It’s The Demand, Stupid

“One thing you’ve got to understand is that we do not hire workers for the sake of hiring workers. We hire them to do jobs,” Mr. Goodnight said. “If we don’t have the work coming in, nothing will make me hire another person.”
Frank W. Goodnight, President, Diversified Graphics, a publishing company in Salisbury, N.C., quoted in today’s NY Times article, “A Slowdown for Small Businesses”

This morning, two reports (see links below) were published that illustrate the economic dilemma the US (and, therefore, the global) economy finds itself in – there just ain’t enough demand out there.

This is nothing new. But with the government stimuli clock running out, the viability of an organically driven, private sector led sustainable economic expansion hangs in the balance. The recent US economic data has put a sharp spotlight on the decelerating US economy. The crisis in Europe is stuck in its own feedback loop, with the outcome quite uncertain. Then, there’s the hot, hot, hot emerging markets with inflation topping the economic list of worries (to be sure, there are lots of other risks that many bullish investors choose to ignore).

With US growth decelerating, the chosen phrase is soft patch. The economic soft patch, however, could quickly turn to quicksand. And, given both the limited remaining resources in the governmental fiscal and monetary bag (not to mention the toxic political atmosphere and the consequences of austerity in a time of weak demand), the quicksand the global economy would find itself entrapped in could be far worse than most investors currently anticipate.

So, what do the two reports tell us about the state of the US economy? For one, it says that in the business world it’s a tale of two economies – one that benefits from the global growth story, the other primarily on US domestic demand. However, herein lies the dilemma for all: In the end, global growth is dependent on end user demand, which is centered on developed economies like the US as developing markets' end user demand is both too small and years away from making a significant impact on global end user demand. This is fairly clear cut to developed economies but is far less appreciated when it comes to developing economies.

Developing economies, like China, depend on two engines of growth – fixed domestic investment and exports. Fixed domestic investments eventually require end user demand. You can build only so many new ghost towns before the money runs out. Excess inventory is the chicken that eventually comes home to roost. (Tech bubble, anyone?)

As for the other engine of emerging markets growth, exports, well that depends primarily on…you guessed it, end user demand in developed economies. And the problem there lies in the fact that end user demand in developed economies (like the US and Euroland) relies on wage growth and higher employment. And that is mainly resides in the small business arena.

I’ll give you one guess as to which report published today painted a less than rosy picture? (Hint: it isn’t the big boy’s report.)

Investment Strategy Implications

As for the stock market - it may all work out. Then again, it might not. Stocks locked in the first of a potential 3 stage march to a bear market (stage 1 – sideways; stage 2 – rollover; stage 3 – breakdown) may actually resolve itself to the upside, which would make the current market action the prelude to higher highs (thereby showing that sideways was little more than a consolidation phase, which all bull markets go through from time to time).

No one knows for sure how the current sideways market action will resolve itself. I would suspect, however, that based on how the past two bear markets came about (topping process in time and manner), we should have a very good idea before this summer is over (when price and its two key moving averages – 50 and 200 day might converge) whether consolidation or distribution was the real story of our multi month sideways markets.

In regards to the economy, one thing is certain: if end user demand turns negative, the environment will become very bad very quickly. And then all that will be needed is some event somewhere (in the economic, financial, or political realm) to turn bad to ugly.

The task for President-elect Romney will not be an easy one.

Here are links for the two reports:

Good

Business Roundtable

Not so good

NFIB

One relies primarily on global growth, the other primarily on domestic demand.

Happy Anniversary. Now What?

Yesterday marked the one-year anniversary of the bear market low in stocks and the subsequent bull rally. Therefore, a review of where we were, where we are now, and, importantly, where we are likely to be headed, seems to be in order.

