Thursday, September 20, 2007

Technical Thursdays: Lowering the Noise Level, Focusing the Mind

The recent questionable rate cut decision by the Fed has sparked numerous speculative comments re the implications of their actions.
• Does the Fed know something re the economy that is far worse than we mere mortals are clued into?
• Has the risk of inflation increased?
• Has the risk of stagflation increased?
• Has the Fed reinstated the Greenspan put and, thereby, moral hazard?

And on it goes. Sadly, the only clear result that came out of this Tuesday’s Fed meeting is that the investor noise level has gone up exponentially. And with it so has the tendency for confusion via the mental gymnastics investors tend to go through when the applecart gets upset. So, let’s try to cut through the clutter and chatter and “keep the main thing the main thing”, as Jim Barksdale would say.

The mega investment strategy question to be answered is, “Are US equities in the process of producing a major market top?”

Last Thursday’s “It’s a Bull Market ‘til it Ain’t” blog entry (S&P at 1485) describes why stocks must be assumed to be in a bull market until the technical conditions dictate otherwise. Despite the justifiable concerns re the Fed’s recent actions noted here and elsewhere, nothing can alter the fundamental technical analysis principle that a bull market is a bull market until it forms a major market top. Since that has not occurred, the relevant question becomes, “Is it in the process of doing so?” The answer (as it was last fall) is maybe. And here is where anticipation is most essential to successful investment strategy decision-making.

There are two primary* technical analysis conditions that would signify a major market top: Divergences (Size, Dow Theory, and other key indices) and Moving Averages. I have described divergences re Dow Theory last Thursday and moving averages on August 2nd (see prior blog entries). I have also touched on key aspects of divergences re Size (market cap) on August 23rd. Let me elaborate and update the Size issue today.

The above chart** shows the four major cap sizes (OEF, mega; SPX, large; MDY, mid, IJR, small) and the micro cap group, IWC. From a size divergences perspective, the key issue to focus on is whether new highs in the closely watched large cap SPX is confirmed by the SMIDS (small and mid). If yes, then higher highs are in store for investors. The bull is intact. If not, then a warning bell has to be rung.

As you can see, no such event has occurred, mainly because no new highs have been made in any index, most notably SPX. That’s where anticipation comes into play.

Investment Strategy Implications

If, in the coming weeks, SPX makes a new high and if it is not accompanied by new highs in the other size metrics, then you have one piece of the major market top puzzle in place. And that’s where anticipation can help focus the mind on what to look and listen for and diminish the noise emanating from the market.

*Supporting technical analysis conditions would include investor sentiment and divergences with other indices.

**To view a larger version of the chart, simply click on the image.

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