Martin Zweig Winning on Wall Street

by Martin Zweig

  From mid-November of 1929 the Dow rallied smartly to a top of 294 in April 1930. That move represented a bull market with a gain of some 48%. (A similar move in mid-1996 would have taken the Dow up about 2700 points in five months.) After that, though, the Depression began, and it was all downhill. By July of 1932 the Dow closed at 41, down an incredible 86% from the spring highs of 1930, and off an amazing 89% from the 1929 peak.

  After the devastation of the early thirties, stocks reversed course and a mighty bull market persisted until 1937. The Depression picked up steam once again and prices fell anew, not bottoming on a real basis until April 1942, a few months after Pearl Harbor. Then the great bull market commenced, carrying the Dow up to a peak of almost 1000 in 1966. Even in real terms, the Dow Industrials gained more than fivefold between 1942 and the top in 1966.

  GRAPH D

  Ned Davis Research

  Here is the point I want to emphasize. In nominal terms, the Dow struck 995 in 1966, about the time the Vietnam War was heating up. With that war came the beginning of heavy inflation that distorted most economic factors, including stock averages. When the bear market bottomed in August of 1982, at 777 on the Dow, it represented about a 22% nominal decline over a sixteen-year span. However, during that interval the inflation rate roughly tripled. Indeed, between January 1966 and August 1982, the consumer price index rose from 95.4 to 308.6, a huge gain of 223.5%. That’s an annualized inflation rate of 7.3% for more than sixteen years. Using the 1966 price level, when the Dow Industrials were trading at 777 in August 1982, it was the equivalent of only 240. In other words, the Dow had lost roughly three-quarters of its value over a sixteen-year period, and that, in my book, is a real bear market.

  Graph D clearly shows this long-term bear trend from 1966 to 1982. Of course, there were interim bull markets within this extensive down cycle. These bull markets occurred in 1967–68, 1970–73, 1974–76, and, to a lesser degree, in 1980. But in all cases the bull market highs came at real prices below the previous bull market peaks, and the subsequent bear market lows came at lower real levels than the previous bear market bottoms. The succession of lower highs and lower lows was part of the ongoing long-term bear market.

  This cycle was broken after the 1982 bottom. In the huge bull advance that followed to 1983, the “real” Dow Jones bettered its 1980–81 peak, the first time in about two decades that it surpassed a prior high. The sell-off that followed into 1984 likewise bottomed at real prices considerably above those at the 1982 lows. Then the 1985 rally blasted “real” prices to above the 1983 high.

  The 7.3% compounded inflation rate from 1966 to 1982 was, in fact, a culprit in helping to create that long-term bear market. Stocks generally do not do well in periods of extreme inflation— it’s the second worse environment for stocks. The worst, of course, is extreme deflation, such as that seen in the early thirties and then again in 1937–38. The stock market likes stable prices such as those in the decade of the 1920s and in the first half of the 1960s. The higher inflation rate of the late sixties and the seventies caused individual investors to abandon the stock market and move money into collectibles, gold, and real estate.

  From the early 1960s on, the individual investor became a net liquidator of stock and continued selling relentlessly until 1983, when the public, for the first time in two decades, turned to the buy side. However, the public temporarily reversed that trend, on balance going back to selling in 1984. During much of that period, real estate prices boomed, especially the prices of homes, fueled by intense speculation. Gold also made an enormous move, running from $35 an ounce to a peak of about $875 in early 1980 before collapsing. Prices of all sorts of collectibles, including art, antiques, coins, and stamps, went sky-high during this span, as people perceived them as hedges against inflation.

  The worst thing about inflation, as far as the stock market is concerned, is that the cure is more damaging than the disease. When inflation gets too intense, the Federal Reserve starts acting to reduce the growth in the money supply, thereby increasing interest rates. This slows economic activity and hurts corporate profits. The result is often a bear market.

  When Paul Volcker became chairman of the Federal Reserve Board in 1979, he called inflation the number one enemy and took restrictive monetary steps to do battle. By 1981 his war was won and the inflation rate was nose-diving. By 1982 stocks had stopped going down on a major-trend basis. With the disinflationary period at hand, stocks began to rise in a very-long-term bull market which carried the Dow to 2722 prior to the 1987 crash, up 250% from the 1982 low. By mid-1996, the Dow had climbed to around 5600, up 435% since 1982.

  In subsequent chapters I will show you how to time your investments so that you can get in and out of the market at optimal moments. But do keep in mind the lesson of these last few pages. If inflation were to heat up, it would tend to work against stock prices and also distort the nominal price averages that are reported. So, in a period of rapid inflation or deflation, be sure to make the proper adjustments to the stock averages to avoid being stuck with a rubber yardstick.

  CHAPTER 4

  Monetary Indicators—“Don’t Fight the Fed”

  In the stock market, as with horse racing, money makes the mare go. Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate—primarily the trend in interest rates and Federal Reserve policy—is the dominant factor in determining the stock market’s major direction. Once established, the trend typically lasts from one to three years.