To refresh your memory, let’s go back to March of last year and note the following excerpts from commentaries made by yours truly regarding the end of the world as we knew it:

March 5 – “Bears Out of Momentum”
“…are we headed non stop to 600? Before I get to why the 600 call is unlikely right now, let me address 2 factors - one fundamental, the other, a market dynamic.”
To read the complete commentary, click here

March 12: “Why Divergences Work”
“Tuesday’s big up-market demonstrated a tried-and-true investment axiom: When market conditions are ready, a catalyst is all that's needed to get the show on the road. The show, in this case, is a cyclical bull rally. And the catalyst was the Citigroup's earnings statement. Here are some of the particulars….”
To read the complete commentary, click here

March 26: The Cyclical Bull Within the Secular Bear
“In stocks, we seem to have a cyclical bull within the secular bear. Investors (and the world economy) have been given a reprieve - that is, until next year, when all the money and all the regulatory changes thrown at the economy and the financial system must evolve into greater private market participation.

In the case of the US economy, capex must take the economic handoff from government and become the principal driver of economic growth, as US consumer spending continues at a more muted pace. For the consumer, balance-sheet repair will almost certainly continue as its largest component -- the aging baby boomers -- set aside real savings out of income to provide for themselves in the rapidly approaching retirement years.

Therefore, as the US economy goes through its transition from its overly leveraged consumer bias to a greater level of corporate activity -- driven largely by exports to the real growth engine of the next decade and longer, emerging economies -- investors should consider repositioning their portfolios to include more emerging-markets investments.”
To read the complete commentary, click here

The rest is history. Stocks rallied, emerging markets did best, and investors were rewarded for their courage and wisdom in relying on time tested market tools, such as the valuation parameters and the divergences principle described above.

Okay, now what?

Investing is a game of “What have you done for me lately?”. In accordance with that game, investors cannot sit on their laurels and revel in the joy of their courage and wisdom. When it comes to investing, the past is always prologue. And it functions as a guide to what is likely to be.

In attempting to predict where markets are headed, it is just not enough to use the past as a valuable guide to what will be. It is also necessary to remember that markets are driven by investors, and investors are people whose tendencies have a certain predictive dynamic due to the simple fact that they are human. This is just another way of saying that human nature doesn’t change; we, as investors, just emphasize different things at different times. Moreover, the principles of asset values are also a reliably consistent tool, one that enables an investor to estimate what the fair value for any given asset might be.

Taken together, the three principles to follow – history as a guide, the constancy of human nature, and estimates of fair value – enable an investor to apply the same tools and principles that got the above noted rally forecast correctly and apply them to today’s market environment. With that said, let’s first briefly consider where we came from and what it means for the equities markets going forward.*

Back From the Brink

The massive capital infusion governments around the world threw at the financial then economic crisis enabled the world economy and markets to step back from the abyss of global collapse and regain some sense of stability. However, government stimuli are good for only so long. Eventually, end user demand must take over and drive the world economy, which will drive the world’s equity markets higher. In this regard, the jury is still out as to whether such an economic handoff will actually occur.

The US consumer, engine of end user demand for most of the past several decades, remains in the throes of balance sheet repair. Paying down debt and building sufficient cash reserves for that rainy day is still priority number 1. Occasional episodes of spending beyond their means will occur from time to time (as it may have last month based on the surprising increase in consumer borrowing). But with the bulk of baby boomers bordering on retirement, balance sheet repair will remain the secular trend for the foreseeable future.

Therefore, the hope that an emerging middle class in developing economies can pick up much of the global growth slack left by the reduction in US consumer demand. This, along with a sustained level of infrastructure and corporate capital spending (capex) rebuilding vital to both developing and developed economies, are central to a sustainable growth phase for the world economy. However, a hope is not a certainty, and whether the handoff will occur and just how robust will it be is one of the key areas to focus on going forward.

At present, the odds do favor such an occurrence, but many obstacles remain in place not the least of which is confidence. For example, in order for infrastructure and corporate capex spending to occur in earnest, policy makers must muster the political will and organize their priorities and corporate senior management must believe that current long range spending plans will result in future growth rates and profitability in excess of their cost of capital. This is one of the key areas where the analytical focus must be centered.

*In my next commentary, I will address the second and third areas – fundamental valuation models and market intelligence readings. Until then, enjoy the ride.

Valuation Gap Closing. Near Term Upside Still Intact.

The equity rally coupled with the rise in rates (10 year US Treasury) over the past several weeks has brought US stocks close to a temporary stalling point. This can be seen on two levels – one technical, the other fundamental.

