The Best Contrary Indicator We’ve Ever Seen

Every day our inbox contains at least one missive packed with seductively scientific jargon professing to predict the future of the stock market.

This jargon is known as technical analysis, and it is appealing to many investors thanks not so much to its proven worth, but to its relative air of exactitude and certainty, what with precise levels of “support” and “resistance” and the like, not to mention comforting equations of logic: “If the market does this, it will do that…but if the market does that, it will do this…”

Technical analysis also has a solid place in the history of our business. After all, as a chartist once pointed out to me, before the SEC came along and companies had to file regular earnings reports, about the only way anybody could look at what was going on at a business—aside from inside information—was to look at patterns of accumulation and distribution by those insiders via charts and “tape reading.”

And sometimes it really works.

In the early 1980s, while a junior number-cruncher in the Merrill Lynch oil group, a man came bursting into our offices one morning waving a chart-book opened to the page of a dull, overlooked company whose stock had suddenly come to life.The man was Chuck Setty—a chart guy who worked with the legendary Bob Farrell—and the stock was Marathon Oil.

“What’s happening with Marathon?” Chuck asked my boss—who was one of the all-time great sell-side analysts, but a firm believer in the sanctity of data as opposed to charts and graphs and 50-Day Moving Averages.

“Nothing,” my boss said. “The stock is up a little. So what?”“So this,” said Chuck, showing us a chart of the stock, which was solidly rising in an otherwise languid oil tape. He then circled with his pen a massive rise in volume running along the bottom of the chart. “Somebody is buying a lot of it,” he said.

That “somebody” turned out to have been an oil company by the name of Mobil.

A few days later, Mobil announced an $85 a share tender for control of Marathon, and I signed up for a course in technical analysis at The New School.

Hey, even Warren Buffett was into charting early in his career.

Over time, however, I have come to believe, like Buffett, that staring at charts often gets in the way of finding good, inexpensive businesses to buy—and bad, overpriced businesses to sell short.

In particular, wallowing in the day-to-day ups and downs of the market as a whole, the ups-and-downs of which only get magnified by the CNBC Talking Heads, has zero to do with getting prepared, as Buffett would have all good investors be, for those rare occasions when opportunity presents itself in individual stocks.Indeed, such wallowing tends to reduce the likelihood that one will take advantage of those occasions.

Witness these actual excerpts from actual emails received during the course of one of the biggest stock market rallies in history:

March 16, 2009

The overall technical trend for the major equity market averages remains down, and there are no major bases in place yet. New lows for the averages were confirmed by new lows in the NYSE advance-decline line and consolidated tape on balance volume as well as by deterioration in our Volume Intensity (VIM) and VIGOR models. March 31, 2009Technically, SP500 futures’ failure to hold 780 will target 767 (38.2% retracement)-764 (filling of gap) as next major support level (per P Dauber).September 1, 2009Technically stocks are doing damage here (breaking under 1015 support from last week, breaking under 1010 20day MA….recall JPMorgan’s M Krauss is looking for a close below 1013 to confirm pullback to ~980). 1000 on the sp500 being watched closely today…. All wrong, and all completely overlooking the fact that on any given day, there are stocks to buy and stocks to sell, regardless of whatever a market average is or is not doing.

But we here at NotMakingThisUp write not to bash chartists or their tea-leaves.Indeed, whoever was paying Chuck Setty-like attention to the option activity in Perot Systems in the days leading up to Dell’s desperately uneconomic bid for that company would have seen something happening—thanks to what appears to have been some good old-fashioned inside information going around according to a newly reinvigorated SEC.

Whoever acted on those price and volume patterns in Perot Systems—like Chuck did, back in the Marathon Oil days—would have made some dough.

And making dough, rather than predictions, is what this business is about.

But instead of worrying about the 50-Day or the 200-Day or the Green Line crossing the Blue Line, we suggest a different market indicator.

In fact, based on past performance, we think we’ve stumbled across the best possible indicator of all: what the apparent knuckleheads in charge of handling cash flow at America’s largest companies do with their cash.

And what they do, it seems, is this: they throw it out the window.Well, not in an actual physical sense, but they might as well, for they seem to buy their own stocks back at exactly the wrong time, and then they proceed to not buy their own stocks back at exactly the wrong time.

Here’s the story, courtesy of the indispensible StreetEvents:

S&P 500 stock buybacks hit record low

Standard & Poor’s announced that S&P 500 stock buybacks have fallen to their lowest level since the first quarter of 1998 – when Standard & Poor’s began tracking the data.

According to Standard & Poor’s Index Services, preliminary results show that S&P 500 issues spent $24.2 billion on stock repurchases during the second quarter of 2009, representing a 72% decline from the $87.9 billion spent during the second quarter of 2008, and an 86% decline from the record $172.0 billion spent on stock buybacks during the third quarter of 2007. All this, of course, turns the old theory of technical analysis on its head: insiders should be buying not at the top, but at the bottom, and selling the opposite way. And in the old, pre-SEC, pre-Beat-the-Number-by-a-Penny days, pre-Dilutive-Stock-Option-Grants-Up-The-Wazoo, that might have been the case.

But not, apparently, any more. Nowadays, Bulls should keep a wary eye on corporate buybacks.

And Bears, it seems, should rejoice.

Jeff Matthews I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.