And a new strategy’s stunning debut from Flexible Plan

Ever since President Lyndon Johnson announced on October 30, 1968 that he was halting the bombing of North Vietnam and intensifying talks with the Viet Cong, there has been fear or hope for an October Surprise in Presidential election years. Back then, it was believed the intention was to help Johnson’s Vice President, Hubert Humphrey, win the Presidency. And it almost did, as Humphrey quickly moved up in the polls, although losing six days later by a narrow 0.7% of the popular vote.

Since then, we’ve seen Kissinger’s “peace is at hand” declaration in 1972, the Iranian hostage deals that didn’t happen (1982), Iran-Contra in 1992, the 1976 George W. drunken driving exposure in 2000, and the Osama Bin Laden video in 2004. And the players who have sought to impact those elections with these disclosures have ranged from Cabinet members, to Saudi Prince Bandar, to the New York Times and Al Jazeera.

This year is no different; rumors continue to spin through the media cycles as Election Day approaches. Some may think that the Libyan consulate fiasco qualifies, but that seems more like an ill-timed event, not one directed to influence the election. (Of course, one could muse about whether the Al Qaida group that carried out the terrorist attack was most concerned with the September 11 date of their assault or its possible influence on the election, or both.)

Now comes the buzz the day before the last Presidential debate (on foreign policy, yet) that the Iranians are willing to have a face-to-face meeting with us on the nuclear bomb issue. Is it coincidental that so many of these October Surprises have revolved around Iran? Is it because they have so often been a nemesis, seeking to cause trouble here, or is it that they are a closed society of which anything can be suggested without much fear of contradiction?

Whatever… the possibility of such a surprise (even though one has yet to ever cause Presidential leadership in the polls to flip-flop and determine a winner) fits right in with the uncertain environment in the financial markets that I made a case for last week. As I pointed out then, uncertainty normally leads to market declines. Add the media chattering of an October Surprise to a suddenly surging challenger in the Presidential race, and a looming (and unmentioned by either candidate) fiscal cliff at year-end, and there is plenty to be uncertain about.

The market responded with a 1.61% decline on Friday. This was the first 1% or greater decline in the Dow Jones Industrial Index in the last 81 days. In the past, such an event has often led to lower prices in the week ahead (two-thirds of the occurrences since 1909).

Since 1% or greater one-day declines are usually met with a rebound the next day and week, there is a conflict here in the statistical trends. While this often happens, in this case it should be quickly resolved as we watch today’s market action for a clue.

One time when the 1% rebound did not occur was in 1987 – talk about an October Surprise! The market, much like this year, was in rally mode. Then on Friday, October 16th, the S&P 500 Index fell 5.16%. The following Monday, there was no rebound. Instead, the Index fell another 19.4% in the greatest one-day stock market loss of all time.

Last Friday was the 25th year anniversary of that event. While there was no celebration of the anniversary, there was a lot of chatter in the media. Perhaps that, and the similarities with this year, is what spooked the market on Friday?

Not only was Friday the 25th anniversary of the 1987 collapse, but it was an anniversary of the event that first brought Flexible Plan Investments to the attention of most investors. For on the day of the greatest decline in stock market history, all of our investors were invested 100% in money market funds.

On August 31st of 1987, just four trading days after the 1987 market top, we had moved out of equities and into money market funds. We moved back into equities on October 30th, ahead of the December 5th bottom that year. In contrast to the Crash, that’s an event these investors are likely to feel like celebrating!

While we are patting ourselves on the back (actually, I’m getting a little old to try to really do that), we did a pretty good job of prognosticating last week. In the Hotline I concluded that “…As a result, I expect a bounce up as the market tests support, then down if earnings suffer this week…” And, of course, that’s precisely what happened in the stock market last week, as the indexes rose Monday through Wednesday, and then declined on earnings news on Thursday and Friday.

Even better than my general Hotline statement, however, was the performance last week of our newest Strategic Solutions strategy, S&P Tactical Patterns. This strategy, which can use leverage and go long or short, uses a proprietary combination of daily stock patterns and position sizing to trade the popular S&P 500 Index through index mutual funds. Last week it was long Monday through Wednesday and short Thursday and Friday – going a perfect five for five in a very volatile week, while racking up an almost 5% gain for the period.

Since S&P Tactical Patterns’ inception on January 23rd of this year, an investment in the strategy has gained 18.16% after maximum fees (versus 10.77% for the S&P 500 Total Return Index, itself). It has done this while being exposed to the stock market only 88% of the time, being long 49% and short 42% of the time. It is truly an equal opportunity strategy.

The indicators this week seem to favor a reversal to the upside. Interest rates remain low, economic reports have been positively exceeding expectations (ten better, three worse and three in line last week) and bullish sentiment among average investors has fallen to levels not seen since the market low point in July.

Still, it’s earnings reporting season and this one has not gone well so far. As we witnessed last week, these reports can quickly turn a blue sky black with storm clouds. So far, we are on track to our worst quarter of earnings reports since 4Q 2008. And, top-line revenue reports have under-performed more often than out-performed, with only 43.2% beating expectations – the worst rate since at least the year 2000.

In addition, our Political Seasonality Index and the Presidential Election Year averages continue to point to one more October drop in stock prices. They both forecast lower stock prices in the week ahead.

This does not make me optimistic when combined with the coming to fruition of what the late, great, technical analyst David Elliot used to call an “ice hole failure.” (David passed away in May after a multi-year battle with cancer. He will be missed.) Based on the premise that when one falls through the ice, you tend to bounce back up, only to be met by the ice overhead, an “ice hole failure” pattern requires a break of the 50-day moving average followed by a bounce back up to that average, before a plunge to lower lows. Check out the NASDAQ Index lately… Look familiar?

Further weakness should not be surprising, and the possibility of an October Surprise just increases uncertainty in an uncertain market…

All the best,
Jerry

For the first time the Electoral Vote Map shows a Romney lead when calculated with toss-ups. 206 likely or leaning Romney, 201 likely or leaning Obama and 131 toss-ups. Still, if you calculate on the last poll results with no toss-ups allowed, Obama leads 277 to 261.

Don’t forget to watch Monday night’s final debate, 9 pm EST.

Disclosures