From a technical analysis perspective, the chart to your left* shows that one short-term metric (slow stochastic) is registering a near term overbought (80 reading or higher) while two other short-term indicators (momentum and MACD) are positive (upward slope to each). To some the fact that the S&P 500 touched its 50 day moving average and then backed down will be interpreted as the market encountering resistance at its moving average. This point is both wrong and largely useless as stocks and indices crisscross their 50 day moving average with great regularity - a point I have noted several time before and as can be seen by looking at the above chart)

(FYI - for more technical analysis perspective, I encourage you to listen to my interview with Louise Yamada posted yesterday.)

From a fundamental valuation perspective, stocks have closed their valuation gap (see Expected Return Valuation Model)** to some degree thanks to the rise in stocks and rates. However, the expected return at a reasonable $82 operating earnings number for 2008 is still averaging around 20% upside potential.

Investment Strategy Implications

The valuation gap has closed to some degree. However, stocks remain sufficiently undervalued to warrant a near-term bullish bias. As for the technicals, while the mega trend is negative (see prior blog postings on the Moving Averages Principle), the near-term indicators remain mostly positive and will likely improve once the near-term overbought is resolved.

*click on image to enlarge
**subscription required

Technical Thursdays: Moving Averages Principle – A Valentine's Day Gift

As time passes, an increasing value can be found in the Moving Averages Principle (MAP) that I developed over the past several years. In today’s edition, let’s illustrate by looking at three distinct slices of the equity markets in two distinct MAP phases – Latin America 40 (ILF), Financials (XLF), and Small Cap style (IJR).

In the first chart (ILF)*, you can see how price is currently above both moving averages (50 and 200 day), that the 50 day has not crossed the 200 day, and that the 200 day slope is upward. These are the three key components of the MAP – price in relation to moving averages, moving averages in relation to each other, and the slope of the moving averages (particularly the slope of the 200 day).

Note how price did cross both the 50 and 200 day on numerous and several occasions, respectively, over the past two years. Yet, at no time did the three components of MAP occur. The bullish mega trend is intact. Now, contrast this data with our second chart – Financials.

The XLF chart shows price crossing the 50 day moving average on many occasions and the 200 day several times. However, it wasn’t until late summer/early fall last year that all three MAP conditions were met for a mega trend reversal call to be made.

The third chart (IJR) shows the same pattern as the Financials.

Investment Strategy Implications

The Moving Averages Principle takes the base form of moving averages analysis to another, more effective level. By going beyond the tried but not quite true method of declaring a stock in a mega trend change whenever it crosses just one of its major moving averages (most notably the 200 day), the MAP produces far less false signals.

A few points to remember re the MAP:

The application of the MAP applies most effectively to overall markets/regions, sectors, and styles. However, the application of the MAP is somewhat less effective when it comes to industries and even less effective when applied to individual stocks. The reason for this reduced effectiveness apparently pertains to the fact that the closer you get to those areas of the economy that are subject to more issue specific factors, the higher the odds are of any market-based tool generating false signals.

Additionally, at no time does the MAP negate the need for judgment. For example, there are times when effective tools like the MAP will be on the cusp of producing a mega trend change signal requiring judgment (including bringing into consideration other factors, such as a fundamental view).

While no tool is foolproof, the MAP has demonstrated its usefulness many more times than not. And certainly far better than the basic crossing of a moving average.

To learn more about the MAP, see prior blog postings under the topics discussed segment of this blog – Moving Averages Principles.

*click images to enlarge
Note: Accounts managed by Blue Marble Research own positions in ILF and XLF.
Neither Vinny Catalano nor any member of his family own positions in any of the above issues.

Technical Thursdays: What a Decline to 1360 Means – Revisited

Bernanke pledges to cut rates. And from a technical analysis perspective not a moment to soon.

The recent market corrections – four since the summer of 07 – are taking their toll on the technical conditions of the market, most notably in the area of the highly reliable mega trend tracking tool - Moving Averages Principle.





As the above chart* shows, the current price of the S&P 500 is below both its 50 and 200 day moving average. This is not unusual as the crossover of price below both moving averages has occurred several times during this bull market. Rather, the key risk factor, one that has not occurred once since the bull market began nearly 5 years ago, has to do with the 50 day in relation to the 200 day AND the slope of each.

