Wednesday, May 27, 2009

When To Ring The Bullish Bell

Driven largely by short covering and a portion of the mountain of cash sitting on the sidelines, stocks have been on a tear since the beginning of March. Many investors have, in the process, bought into the idea of the reflation trade as sectors and countries associated with it (e.g. emerging markets, basic materials) have led the parade thus far*. In the process, valuation levels have become quite stretched on the concern that the next 12 months will produce sub par earnings that do not justify currently lofty P/Es.

For the bears, there is high skepticism that S&P 500 operating earnings will reach a $70 number, which would justify not just where the market is today but be supportive of a run above 1000 (S&P 500). The bulls, on the other hand, argue that corporate profits are on the cusp of a major rebound mainly due to recession-necessitated cost cutting. Accordingly, any economic rebound in our globalized economy will produce the $70 number – and then some. Who will be right?

To gain insight into who will win this fundamental analysis debate, a peek at the technical analysis side of the equation can be most enlightening.


Many of the technical analysis patterns and indicators that I follow are flashing very constructive longer-term signals. Mega Trend bullish reversals are on the horizon for just about every index tracked**, along with chart patterns that bear more than a glancing resemblance to head and shoulder reversals.

On a short and near term basis, however, equities are faltering as momentum – the lifeblood of near term market power – is eroding (see second and third indicators in the above chart). On the surface, the fundamental analysis debate appears to playing out in the technical analysis space as well – longer-term things look promising, short and near term not so much. So, where’s the enlightenment?

The missing ingredient is the completed bottom – that point at which stocks have built a sustainable base from which higher prices have a greater chance of becoming an actuality.

Such a bottom has been formed in leadership areas, such as emerging markets (see above chart). Breaks above previous tops formed in multi month trading ranges signal a (mostly) completed bottom. This is not quite the case, however, with developed economy markets, as they have not made such a move. Yet, as constructive as the emerging markets patterns are, only when a mega trend reversal has occurred (which looks like it needs only a few more weeks of positive trading action) can the bell be rung.

Investment Strategy Implications

Old school market technicians will tell you that it is always better to wait until a major pattern has been completed and give up x% of the early move just to be sure that you are on the right side of the trade. Given the fluid nature of the real economy environment, this piece of advice will produce more than its value in peace of mind.

The bullish bell looks like it only needs a few more weeks of positive action. Then again, the Cavs were a slam dunk to make it to the NBA finals.

And Now, Another Soapbox Moment

By blending both fundamental and technical analysis, an investor can see how market participants are interpreting the fundamental stories in the real economy. This occurs on both a macro and micro level, with sectors and industries reflecting the prospects on an individual company level. This also involves Soros’ reflexivity, the feedback loop from the markets to the real economy in which changes in market values help produce the very outcomes they measure.

Fundamental analysis tells you what should be. Technical analysis tells you what is.

*While the stats do show Financials as having the sharpest rally since the early March lows, it is arguable that the profound changes the sector will undergo (to profitability and growth) does not auger for a leadership role on a sustainable basis. Therefore, the powerful rally come from a deep oversold condition that will likely dissolve into mediocrity once the bull phase gets underway in earnest.

**Price above moving averages, 50 day above 200 day, both 50 and 200 day upwardly sloped. See chart above for an example, as well as numerous previous blog postings.

No comments: