suppose  the  current  yield  on  the  Dow  Jones  Industrial  Average  hasbeen 3 percent at the market top. If we were to double that we would get a6 percent yield, at which point one would look for a market bottom basedon value. That has been the general relationship of high yields to low yields
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HOW TO FOLLOW THE FEDERAL RESERVE SYSTEM
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in the past. A yield below 3 percent seemed to cause market highs; over 6percent market lows.
On July 31, 2001, the yield on the Dow Jones Industrial Average was1.69. Doubling that would be a yield of 3.3 percent. This ought to be thegeneral area where we would next see a market undervaluation point oc-cur. A yield somewhere in the area of 3.5 and 4.0 percent yield would mostlikely signal the next market bottom area. This would indeed be the high-est yield for the past 20 years! The Dow had not been at such a valuationlevel since 1982. Accordingly, I suspected that if we again got this type ofhigh-yield  performance  by  the  Dow  it  would  attract  long-term  investors.After all, bank accounts currently are yielding about that, yet offer no op-portunity for upside appreciation.
HOW TO FOLLOW THE FEDERAL RESERVE SYSTEM
The Federal Reserve Board is as concerned about stock prices as you are.Whether the chairman of the Fed has been Arthur Burns, Paul Volcker, orAlan  Greenspan,  they  have  all  expressed  great  concern  about  higher  orlower levels of stock prices. Students of Burns have shown me the modelshe had developed and surely used while at the Fed.
After all, the stock market has always been the most immediate mea-sure of conﬁdence, and conﬁdence is the currency of every banking system.It appears as though they have a valuation for stock prices that they haveused over the years to help them determine monetary policy. The Fed measureis arrived at by determining the ratio of the S&P 500 to its fair value—that is,the 12-month forward consensus of expected operating earnings per share di-vided by the 10-year Treasury bond yield minus 100. This is readily availableon a web site published by Ed Yardeni (just do a web search for Yardeni or EdYardeni). While Yardeni himself has been a bit extreme in his bearishness attimes, and in particular regarding the Y2K supposed crisis, he was also one ofthe few bulls at the 2002 low. The index has done a wonderful job of tellingus, and the Feds, when stock prices are too high or too low.
Figure 4.1, showing the index as of September 2001, is pretty simple tointerpret. When the index is above 20, historically speaking, stock priceshave been overvalued and declines of some magnitude have taken place.
When the index is under –10, stocks have been in a long-term pur-
chase area.
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Figure 4.1 Federal Reserve’s Stock Valuation ModelRatio of S&P 500 Index to its Fair-Value (52-week forward consensus expected S&P 500operating earnings per share divided by the 10-year U.S. Treasury bond yield) minus 100.Source: Thomson Financial.
The  index  topped  out  at  over  65  in  1999,  and  in  2001  and  in  2002was in the neutral zone. The most logical reading to next appear should beone of undervalued. That is because the market goes from undervalued toovervalued and back to undervalued. Since we were in the overvalued zonewe know that the markets are heading for an undervalued zone in the nottoo distant future.
Accordingly, if you see this index got below the –10 reading in 2003,you  will  know  a  low  in  stock  prices  should  be  at  hand.  At  that  time  in-vestors will be helped by the power of the Federal Reserve system; the Fedwill  see  this  reading  as  a  strong  indication  that  stock  prices  are  low  andthey need to help buoy market activity.
This also drives home the importance of stock market earnings, andillustrates rather graphically how they are the key ingredient to real mar-ket success.
Keep in mind that money always has choices; it can go into a conserv-ative  and  safe  investment,  such  as  a  bank  or  savings  account  earning  aﬁxed rate of return, but in doing so it cannot accomplish any advancementthrough capital appreciation. When money chooses this option it suggestsmoney is afraid of the future. Yet if money can get a comparable return in
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a safe haven and still have the potential for upside investment it’s a prettysimple choice of where money will go. It will go where it can get the best ofboth worlds—a comparable yield or return in conjunction with a potentialfor growth and appreciation.
Money  always  follows  the  basic  law  of  human  motivation,  which  isthat  self-interest  prevails,  and  given  a  choice  of  the  best  of  both  worlds,smart-money investors, in fact people of all nations and races, will makethat most logical choice.