Should the stock market fail to stage some sort of a meaningful rally, along the lines of reversal of the decline experienced thus far, the 50 day will cross decisively below the 200 day and, importantly the slope of both averages will point downward.

This risk was noted several blog entries ago (“What a Decline to 1360 Means”) and one that would necessitate a reduction in equity market exposure despite its obvious whipsaw potential (also noted previously). What makes this potentially negative event particularly scary is the fact that the S&P 500 is not alone.

According to the Moving Averages Scorecard that covers 20 different segments of the global equity market and US economic sectors (weekly report, subscription required), an increasing number of sectors and segments are now borderline negative, much like the S&P 500 is.

Investment Strategy Implications

The technicals are the big fly in the bullish ointment, assuming one buys my decoupling/valuation scenario. Time will tell if the Fed will ride in and rescue this technical damsel in distress.

* click image to enlarge

Technical Thursdays: What a Decline to 1360 Means

In Tuesday’s blog posting, I provided a realistic worse case scenario for the S&P 500 – operating earnings for 2008 decline around 6% to $86 and longer term interest rates (10 year US Treasury) rise ½%. The combination of the two results in a decline in the S&P 500 to 1360, a level at which the potential return for large cap equities equals its historical long term average of 12%.

From a technical analysis perspective, what does it mean for the market to decline to 1360? Here are a few thoughts.

The above three charts* cover three distinct time frames that help shed some light on the characteristics of the current bull market current vis-à-vis the prior periods, one bull, one bear. In all cases, the application of the Moving Averages Principle (MAP) will be used.

Applying the moving averages principle to the first chart we see that the extended current bull market cycle (Jan. 1, 1995 to present) is in keeping with the global macro real economy trend of the Great Moderation. In three sustained cycles, the three components of MAP** are NEVER violated. Mega trends are sustained over several years with no whipsawing short term mega trend reversals. This, however, is not the case with the second chart.

Encompassing the period from August 1982 (the official start of the previous bullish supercycle) to Dec. 31, 1994, we see that there were three points at which MAP produced a mega trend reversal signal – Fall 1987, Fall 1990, and Spring 1994. In all three cases, the mega trend reasserted itself requiring investors to be flexible in their thinking and willing to reverse course as the bear signal produced was then reversed back to a bull signal. No doubt, there was some cost to the whipsaw nature of the times, selling when prices has already declined and buying back when they reverted to its prior bullish mega trend. However, that cost was miniscule compared to cost of missing the power of the reasserted bullish mega trend.

The third chart provides a view of much different time. Covering the time period of Jan. 1, 1970 right up to the start of the above noted bullish supercycle, the era of high volatility in the real economy (stagflation, extraordinarily high interest rates, etc.) was somewhat evident in the rocking and rolling of the market and the increased frequency of mega trend reversals – I count five – that took place, with a few additional very close calls.

Investment Strategy Implications

A break to 1360 will likely signal a change in the behavior of the market. A look back at the first chart shows that should such a break occur, not only will many market technicians (and no doubt numerous media mavens) point out that the prior lows have been violated (not to mention a more serious breach of the 200 day moving average) but, far more importantly, the MAP will signal a mega trend reversal.

For those adhering to the MAP, reducing their equity exposure will be required, despite whatever may be occurring in the real economy. However, as experience has shown, mega trend reversals can occur with greater frequency than many current bull market participants are accustomed to.

Should 1360 become a reality anytime soon, investors should be prepared for a period of whipsaw action in their asset allocation decision. This will then necessitate greater attention to the individual sectors and their mega trends. Moreover, a more thematic approach to investing might also be required to achieve alpha.

The bottom line conclusion is simply this: If 1360 occurs in the first half of 2008, the potential of a more permanent bearish trend cannot be ignored. Accordingly, investors should then reduce their overall US equity exposure. However, should a whipsaw occur (from bearish back to bullish), that will certainly cut into an investor’s performance results for the year, for the reversal signals tend to occur after a period of some decline or advance.

Net, net: Whipsaw action may be the new reality. However, the cost of ignoring the mega trend reversals is far too great compared to the cost of being whipsawed.

