The Fear Side of the Greed and Fear Cycle

“The only thing new in this world is the history that you don't know”
Harry S. Truman






Just as day follows night and spring follows winter so, too, does investor psychology follow the seasons of emotions from greed to fear and back. Behavioral finance rules and the Efficient Market Hypothesis remains a hypothesis. Loss aversion over risk aversion.

So, to help investors in need of a little timely perspective, the above two charts (click images to enlarge) reflect the ever reliable greed/fear cycle quite nicely.

Investment Strategy Implications

The contrarian in me believes in the Baron Rothschild saying, "The time to buy is when there's blood in the streets". It is an investing example of President Truman's quote and a testament to the reliability of the greed/fear cycle. Therefore, since the epicenter of the current fear cycle is the Financials, I can't help but notice the recent relative strength in Financials in the midst of outright panic.

A Scramble for Alpha in an Alpha Starved Environment

commentary from this week’s “Sectors and Styles Strategy Report”*:

Unless one buys into the idea implied by the recent price action of US consumer related sectors (see pages 4 and 8*) that economic matters in the US are about to get much better, the only reasonable conclusion one can reach re the recent market action is the hedge fund dominated action of rotational trading. A scramble for alpha in alpha starved environment (for most hedge funds, specifically) appears to be clearly underway.

As noted on numerous occasions and described at my recent NYSSA Market Forecast event, the current equity markets are overwhelmed by short term hedge fund traders with a near non existence from the more traditional investors. For what else can explain the surge and purge nature of the market action overall. Or the recent fascination with the second least attractive sector – Consumer Discretionary?

At the same time, the current US dollar rally (see chart on next page*) has encouraged fence sitters to take the plunge into US assets.

And while the dollar rally may have more strength left in it, the difficulties that the US will face in the coming years should give longer-term investors pause before completely buying into the strong dollar scenario.

Investment Strategy Implications

Just like cyclical corrections in secular bull markets, counter trend moves in bear markets are common. And can be quite productivity played if one is nimble. Combined with the recently oversold Financials sectors (which provides an alleviation of the pressure on the market overall) and strong undervaluation for equities (see next page for several thoughts on this matter*), the reasoning behind a fully invested position for the time being seems warranted.

Nevertheless, as noted in last Thursday’s Minyanville blog posting, this is a game of chicken with one of the signs to keep a watch out for is a return to form, especially in areas such as Consumer Discretionary and Financials.

*Published Aug. 18, 2008. Subscription required. For more information, click here

A Game of Chicken

I am delighted to announce my affiliatiion with Minyanville. Beginning today and for every Thursday going forward, my blog postings will appear on the Minyanville website. The postings will be more "educational" in nature emphasizing core investment principles and practices often forgotten or neglected.

re today's inaugural installment:


"Portfolios that benefited from being underweight the two sick men of the US economic sectors - Consumer Discretionary and Financials - were faced with a performance related decision this summer: play the potential counter trend rally or sit on the sidelines and watch your relative performance suffer. Take, for example, Consumer Discretionary..."

To read today's posting on Minyanville, click here

Financials in the Larger Context

To elaborate on my Tuesday BNN TV interview and to provide a technical analysis perspective as to why the Financials are a value trap for investors, here are a few thoughts.

As stated in the interview, from a fundamental perspective any sector that is about to undergo regulatory change is by itself sufficient reason for longer-term investment pause. And in a highly charged election year, this risk becomes of greater concern. However, it is longer-term consequences of a changed business model that is the greatest risk to investing in the sector. For example, the specific risks to the Financials sector pales in comparison to the likely impact that a changed business model will have on the US and global economies - and then in turn back to the sector.

There is a larger economic consequence to the changed business model, one that few seem to be focusing on – the effect that a deleveraged, changed business model will have on credit creation. If the global economy was aided and abetted in the recent years by financial innovation, it is logical to assume that a dramatic (radical?) shift away from that business model of easy credit and financial innovation (securitization, for example) will result in a lessened degree of capital for consumers and businesses. Therefore, economic activity, particularly domestic activity in the US, will ratchet downward, influenced also by the need for US consumers to rebuild their depleted personal balance sheets.

As this relates specifically to financial institutions, the risk of competition (financial institutions in other regions of the world less burdened by regulatory constraints) due to a changed US regulatory environment for US financial institutions will also almost certainly create growth and profitability difficulties in the years ahead.

While all this real economy stuff gets absorbed by fundamentally-oriented investors, the technicals of the market may paint a different picture. It does not, as the two charts** above show.

The first chart provides a longer-term picture of the sector, which plainly shows a sector that is solidly in a negative mega trend, based on my Moving Averages Principle*. The second short-term chart provides a few reasons why the near term trend is modestly positive. Specifically, momentum and MACD are both positive. And the slow stochastic is not in high overbought territory (above 80 for both trend lines). Moreover, both MACD and the slow stochastic lines have not crossed, which would indicate the end of the near term uptrend.

