Monday, August 17, 2009

Cramer Discusses Parabolic Rises/My Prior Discussions of Selling into Parabolas

Throughout this blog, I have mentioned that one of my cardinal rules for ages now has been to sell into a parabolic rise in any asset class. The only difficult question is deciding how to structure the selling. Last year, there was a parabolic rise in energy prices. I sold my commodity ETFs, all of my natural resource funds, and most of my stocks into the rise, and have only started to buy those positions back. Parabolic moves in an asset class: role of dynamic asset allocation theoryThis is based in part on a belief that parabolic rises are not sustainable without a correction. This would be true for any asset class. This is a quote from a post in March that is typical of my approach:

"One hard and fast risk reduction rule would be to sell stocks when there is a move in the S & P 500 index to elevated P/E ratios. The chart of ten year moving averages for the S & P 500 P/E shows two clear cases when to leave the party. NYTimes.comWhenever it spikes I will sell and I will not listen to pundits trying to justify a market P/E of 44.2. If I am alive to see it happen again as it did in the late 1990s and the late 1920s (just look at the chart), I will not hesitate to sell, and would not even pay attention to the arguments about how it is different this time. Parabolic moves in any asset class have to be sold in my opinion. The only question is how to structure the selling. My approach has been to start selling when the parabolic nature of the move becomes evident to me, space out the transactions until I believe that it would be foolish to try and hold on for more and then sell whatever is left in the particular asset class undergoing the parabolic move. I would never expect to sell at the absolute highest level and view even having such an objective to be a foolish. Then, once the decision is made to entirely eliminate the asset undergoing the parabolic move, I have to stay out until it crashes, bottoms, and everyone just throws in the towel on it. Energy was one such asset class that I eliminated during the rise to $140 a barrel oil. Treasuries are such a class now in my opinion. Technology stocks had their day in the late 1990s and real estate between 2002 to 2006." Bungee Jumping Aegon and ING Preferred Stocks/ BlackJack and Stock Investing: Lessons Learned & Applied

I would urge a reader to look at the chart from the NYT that I referenced in the above quote. NYTimes.com When you see a parabolic rise like there was into the 1929 crash or the 1999 dot bomb bust, that is not a buying opportunity. Drill that into your head.

Even though this phenomenon has been seen over and over again, most recently with the 1999-2000 bubble in stock prices and the bubble in home prices in 2004-2006 in many localities, there is something in the human psyche that causes a short circuit in the ability to learn from prior experiences. Stock and home prices can not be divorced indefinitely from economic reality. Twenty per cent compounded growth for a few years is not a trend capable of sustaining itself. Home prices have to have some relationship to growth in incomes, and stocks have to be anchored in a realistic assessment of what a future stream of earnings is worth now. Cisco was not worth 150 pro forma earnings in 1999 based on a projection of 50% earnings growth into infinity, as if it was going to grow into entire GDP of the U.S. Home prices in San Diego could not accelerate 20% or more per year for several years in a row until less than 20% of the families could afford a median priced home. More on the Case-Shiller Index In San Jose, I read a story that prices had risen to the point that only 16% of the population in that geographic area could afford a median price home. Home Prices & Household Income

Cramer devoted part of his show tonight to reference the problem with the parabolic rise in the market. He mentioned that a 3 to 5% pullback would cure a parabola. TheStreet.com Maybe that is true for a parabola coming out of bear market. I would distinguish a dangerous parabolic rise from one that is not as ominous. A 3 to 5% correction will not cure a dangerous parabola, like the one experienced in stocks in 1999 or home real estate prices in 2004-2005. The dangerous parabola will be followed by carnage. I do not view the rise off the March low as a dangerous parabola. The dangerous kind, excluding some of the more hyperactive commodity markets, come at the end of a long bull run when prices have been in a steady advance for several years, or something like a more smooth 15 to 25% annual compounded rise in prices over several years. Occasionally the parabolic move may come at end of a bull and make a straight line move up in a shorter period, like the Nasdaq rise in 1999. The parabola takes prices to levels that make no economic sense.

While I have sold some stocks into the move off the March lows, I do not view the markets move since March to be a dangerous parabola. It is a parabola, and consequently required some selling into it.

The current parabola is not occurring off significant advances in a bull market but off a waterfall low at what will hopefully mark the tail end of the worst bear market since the Great Depression. This is the critical distinction. The rise has not taken the averages to the kind of extreme valuation levels seen in 1999, and is mostly a reaction to the market going too far down in the weeks preceding March 9, 2009. I look at it this way. The S & P 500 was at 1558 in October 2007, and is now at 979. Sure it rallied quickly off the 666 level in early March to over 1000 in August. That is a parabola. But, the average was at 869 on 2/9/09. ^GSPC: Historical Prices for S&P 500 INDEX,RTH If you look at the fall in the 30 days after 2/9 as an over reaction, and measure the rise from 2/9 to the close today, then the rise is placed in perspective, and is a less concerning 12-13% rise. And that kind of increase over five months is not in my view a dangerous parabola, that is, the kind that will generally correct more than 50%. So, in this context, I would agree that a 3 to 5% correction would flush out those who bought stock at or near the bottom, and start to draw investors back who largely missed buying in March and April. Eventually, however, while a 3 to 5% correction may cure the kind of parabolic rise experienced since March, as a correction to the first pop coming out of a nasty bear market, the economy is going to have to turn more to the upside, continue showing improvement, to sustain a move to DJIA 10,000 before the end of the year. What was largely overlooked today was the New York survey for manufacturing in New York, which confirms the improving trends in these surveys from the Fed and the ISM.

The chart that I referenced above, found in the NYT article, is also instructive of when not to panic and sell indiscriminately into a parabolic rise. Look at the parabola forming in 1982 in that chart, which was coming out of a long period of stagnant to down stock market performance. That is not a dangerous parabola. The dangerous one was formed in the late 1990s. We pay a dear price for these dangerous parabolic moves. The chart adjusts the S & P 500 averages for inflation and uses 10 year average earnings. (see discussion on Shiller:

My views on parabolas were not based on any training, or reading any material on technical analyst. I have yet to read my first book on that subject. Instead, it was formed from my experiences in the late 1960s, when I started to invest, which experienced a similar craze in valuations that was followed by a 15 year secular bear market in stocks.

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