*click images to enlarge
**price relative to the moving averages, moving averages relative to each other, slope of both moving averages (50 and 200 day)
charts courtesy bigcharts.com

Your Move, Mr. Market

excerpts from this week's report:

This week I am pleased to provide a new weekly market-tracking service based on a very reliable tool – the Moving Averages Principle.

The Moving Averages Principle (MAP) is an excellent guide to determining the state of the mega trend in any one sector, industry, country, region, or stock. MAP minimizes the noise of the market and helps keep our eye on the most important investment ball – the mega trend.

The Moving Averages Scorecard noted in the table on the next page (see report*) applies the MAP and measures the mega trend for each of the ten economic sectors tracked by the S&P 500 in the first grouping. The second grouping applies the MAP to the five size metrics of the market – mega, large, mid, small, and micro. Lastly, the third grouping applies the MAP to selected global markets.

As above table (see report*) shows rather clearly, the mega trends for 15 out of the total of 20 individual sectors, styles, and global markets are bullish. At present, with 75% of the key metrics for the US and global markets on the bullish side of the MAP ledger, the only investment strategy question to answer is tactical. For that, we look at my Expected Return Valuation Model (see report*)..."

Chart Focus: Mortgage Tranches

"The first chart above (see report) is from today’s Wall Street Journal. The second is the S&P 500 over the same period. It is interesting to note how investors chose to ignore the warnings signs as prices deteriorated in early 2007, yet equities moved to all-time highs, which takes me back to the follow excerpt from my August 6, 2007 weekly report:

"Ever so slowly but no less dramatically, investors are coming to appreciate what readers of this newsletter and blog have known for well over a year – risk has been grossly underestimated and correlations among assets are..."

also in this week's report:

* Expected Return Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: Mortgage Tranches
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.
*requires subscription

Technical Thursdays: The Quality Migration Cycle

The Quality Migration Cycle is a very useful tool that no investor should be without. It provides the mega trend context by applying the Divergences Principle to the five size (market cap) categories – mega, large, mid, small, and micro - to give to perspective on the breadth of the mega trend in force. It assumes that size = quality, which is affirmed as such by the performance history of other quality metrics such as S&P quality ratings for stocks.

The application of QMC can be seen by looking at the first chart above*.

As the chart makes clear, the current market conditions show the beginnings of a breakdown in relative performance of the Small (IJR) and Micro (IWC) cap ETF index trackers. Lower lows for each while the remaining three size groupings have not made such a move during the recent phase of the current market correction.

The underlying principle of QMC is to help determine who is leading the mega trend parade at any given point in time. If all are marching in sync AND the mega trend parade is being led by the Smids and Micro, then the mega trend is intact. The logic being that lower quality issues should reward investors for the greater risk of owning them. However, when the mega trend parade is being led by the big boys AND the lower quality issues not only trail in relative performance but exhibit signs of breakdown (such as lower lows unconfirmed by the larger indices), then the prospects for a market topping process must be put into a potential bearish mix.

The fly in the bearish mix currently is the strength in Mid cap. It has not confirmed with a lower low but may do so in the near future. This cannot be determined beforehand. Nor should it, as indicators such as QMC are mega trend indicators helpful in making longer term market calls.

The Quality Migration Cycle helps an investor determine the market ending process of improving relative performance of the higher quality/larger issues as the lower quality sectors underperform in sequence. That appears to be the case currently. Micro failed first, followed by Small. Is Mid cap next? For that answer, see the second chart above* and the application of the long term Moving Averages Principle.

Here we see MDY on the verge of rolling over. Price is at its moving averages and the moving averages are close to crossing (50 below 200 day). However, unlike the Small cap (see third chart), MDY’s moving averages have not crossed nor are they trending down, a condition of a mega trend change as required by the Moving Averages Principle (MAP).

(see prior blog postings under the Topics Discussed category - scroll down, left side - for more on the MAP.)

Investment Strategy Implications

The QMC’s usefulness rests in providing the mega trend context as to where we are in a bull market cycle. At present, the cycle suggests that a market topping process is underway. However, a misapplication of the QMC would be anticipatory. The full cycle must be allowed to play out as what appears to be a market top may actually turn out to be a consolidation range, launch pad for the next up phase.

