Bad Generals Make Good

By Eric J. Fry

Sometimes it's good to be a bad general.

On the battlefield, bad generals tend to "fight the last war." They utilize military tactics from prior campaigns, rather than devising new tactics for the campaign they are in.

But on Wall Street, a bad general would be a good investor, because a good investor tends to fight the last war. In other words, successful investing demands repeated campaigns against familiar enemies: like rising interest rates.

Whether cause or effect or sheer coincidence, rising interest rates tend to coincide with bull market mortality. Thus, as bull markets approach their final days, the earliest signs of failing health tend to appear in the financial sector. In other words, bank, brokerage and utility stocks tend to top out weeks or months prior to major stock market declines.

"I've kept a close on the share price of Merrill Lynch (MER) for over ten years," our colleague, Jeff Clark remarked in the January 12, 2007, edition of the Rude Awakening ("Time to Sell Short?"), "and don't ask me why, but the stock is one of the best leading stock market indicators I've ever seen. If the price action of MER is bearish, you can almost always bet the overall market is due for a fall. I even had a saying around my brokerage office, 'As Merrill goes, so goes the stock market.'

"Right now, the chart of Merrill Lynch (NYSE: MER) looks bearish… and if it breaks to the downside, it will be an ominous sign for the broad stock market."

As it turns out, Jeff called the exact top…of Merrill Lynch stock (NYSE: MER), that is. MER has slumped 10% since mid-January. Meanwhile, however, the stock market has continued to charge ahead - up more than 8% since the day Merrill topped out.

This curious divergence is not as curious as it may appear. MER is simply one of the many interest-rate sensitive stocks that tends to peak before the overall market peaks. The Dow Jones Utility Average also tends to provide a leading indicator of overall market weakness…and it, too, has been drifting lower.

Since interest rates have been rising for the last three or fours years - and rising sharply for the last three or four months - interest-rate sensitive stocks of all sorts have been faltering. Over the last two years, the yield on 10-year Treasuries has advanced from 3.89% to a recent 5-year high of 5.29%. Interest rates at the short end of the yield curve have also been climbing.

No surprise then that the Utility Average topped out one month ago, and has tumbled 8% since then. But the broader market averages remain buoyant nonetheless.

We've seen this battlefield before. Back in mid-June of 1987, interest rates were rising along the entire yield curve. Merrill Lynch shares topped out in January of that year. The Utility Average topped out in March. But the Dow continued charging ahead - up 28% through mid-June of 1987.

The Dow continued soaring until mid-August, when it topped out with an astounding year-to-date gain of more than 40%. Two months after that, the "Black Monday" crash of October 19, 1987, converted the Dow's sizeable gains into sizeable losses.

The fact that stock market trends of 2007 bear an eerie resemblance to stock market trends of 1987 is not automatically cause for fear, but it is absolutely cause for concern. Adding to this cause for concern is the fact that investor sentiment has become extremely complacent and optimistic, which, as a contrary indicator, suggests the market is approaching an important peak.

"The giant stock market rally has brought the broad market put/call ratio to the levels that prevailed at prior market tops," observes the seasoned options pro, Jay Shartsis. "One such ratio is the 21-day 'dollar-weighted' put/call ratio for the S&P 500 futures. Now standing at about 44 cents of puts traded for every $1.00 in calls, this ratio is way down from levels near $3.25 in puts per $1.00 of calls at last summer's market lows and $2.40-to-$1.00 at the market low in early March, 3 months ago. The current level, therefore, represents the lowest level of put-buying - hence highest level of option trader optimism - in several years and is of course contrarily bearish. One of these fine days all these 'Fearless Fosdicks' are going to get smacked real hard on their snoots and sent home crying to their mommas."

Furthermore, Shartsis concludes, the "Titanic Indicator" triggered last week. This powerful sell signal occurs whenever "within 7 days of a new Dow high, there are more new lows than new highs on the NYSE. This indicator has quite accurately identified past market tops."

Hmmm…time to prepare the defenses.