  Combining to produce a monetary “climate” are loan demand in the economy, liquidity in the banking system, inflation or deflation, and, of course, policy decisions by the Federal Reserve Board. These are the major factors that create a trend in interest rates. Generally, a rising trend in rates is bearish for stocks; a falling trend is bullish. Let’s see why.

  First, falling interest rates reduce the competition on stocks from other investments, especially short-term instruments such as Treasury bills, certificates of deposit, or money market funds. For example, when an investor sees yields on CDs drop from, say, 7% to 3%, he becomes a lot less enthusiastic about “rolling over” his CDs and reinvesting them. The newer and lower yields just aren’t as good. Stocks begin to look more attractive. Obviously, the reverse is true when interest rates rise.

  Second, when interest rates fall, it costs corporations less to borrow. That reduces a major expense, especially for companies that are heavy borrowers such as airlines, public utilities, or savings and loans. As expenses fall, profits rise. Wall Street loves the idea that future earnings will go up. So, as interest rates drop, investors tend to bid prices higher, partly on the expectation of better earnings. The opposite effect occurs when interest rates rise.

  So much for theory. Now let’s see how it works out in practice. I’ll take you through three different monetary indicators, each very simple to construct and easy to understand. Although I keep tabs on a much wider range of economic data for my forecasting, I have found that these three indicators are so effective and so much less complicated than my entire system, that they fall into the category of “less is better.”

  PRIME RATE INDICATOR

  The prime rate is that interest rate that banks charge their best customers, principally the top-quality major corporations. Most rates on bank loans are based off the prime rate, with the charge increasing relative to the prime rate as the riskiness of the loan rises. In other words, the less credit-worthy the borrower, the more above the prime rate he will pay. Movements in the prime rate are plotted in graph E (pp. 44–45) against the Dow Jones Industrials.

  The beauty of using the prime rate as a stock market indicator is that it does not change every day as do other interest rates. Over the thirty-two years to 1996, the prime rate changed an average of 10.7 times a year, or roughly just once a month. Also, it’s difficult not to notice a prime-rate change since such moves always make headlines in the financial pages and usually are noted on the evening news as
well. So, for the busy investor, following the prime rate is certainly easy enough.

  The prime rate has another virtue: it lags behind other interest rates. The prime rate usually falls only after a drop in federal funds rates or in the yields on certificates of deposit or commercial paper. But that’s exactly what an investor wants to keep his eye on, because changes in interest rates generally lead changes in the stock market. An interest rate that moves a little behind other interest rates can often mark just that point when stocks finally begin to respond to the changes in rates.

  GRAPH E

  Ned Davis Research

  Rules:

  First, I made a somewhat arbitrary decision that 8% or above is a relatively high interest rate and below 8% is relatively low. Therefore, small declines in rates below 8% are enough to give a bullish signal for stocks, but somewhat larger declines in rates are necessary for a bullish signal if they come from above the 8% level. Conversely, minor increases in rates at levels above the “high” 8% zone are enough to give bearish signals for stocks. But at levels below 8%, somewhat larger increases in rates are needed to give bearish signals. While the 8% demarcation is open to debate, clearly both the level and the direction of rates are important, although all of my studies show that the trend of interest rates is more significant than the level itself. In any case, there is logic to these rules, and, most of all, simplicity.

  Buy Signals:

  1. Any initial cut in the prime rate if the prime’s peak was less than 8%. Example: The prime has risen several times from, say, 5% to 7% over a period of months. Finally, it is cut one day to 61/2%. That day immediately marks a buy signal for stocks based on this indicator.

  2. If the prime’s peak is 8% or higher, a buy signal comes on either the second of two cuts or on a full % cut in the rate. Example: The prime has risen several times from 6% to 10%. Then it is cut to 91/2%. That’s not enough for a signal. Later it is cut again, to 9%. That’s the second cut, and that’s when the buy signal flashes. If the first cut had been a full percentage point to 9%, the buy signal would have come at that time. Changes in the prime rate usually come in ¼% or ½% increments. A full-point change at one time is much rarer (about one in twenty cases)_and _ also more significant.

  Sell Signals:

  1. Any initial hike in the prime rate if the prime’s low is 8% or greater. Example: The prime has fallen several times from 12% down to 10%. Then, it’s boosted to 10½%. That day marks a sell signal.

  2. If the prime’s low is less than 8%, a sell signal comes on the second of two hikes or on a full 1% jump in the rate. Example: The prime has fallen several times from 10% to 6%, Then it is lifted to 6½%. That’s not enough for a signal. Later it is raised again, to 7%. That’s the second increase, and that flashes the sell signal. If the first rise had been a full percentage point to 7%, the sell signal would have come at that time.

  Table 1 shows the performance of the Prime Rate Indicator when tested against my Zweig Unweighted Price Index, a market average that gives equal weight to all Big Board stocks. Its movements are very similar to the Value Line Index, against which one can now trade stock index futures (the ZUPI was explained fully in chapter 3).

  For example, the first buy signal came in March 1954 when the ZUPI stood at 33.73. Some nineteen months later the indicator gave a sell signal in October 1955, as seen on the right side of the table. The ZUPI at that time had climbed to 48.29. The percentage gain on the buy signal was 43.2% and is shown in the “% Change” column under “Buy Signals.”