Context, yes. Tactical decisions (sector and style allocation), yes. Anticipatory, not advisable.

*click on the image to enlarge
Charts sourced from Bigcharts.com

Trader Alert – Buy Citigroup

Boy, I hate doing this. But ya gotta do what ya gotta do.

The high profile sovereign wealth fund decision by the Abu Dhabi Investment Authority to make a $7.5 billion deposit in Citigroup’s piggy bank was certainly done with the long-term in mind. However, since most active investors are much more short-term oriented, the decision process for this group tends to be a tad different.


For this more twitch oriented audience, I refer back to the very successful technical timing tool that I have noted on frequent occasions – momentum and MACD.

To make this work, the two must be viewed in concert with each other. One alone will not produce the kind of reliable results an investor needs. Taking Citigroup and its economic sector, Financials (which include other financial institutions), the above charts* show that Citigroup is actually fairly close to outright short-term buy call, while the Financials are not quite there.

C’s momentum is not confirming its lower price lows while MACD is right at its crossover point. In other words, while MACD has not exactly flashed a buy call it is close enough and, therefore, anyone thinking of buying C for a trade should do so.

XLF presents a slightly different story. Its momentum is also not confirming the price action lows (a sign of slowing downward selling pressure) but not to the same extent as C is. Its MACD, however, is not quite ready to produce the crossover. Until both conditions are met (or at least close enough), XLF remains off the short-term buy list.

It is important to note that the buy call on C and the potential buy call XLF are within the context of its downward mega trend, as noted in the moving averages principle.

Investment Strategy Implications

If the stock market stages an end of year rally, ADIA will be noted as prescient in their decision to buy into Citigroup. What will likely not be noted outside this blog is that the short-term timing tools noted above concur.

*Click on image to enlarge.

Technical Thursdays: Tech vs. Financials – Two Horses of Very Different Colors

There is a temptation by some to view the recent correction in Tech issues as signaling something more ominous lies ahead for the group. From a moving averages principle, don’t buy that argument.

There is also a temptation by some to view the recent bounce by the Financials as an indication of a bottom and a reason to invest (versus trade) in the group. Again, from a moving averages principle, don’t buy that argument.

As the two charts above* show rather clearly, one (Tech) is merely correcting its bullish mega trend while the other (Financials) has enjoyed its’ dead cat bounce within its’ bearish mega trend.

In the case of the large cap Tech and Telecom (XLK), the moving averages principle says stay in the issue as price is above the moving averages, the 50 day is above the 200 day, and both moving averages are pointing up. As the chart shows, the recent correction has pulled price back to its 200 day, a typical corrective action in a bull mega trend. However, should XLK trade below its 200 day, one should add to the position as the 50 and 200 day must cross and turn down to send a reversal signal of the bull mega trend. That appears to be unlikely anytime soon.

Re the short term indicators, momentum and MACD, they are in deep oversold territory and will require a few days to a week or two to repair the recent damage done. If all unfolds as noted, it then should be off to the races as XLK will be in good technical condition to make a strong year end run.

Now, compare this racehorse to the nag known as Financials.

On a longer-term basis, the opposite conditions exist for the Financials. Applying the moving averages principle, price is below moving averages, 50 has crossed below the 200 day and both are pointing downward. The exact opposite of Tech and Telecom and of its own prior multi year bullish mega trend.

On a shorter-term basis, XLF, like XLK, is in deep oversold territory, which was good for bottom fishing bounce traders (that trade seems to have come and gone) but bad in the sense that it will take a few days/weeks to repair the damage.

Investment Strategy Implications

Tech (specifically big Tech plus Telecom) and Financials are two horses of very different colors. One is in race to new highs benefiting from the weak dollar and the global growth story while the other is, at best, fishing for a bottom hampered by credit woes and large losses still to be reported.

Which horse will you place your bet on? Seabiscuit or Swampnag?

*click images to enlarge.
Note: all charts sourced from Bigcharts.com

Technical Thursdays: This Thing Called Moving Averages

click on images to enlarge







To paraphrase Ronald Reagan: "There they go again."