Now feast your eyes on this same chart as it appeared in 2002, as Fig-ure  4.2.  Lo  and  behold,  shortly  before  stocks  bottomed,  the  index  hadmoved into the buy zone I had predicted in 2001.
Figure 4.2 Stock Valuation Model and Asset Allocation Model—Bonds/StocksRatio of S&P 500 index to its fair value (12-month forward consensus expectedoperating earnings per share divided by the ten-year U.S. Treasury bond yield) minus100. Monthly through March 1994, weekly after.Source: Thomson Financial.
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ADDING FUEL TO THE FIRE
Money, cold hard-earned cash, is the mother’s milk of market rallies. It isthe  singular  stimulant  and  ultimate  fuel  for  all  upside  activity.  When  thegas tank is full, this car can go forever. The fuel largely comes from:
❙ Stock  Mutual  Funds—These  guys  get  their  money  from  folks  justlike you and me, folks from all walks of life, rich and poor, wealthyand  superwealthy.  In  recent  years  pension  fund  dollars  have  alsotopped off the tank.
❙ Private  Investors—Private  investors  may  either  pony  up  their  ownmoney exclusively or borrow from their brokerage ﬁrms on marginto seek even more bang for their buck. To that extent their ability toborrow these funds is the potential for fuel. When they are all loanedup, the tank is empty; when they have borrowing power the prospectof a brighter moon looms on the night’s horizon.
To  a  large  extent,  the  tremendous  inﬂux  of  mutual  fund  money  hasbuoyed stock prices in the past decade. One could truly say that cash fuelsthe engines of higher stock market prices. This cash may come in from in-dividual investors or may come in from mutual funds or even from govern-ments and ﬁnancial institutions. Currently mutual funds are the big playerin the game, at times accounting for almost 60 percent of the volume in themarketplace. This percentage has been consistent both before and after thecrash of 1999; thus it is of great value to see how much cash these fundshave on hand.
When mutual funds are sitting on a great deal of cash it means theycan buy—they can add gasoline or fuel to the ﬁre of upside activity. Whenthey have very little cash on hand—that is, on a relative basis—it’s very dif-ﬁcult for prices to go higher because the gas tank is empty.
From 1982 forward, when the funds were sitting on more than 8 per-cent cash, markets had a distinct tendency to rally. The best buying oppor-tunities from 1982 forward came when the funds’ cash position was over10  percent.  Other  high  readings  occurred  at  the  1985,  1986,  1987,  and1990 buy points.
It would be nice then, wouldn’t it, to see the funds in a cash positionof somewhere over 10 percent. It may not even have to get that high. Ona  three-  or  four-year  look-back  basis,  if  the  fund  position  were  to  get
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A “FUELISH” THING TO DO
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over 8 percent it would indicate the largest cash position of the past fouryears,  which  should  be  bullish  toward  a  market  rally.  The  higher  thecash position grows, the more bullish it will be, as there is more fuel forhigher prices.
Mutual funds’ cash on hand is such a signiﬁcant index that it is of ex-treme  importance  to  follow  it.  It  can  be  found  in  Barron’s or Investor’sBusiness Daily, and you do not have to look at it every single day of theweek.  This  information  is  released  once  a  month,  which  is  adequate  be-cause it is such a long-term index. It is fundamental to the structure andcausation of stock market up-and-down movements, so it certainly shouldbe on your list of important stock market indicators.
A “FUELISH” THING TO DO
Brokers  often  encourage  their  customers  to  borrow  money  to  purchasestocks.  The  amount  an  investor  can  borrow  is  a  function  of  how  muchmoney is in the account and what the loan ratio on those funds is. Frankly,I think it is unwise to borrow to trade or invest. Of course, when you areright it’s to your advantage, and if you can beat the pipers—that is, earnmore  than  the  broker’s  interest  rates—you’ll  make  more  than  if  you  hadnot borrowed.
But when you are wrong you are doubly injured: you have lost moneythat was not yours. I’m content to earn what I earn without increasing lia-bilities,  but  then  I  don’t  like  debt.  Been  there,  done  that;  it’s  not  all  it’scracked up to be.
Figure 4.3 shows 37 years of the S&P 500 index with margin debt (themoney investors borrowed) overlapped on the same chart. Two things areat work here: As stock prices go up, customers’ equity increases, enablingthem to borrow more. And as prices go higher investors are prone to bor-row more, and more, and more. This borrowing is the fuel to the ﬁre, asyou can see. Exponential increases in debt are harbingers of rallies.
