Friday, April 20, 2007

Surge, Then Purge

If there is one constant, one consistent characteristic to the current bull market, it is its propensity to surge, then purge. And many of the tools an investor might use have been rendered less effective (even useless) in a fully synchronized market such as this. So, what advice can an investor rely on? How does leaning against the wind sound?

To be sure, there are some signs that the latest surge, as impressive as it is, is not as robust as the major indices would suggest. Momentum is showing signs of deterioration. And, bullish sentiment is certain to be even more widespread (especially among the pundentry and strategistas). However, there is a piece of data that bears (are?) noting: the advance/decline line.

Much is made of the advance/decline line and how it is confirming the surge. This is true is one looks only at the NYSE. However, as the chart to the left makes clear, the NASDAQ a/d line is going in exactly the opposite direction. Higher highs in price, lower lows in the a/d line. This is a divergence of major proportions and the single largest weak link in the technical chain.

As for the NYSE a/d line, there is the issue of truly economically sensitive stocks versus funds and financials. According to the NYSE, there are “more than 480 closed-end funds with a total market value of approximately $114 billion.” The total number of listed companies on the NYSE is just over 2,700. That means that just under 18% of companies listed on the NYSE are not economically-oriented operating companies. And subject to double couting in the a/d data. Then we have the Financials group.

Everyone knows that Financials constitute the largest market cap component of the S&P 500. What needs to be added to the investment strategy equation is their composition in the NYSE mix. There are 429 companies classified in the Financial sector that are listed on the NYSE. That makes for another 16% of non operating companies in the NYSE a/d mix bringing the total of non economically-oriented operating companies to approximately 34%, or 1/3 of the total stocks listed on the NYSE that are counted in the a/d figures for that exchange.

Note: With so many trades now being conducted away from listed exchanges, it is hard to get an exact read. But, if the data noted above is close to accurate, the hoopla surrounding new highs needs to be tempered just a bit.

Also, note: I am gathering data on the NYSE a/d ex funds and Financials and will post that info next week.

Investment Strategy Implications

Whether the data and divergences re the a/d lines bears out, regression to the mean is always the most prudent principle in parabolic/melt-up market moves. Leaning against the wind and taking some chips off the table may be intolerable for some as it will diminish the short-term performance of a portfolio and make an Alberto Gonzales-like interrogation by others more likely. (Imagine a client, associate, or boss with a strong resemblance to Senator Ted Kennedy. Can you say "regret aversion"?.) However, if I am correct re the basic characteristics of this market, purges always follow surges. The problem is their unpredictable nature. And that argues even more for leaning against the wind, especially when that wind likely contains a fair amount of hot air.

Have a good weekend.

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