Every time the stock market’s major indices slump to their 200-day moving average, the bears come out of their caves to announce the end of the bull. As interesting as a price trade below the 200-day might be, it is a misuse and misunderstanding of how to read such trading action.

As noted numerous times before, it is far less important when the current price trades below its 200-day moving average than it is if the 50-day moving average crosses the 200-day. And even that is not as important than if both the 50 and 200 day point in the opposite direction of the established trend, which in this case is up.

Then, and only then (price below moving averages, 50 day below 200 day, both 50 and 200 day pointing downward), do you have a trend reversal.

Again:

* Price below moving averages
* 50 day below 200 day
* 50 AND 200 day pointing down

Now to take this one step further, when seeking to identify a mega trend reversal, it would help if other key indices were also experiencing a similar such episode. For example, if the twins of the Dow Theory (Industrials and Transports) or the NASDAQ and the NASDAQ 100 or the Russell 2000 were in synch with the angst perhaps then an investor might suspect a mega trend reversal was in the works.

At present, aside from the Dow Transports (second chart), the other indices noted are either at a similar juncture (Dow Industrials, Russell 2000) or nowhere near such a potential turning point (NASDAQ (third chart) and NASDAQ 100).

One additional way to evaluate the potential of mega trend reversal is to view the three market cap segments – mega, mid, and small – to see if a mega trend reversal is at hand. Once again, the data says no trend reversal has occurred, although the small cap style is in the worse shape with the price 4% below its 200 day.

Lastly, let’s go global. Here’s a short list:

EAFE (EFA) – nowhere near
Europe 350 (IEV) – nowhere near
Emerging Markets (EEM) – nowhere near
Latin America 40 (ILF) – nowhere near
Japan (EWJ) – on the verge

Naturally, other reasons to be concerned exist in some of the above noted markets, specifically overbought levels in highly speculative markets like the emerging markets. However, overbought conditions in speculative, smaller markets, while likely to experience substantial market corrections, are not systemic threats to the global mega trends in place. Only a massive plunge in concert with a breakdown in developed markets would give cause for serious concern. That is not the case thus far.

Investment Strategy Implications

For the umpteenth time: It’s a bull market ‘til it ain’t.

The momentum lemmings may scare the bejesus out of some investors with days like yesterday. However, it is advisable to keep in mind that as swiftly as the pack runs for the hills so, too, do they race right back in the game when the money flows in an upward direction. (See yesterday’s blog for the latest comment re our little furry friends.)

My advice: Never lose sight of the fact that mega trends are what matters most first, foremost, and always. The call re a mega trend drives the single most important decision any investor needs to make: the Asset Allocation decision. From that point of view come the strategic and tactical decisions of where to allocate one’s assets and when to expand or contract current and prospective positions (what I call modified market timing).

The great value in technical analysis is keeping one in or out of the game when emotion, personal circumstances (a/k/a loss aversion), or fundamental logic dictate otherwise.

Investing is a dynamic, perpetual social science experiment that is both rational and irrational. Therefore, to the best of one's ability - Identify then Exploit the behavior.

Technical Thursdays: Playing to Win

What September giveth October taketh away.

The October takeaway of September’s Fed rate cut inspired gift is right on schedule. FUD (fear, uncertainty, and doubt) has returned and angst is on the rise again. No surprise from this strategist’s perspective.

As noted at the start of both September (see “September Swoon? Not Likely”) and October (Boo!) the commentary on this blog and in my reports forecast a market that would be a net zero by the time Halloween came and went (see prior blog postings). And while only a crazy man would try to be so cute in timing each wiggle and swiggle of a highly dynamic economic and market environment, sometimes conditions line up just right where making such a call is worth the risk. Playing to win trumps playing not to lose.

The fundamental argument for the net zero view centers on the unresolved credit problems that were first considered dealt with when the Fed cut the discount rate as the momentum lemmings put their mountain of capital to work. A little premature and quite a bit simplistic, to say the least.

The unresolved credit derivative’s risk factor is counterbalanced by the positive effects of high degrees of liquidity (aided further by the Fed’s dubious rate cut), very strong balance sheets (corporate and government), and strong global growth, among others that have been noted on this blog and in prior reports time and again.

