Tuesday, January 03, 2006


I must graciously agree with my good friend Random Roger again. Using a "calendar call" as a primary market indicator can be hazardous to your health.

Do I pay attention to historical patterns? Absolutely! However, when there is a lot of chatter about any particular pattern, one must balance precedent with a contrarian attitude toward sentiment. In most cases, once the majority of investors believe in a particular pattern, the pattern is at least temporarily broken.

The year 2005 is a great example. For a hundred and ten years, years ending in 5 have been winners. From 1885 to 1995, the Dow Jones gain in these years averaged 30.7%. The Dow was up 12 out of 12 of these years; a calendar call with a 100% track record (Source of data: "The Almanac Investor" by Jeffery A. Hirsch and J. Taylor Brown). Investors who purchased one year calls on this perfect indicator lost 100% of their investment.

Think about how the pattern was broken. By September of 2004, a number of market mavens reported on the "Decennial Cycle". Sure enough, the market rallied like a banshee late in 2004. Traders in effect moved the typical great performance of the 05 year to the end of the 04 year. If everyone knows that the last trading day before the 4th of July is a great day, then almost everyone buys too much two trading days before the 4th. The next year, the buying occurs three trading days in advance. Eventually, the market is so out of whack by the day before the 4th that it falls dramatically.

The same process played its hand in advance of 2006. This time, the oft reported patterns are the Santa Clause rally and the Presidential election pattern. Most investors are very aware of the annual Santa Clause rally and that the second year of the Presidential term has historically been the weakest of the four years. Investors bought in advance of the Santa Clause rally and the market ran out of steam while facing the terror of the “second presidential year”.

I don't think most investors are aware that the average second year is actually an o.k. year and that it typically sees wonderful returns from about September to year end. After the 2005 Santa Clause rally was nearly stolen by the fear of 2006, I think it is significant that the market reversed on the next to last day of the series. Again, I don't want to make too much of any one day move, but the action warmed my heart.

IMHO, the following is the proper investor perspective. One should appreciate that markets are anchored by logic but they trade on emotion in the short to intermediate term. My call for 2006 to be a great year is based on the relative value of stocks to bond yields and real estate rents.

For stocks to have a very bad year, bonds will likely have to have an even worse year. Of course, if bonds have a terrible year, it is easy to assume that real estate will have a terrible year.

All indications are the current slow down in real estate is showing up in lower demand for long-term paper. Bond yields and 30 year mortgage rates have been going down for months. Bond returns for the past 7 or 8 weeks have been spectacular and one of the best forecasters known to man, the yield curve, is forecasting lower long-term rates (the yield curve steepened today because short rates fell even faster than long rates).

Ultimately, ones inflation forecast is the key forecast. Since total compensation is the biggest component of inflation and since total compensation is growing at only a moderate pace, my forecast for inflation is low. Low inflation implies strength in bonds. If bonds are expensive relative to stocks and real estate but go up anyway, then stocks and real estate should over take and out-perform bonds; making excellent returns.

One last long-term pattern that has been broken is in regard to congressional seats gained and lost. President Bush is the only President to ever gain party seats 2 years after his election and again 4 years after his election. Will he score the incredible hat trick?

The second year pattern has been historically been up strong during the first 4 or 5 months of the year, down strong until a month or two before the election and then a really nice finish once the polls show who the winners will be. It has been a huge mistake to bet against a George Bush election victory. The market may follow the historical pattern but I believe Bush is even money to score the hat trick, with good news from Iraq. If the market gets wind of a Bush pick up of a senate seat or two this November, then hold your reigns tight because we might be riding one of Ken Fishers bucking broncos all the way to the bank.