Be Right and Sit Tight
We noted last week that the energy boom appears set to continue for some time. We have also written several times in the past about how we believe the stock market is currently in a long-term P/E compression cycle. We found this piece from Financial Sense that encapsulates part of our investment thought process and wanted to share it.
Financial Sense: “The Key to Stock Market Success!” by Elliott H. Gue 07/06/2006
Jesse Livermore was perhaps the most famous stock trader of the early 20th century; he made and lost millions of dollars in his day. And, for the record, that was a lot of money 100 years ago. Livermore was most famously immortalized in Edwin Lefevre’s thinly veiled biography Reminiscences of a Stock Operator, probably one of the best and most helpful books on trading and investing ever written.
One of Livermore’s trading rules was “Be right and Sit Tight.”
He also said this is one of the hardest lessons for any investor to learn. In other words, Livermore suggested jumping on board a major trend and then having the courage to hold on to make the really big gains.Clearly, energy is just such a major trend. As I’ve outlined on numerous occasions in The Energy Strategist, demand for oil and gas is booming while the world’s ability to expand supplies and production is, at best, limited. The great commodity bull markets throughout history have lasted for at least 15 to 20 years–this current up-cycle has more than a few good years left in which to run.
But that doesn’t mean there won’t be corrections. Long-term readers are well aware that we’ve seen three significant energy corrections during the past 12 months. Each pullback lasted between one and three months and resulted in prices 15 percent to 25 percent off the highs for most stocks in the group. Each pullback also represented an excellent buying opportunity as the group subsequently rallied to new highs.
We agree that the energy market is one place where there is such a trend. The other places we think we are right are the upswing in commodities and the compression cycle in stocks. A big part of our discipline will be sitting tight on these major themes.
On the other hand, when things go too far in one direction or another there may be opportunities for short-term plays. (In our book, those are 3-month to one-year – we are not day traders for the most part.) We want to take advantage of the shorter-term movements, when possible, without violating the overall sit tight principle. That could mean lightening up on positions, writing covered calls or taking shorter-term long positions in certain stocks when we think the time is right.
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[...] With the Dow Jones Industrial Average well within striking distance of a new high, it seemed an appropriate time to revisit a theme we consider important enough to get right and sit tight. That theme is the concept that the long-term bull market of the 1980’s was due as much to expanding valuations as it was to improving fundamentals. Under this thesis, valuation tends to move in waves over very long time horizons. The chart below, which was taken from Barron’s (via The Big Picture) provides graphic support to the theory. During the flat periods, earnings growth is largely offset by shrinking multiples the market is willing to pay for those earnings. [...]
[...] We have written about the apparent long-term valuation cycles in the stock market, and one of our core beliefs is that right now the markets are in the midst of a long-term valuation contraction. As we have noted in our previous articles, that doesn’t mean the market can’t rise – it just means it is likely to rise at a slower rate than earnings grow. Typically such cycles have not reversed until P/E multiples were in the single digits. Today, there is a different take on the phenomenon presented at Econoday: Remember back if you will to the days of Y2K and earlier when Alan Greenspan was warning of “irrational exuberance.” Perhaps I was the one elbowing you in the Charles Schwab line. Those were times when there was an opposite play between profits and share prices, when share appreciation greatly exceeded profit growth as will be seen in the final graphs of this short take. The graph below shows the ongoing play between profits and shares. The green bars are the same as the first graph, representing year-on-year S&P 500 profit growth. The orange bars are year-on-year changes in the S&P 500 index. The left side of the graph shows that the index was contracting even while profit growth was emerging. Growth between profits and stocks then matches up well in late 2003 and early 2004 before stocks begin to lag again. Stock growth has in fact lagged now for 10 straight quarters up to the third quarter where the bars are highlighted. The graph suggests, at the least, that speculative excess is not a threat to the stock market. [...]