One technical argument (among others) for a flat September/October time period is illustrated in the above chart on the S&P 500. Applying my long term price action indicator, the moving averages principle*, to the current price action of the S&P 500 it is plain to see that no violation of three elements of the principle – price relative to moving averages, 50 day relative to 200 day, and the slope of both moving averages – has occurred. Therefore, until all three conditions are met, the established trend must be assumed to be the mega trend in force. Which is another way of saying it’s a bull market ‘til it ain’t. And ain’t happens when a major market top is formed, part of which involves the aforementioned moving averages principle.

Investment Strategy Implications

From a technical perspective, the current October correction of September’s rate cut mini euphoria suggests a move to the 200 day moving average, which is right around 1470. Given the strong downward move in MACD, should the S&P 500 reach 1470, it will probably have to trade around that level for a short while thereby repairing the technical damage that all corrections produce before any November/December year end rally can get underway. My estimate is < 2 weeks. Then it’s off to the year end races.

*See prior Technical Thursdays entries for more info on the moving averages principle.

To view a larger version of the charts, click on the image.

Technical Thursdays: Long Story Still a Short

When a dominant sector of a bull market enters rough waters, some investors may be tempted to establish a contrarian long position. Case in point - Financials.

Such inclined investors might perceive that the current bad news for the Financials is close to fully discounted. After all, with the low point for Homebuilders, and thereby Financials, forecasted by certain prognosticators to be the spring of ’08, the requisite lead time of six months to an economic trough in the sectors seems plausible. Therefore, given the discounting mechanism of the market, the contrarian reasoning says now is the time to establish long positions. The advice from this contrarian’s desk is don’t do it.

The above chart shows the Financials sector firmly in the grip of a neutral to negative longer-term pattern as the very reliable moving averages principle indicates: Price below moving averages, 50 day below 200 day, both 50 and 200 day moving averages pointing south.*

It should be noted that in 2005, XLF produced a somewhat similar neutral to negative moving averages signal. So, perhaps the same will occur this time. However, as with most technical indicators, it is far better to wait until a clear cut signal is made and pay a few percent more than to anticipate a reversal of an established pattern.

Investment Strategy Implications

There’s a time when being a contrarian makes sense. From a technical perspective, when it comes to Financials this is not that time.

*See prior Technical Thursdays entries for more info and examples re the moving averages principle.
To view a larger version of the above chart, click on the image.

Technical Thursdays: When Technical Analysis Doesn’t Work

Every prior edition of Technical Thursdays espouses the value and benefits of Technical Analysis (TA). In today’s blog posting, I wish to highlight a different aspect of TA – when it doesn’t work. Case in point: the yield on the 10 year US Treasury.




Employing the first of the two primary charting tools I use – moving averages, the above chart of the 10 year* is a hodgepodge of erratic price movement that is matched by the frequent crisscrossing of price to moving average (50 and 200 day) as well as the moving averages to themselves (50 crisscrossing the 200 day). Of course, one could argue that the trend is range bound. That is clearly evident. But the predictive value in the moving averages principles (noted on numerous prior Technical Thursdays) rests not on forecasting the sideways action of an asset (which it cannot do) but on its ability to forecast sustainable up or down mega trends. In other words, when it comes to the 10 year yield, there is no up or down trend predictability using the moving averages principle (use the label link below to see prior Technical Thursdays for examples).

As for the second charting tool – momentum and MACD, the timing value of these tools is rendered largely (but not completely) useless as the divergences principle (trend highs or lows not confirmed by momentum and MACD) that works so well in other situations (again, use the label link below to see prior Technical Thursdays for examples) is of limited value here. For example, the August decline in yield produced several non confirmations in both momentum and MACD before the yield finally turned higher. The net investment/trading effect would have been a loss or at best a breakeven transaction.

Investment Strategy Implications

Perhaps it is the single issue aspect (versus markets, whole sectors, industries, or styles) that nearly eliminates the predictive value of the two tools. Or perhaps it is nature of the instrument with all its external influences (economic and political) that reduces the ability to predict its future price action. Whatever the reasons, the fact is that certain TA tools do not work in all situations.

The moral of the story: Knowing the limitations of any predictive tool is just as valuable as knowing its strengths.

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