Now let’s look at the ability of the private investor to buy more stocksdue to his or her ability to borrow money. Figure 4.4 depicts the annual-ized 12-month rate of change of stock market margin credit extended bythe New York Stock Exchange (NYSE) member ﬁrms. When borrowingshave  been  increasing  by  about  40  percent  more  than  a  year  earlier  this“source  of  fuel”  has  been  about  used  up.  Virtually  every  major  markethigh from 1970 forward has been tipped to the astute investor by such a
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Figure 4.3 37 Years of S&P 500 Index with Margin Debt
Figure 4.4 Margin Stock Credit Extended by New York Stock ExchangeMember Firms
reading. Granted, this does not pinpoint the exact high; it’s just a messagethat the party is ending, the last dance has begun.
The reverse is equally true: When there has been a substantial decreasein  credit  (ie.,  private  investors  have  not been  borrowing  money  to  buystocks) there exists the potential for them to begin buying. It is for that rea-son  that  most  market  lows  since  the  late  1960s  have  occurred  about  thesame time the 12-month rate of change of credit was –20 percent or more.
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INVESTOR SENTIMENT IS THE SECRET TO INVESTMENT SURVIVAL
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Again, this is not a pinpoint, precise tool. But its record of suggestingwhen a major market bottom is close at hand is, indeed, excellent. You canjudge for yourself, as this index was clearly indicating that a market lowwas due in the fall of 2001. Additionally, as of the end of 2002 the indexwas still under the zero level, telling us to expect higher prices.
I would love to see this index at –20 percent or close to the other buy
points I have listed in this book. That would be wonderful conﬁrmation.
INVESTOR SENTIMENT IS THE SECRET TO INVESTMENT SURVIVAL
If there is any one secret to investment survival it would be to understandthat to a very large degree swings in the stock market are in response toinvestors’  emotions.  While  on  a  long-term  basis  stocks  may  be  goinghigher, the intermediate-term highs and lows along that route are causedby investors getting extremely bullish or extremely bearish. I can think ofno  better  short-  to  intermediate-term  indicator  than  that  offered  by  astudy  of  what  the  majority  of  investors  are  doing.  Interestingly  enough,this  can  be  mutual  funds  or  individual  investors.  Perhaps  best  of  all,  orperhaps we should say worst of all, is what the investment advisers them-selves are saying.
It is ironic, but absolutely true, that when the majority of investment
advisers become excessively bullish stocks decline.
By the same token, when the majority of investor advisers become ex-
cessively bearish stock markets rally.
It is of great importance to understand this because at virtually everystock market low you’ll ﬁnd investment advisers, newspapers, brokers, andthe like to be negative on stocks. They will be reticent and reluctant to buy.They will tell you not to do what you have to do. This ﬂies in the face ofeverything  you  have  learned  your  entire  life.  We  have  always,  outside  ofthe markets, looked to the experts to tell us what to do.
So when the experts are not telling us to buy we don’t buy. The stockmarket, though, is a totally different world than the one we live in everyday. Here the world is turned upside down; what seems good is bad, andwhat looks bad is very, very good.
There is a reason for this. Investors, be they advisers, mutual funds, orsimply individual folks like you and me, are primarily inﬂuenced by the ap-pearance of trends. The more the market advances the more bullish we be-come.  The  more  a  market  declines  the  more  bearish  we  become.  This
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seems to be an immutable law of psychology. It is the way the human mindworks. It is almost as though investors are acting as judge and jury seekingmore information and more information in order to come to a conclusion.When all investors reach the same conclusion, the game is over.
If there is a reason for this, it is simply that there is no more fuel fromthese investors to keep the engines of growth churning. The market runsout of mutual fund fuel or public investor fuel.
As  my  good  friend  Tom  DeMark  said,  “Markets  don’t  top  becausesellers come into the marketplace. Markets top because there are simply nomore buyers.” That’s it! See? When there is nobody left to buy there’s nomore money to drive prices higher. When all of the investors or investmentadvisers are already bullish, there simply isn’t much more buying to comeinto the marketplace. Stocks have no choice but to decline. There are nu-merous ways of looking at the psychology of the marketplace. I