  After the 1955 sell signal the Prime Rate Indicator stayed bearish until January 1958, when it gave the second buy signal listed in the table. At that point the ZUPI had drifted back to 47.66. That was 1.3% lower than the level at the 1955 sell signal and is noted in the first entry on the far-right column under “% Change” for “Sell Signals.” The rest of the table should be easy to follow.

  In all, twenty-two buy signals have been given by the indicator. Of the buys, twenty produced profits, a 91% success rate. Indeed, the only losses were insignificant fractional ones in 1981 and 1982, when the prime rate whipped back within a week or two.

  Some of the gains are startling, such as the one coming on the July 1982 buy signal; it produced a hefty 61.2% profit in just over a year. That signal essentially caught the entire 1982–83 bull advance. The October 1984 signal resulted in a 56.7% profit. In all, the indicator was in its bullish position (or mode) a cumulative total of 24 years. Had you invested $10,000 in a basket of typical stocks (or mutual funds) that moved in line with the Zweig Unweighted Price Index, it would have grown to $610,554. That’s an annualized rate of 18.7%. By contrast, had you bought stocks or funds similar to the ZUPI and held constantly for forty-two years—the approach called “buy-and-hold”—$10,000 would have increased to only $140,826. These calculations, and all others in the book, except where noted, ignore dividends and taxes.

  Now, suppose that you had bought the “market” (ZUPI) on the buy signals, sold stock on the sell signals, and then invested in short-term money market instruments (such as CDs) at an average rate of 7% until the next buy signal. That strategy would have grown a $10,000 stake into $1,913,660 over a period of 42 years. That’s a healthy 13.3% a year, far in excess of buy-and-hold’s 6.5% a year.

  The sell signals also produced solid results, although, as is generally true with monetary indicators, the record is not as good as it is on buy signals. Nonetheless, thirteen of the twenty-one sell signals “worked”; that is, prices fell. (The last signal is a “buy” at this writing.) That’s a healthy success average of 62%. (See Table 1, bottom line.) Moreover, you would have avoided the bulk of both the 1969–70 and 1973–74 bear markets, the two worst since the Depression, and the crash in October 1987. To be sure, the fact that 1962 monetary conditions were okay did not prevent the 1962 crash (a lot of other factors, especially the overly extended price/earnings ratios, were terrible then). But the more recent 1980, 1981, and 1987 downturns were nailed.

  Had you been hapless enough to have ignored the warnings of rising interest rates and insisted on owning stocks during the “sell modes” (the spans from sell signals to the next buy signal), a $10,000 investment would have shrunk to only $2,336. That’s an annualized loss rate of 7.8%.

  Table 2 shows a similar test of the Prime Rate Indicator against the Standard & Poor’s 500 Index. Recall from chapter 3 that the S&P is not as volatile as the ZUPI and virtually never will provide returns on any indicator as good as those on the ZUPI. The S&P test shows gains on the buy signals of 15.5% per annum vs. buy-and-hold of only 7.9%. The buys enabled $10,000 to grow into $318,068. Had you then, in the sell modes, gone into money market instruments at average yields of 7%, the $10,000 investment would have appreciated to $996,909, a nice 11.6% annualized gain, or significantly better than buy-and-hold.

  TABLE 1

  PRIME RATE INDICATOR VS. ZWEIG UNWEIGHTED PRICE INDEX: 1954 to 1996

  BUY SIGNALS SELL SIGNALS

  Date

  ZUPI

  % Change

  Date

  ZUPI

  % Change

  3/17/54

  33.73

  +43.2

  10/14/55

  48.29

  -1.3

  1/22/58

  47.66

  +57.2

  5/18/59

  74.93

  -1.6

  8/23/60

  73.74

  +70.1

  3/10/66

  125.43

  -3.3

  1/26/67

  121.28

  +20.8

  4/19/68

  146.45

  +12.2

  9/25/68

  164.98

  +7.7

  12/2/68

  177.68

  -42.7

  9/21/70

  101.86

  +21.9

  7/6/71

  124.17

  -6.1

  10/20/71

  116.59

  +3
.8

  6/26/72

  121.02

  -34.6

  1/29/74

  79.17

  +2.2

  3/22/74

  80.95

  -33.5

  10/21/74

  53.83

  +31.0

  7/28/75

  70.53

  -5.6

  11/5/75

  66.59

  +20.1

  6/7/76

  79.95

  +6.1

  8/2/76

  84.79

  +8.0

  5/31/77

  91.57

  +21.2

  12/7/79

  110.96

  +5.5

  2/19/80

  117.09

  -11.4

  5/1/80

  103.73

  +27.3

  8/26/80

  132.08

  +.6

  12/22/80

  132.87

  +11.7

  4/24/81

  148.46

  +.9

  6/16/81

  149.84

  -.5

  6/22/81

  149.02

  -14.7

  9/21/81

  127.04

  +1.3

  2/1/82

  128.68

  -5.9

  3/8/82

  121.07

  -.1

  3/16/82

  120.96

  +2.8