Investment Strategy Implications

As stated on Tuesday, Financials should participate in the current spring rally. However, beyond this point in time, it is hard to conceive of the longer-term investment case for a sector undergoing a change to the core of its business model. As noted above, the technicals also reflect this longer term concern.

*See prior blog entries and reports for definitions and examples
**click images to enlarge

Feed Me!

Gone largely unnoticed, the Global Consumer Staples ETF (KXI) has been producing a very nice return to investors. Benefiting from the global growth story, KXI’s holdings are well positioned to provide the basics of modern life as the populations of the emerging economies gradually migrate to the middle-income strata of their respective societies.

Since its introduction one year ago, KXI has outperformed the S&P 500 and the more domestically oriented Consumer Staples XLP (see chart above*). The standout reason for the outperformance vis-à-vis XLP is illustrated in the composition of their top ten holdings. As the table above* shows, XLP is much more heavily concentrated both in the top 10 holdings as a percent of the total portfolio as well as its two largest positions, PG and MO.

Investment Strategy Implications

KXI provides investors with a vehicle to play the rising middle-income classes of emerging countries. While the US economy may slump, the global growth story remains intact (unless, of course, you don’t buy the decoupling scenario). Additionally, anyone seeking to stay in the aged bull with a reduced level of risk, consumer staples as a group is a place to be. (It should be noted that the weak US dollar has aided the US oriented XLP as more issues in that portfolio are major global providers benefiting from the falling dollar, as evidenced by the fact of its near equal performance over the past several months.)

With a P/E just a notch above XLP and a beta of .68, KXI should be on every moderate to conservative investor’s radar screen.

*click on images to enlarge
Note: The above is strictly for informational purposes and should not be construed as a recommendation to buy or sell any securities. Please consult your financial advisor. Neither Vinny Catalano nor any member of his family owns the above referenced securities. Accounts managed by Blue Marble Research do have positions in the above referenced securities.

Lunch Money

Okay, you got me in. Now, when do I get out?

The buy call on Citigroup made yesterday required judgment. The sell call for the trade (it is only a trade as the mega trend indicators are decidedly negative) will also require judgment.

For black box types*, all this talk about judgment is unacceptable. After all, the whole point of quant trading is to remove that human element called judgment from the equation. But the timing tools employed for this (and other such trades and investments) isn’t black box stuff. So, judgment is a key component, just as it is when trying to make mega trend calls like the recent spate of Dow Theory “sell signals” by certain market strategists and pundits. (See prior blog postings on this last point.)

To be clear, judgment is an important component of the timing tools described and employed yesterday (and in prior calls). However, the parameters for the calls are the timing tools themselves. Yesterday, I described how to get in. Now, I will describe when to get out.

What we are looking for in a lunch money trade like the one made into C is when our short-term timing tools – momentum and MACD – achieve the following conditions:

• Momentum gets to zero.
• MACD gets to zero, which is when the two lines re-converge at a higher point.

Now, let’s talk about the length of time it takes to get to these levels.

As the above current chart on C shows (click on image to enlarge), momentum has already almost reached zero. At same time, MACD has actually gone somewhat flat. Both suggest that this will likely be a very short-term trade (as in days not weeks) due to the fact that momentum is close satisfying its requirement of getting to zero (which signifies a degree of lessened selling pressure and, therefore, a move more closely to a balance between buying and selling pressure). Re MACD, its failure to turn the lines upward signifies very poor upward pressure.

Trading Action Implications

Here are the advisable action steps:

• If momentum gets to zero and MACD fails to turn upward, sell the entire trading position.
• If momentum gets to zero and MACD turns upward, sell half the position.
(Note: If this second step occurs, when MACD finally turns down sell the remainder of the position.)
• If momentum fails to get to zero and turns downward and MACD turns downward, sell the entire trading position.
• If momentum fails to get to zero yet MACD does not turn downward, hold the position. Actionable steps on what to do next will follow in a future blog posting.

As I said, this is not black box stuff and does require judgment. However, that judgment component is made within the context of the parameters of the reliable short-term timing tools – momentum and MACD. Now, let’s see how this trade turns out. Maybe we can make some lunch money.

Note: It helps, of course, to have a larger conceptual framework, a fundamental framework, that can makes real economy sense out of the market decisions made. For technical analysis purists, this is unacceptable. But the methodology employed here is a blended approach, both of which have their value added features to contribute to the decision process. For fundamentally-oriented investors/traders, this is unacceptable.

*The same applies to what I call “info junkies”, those investor/trader types who rely to great degree on information (I am not referring to inside information) that can give them an edge. This information often comes in the form of a thought leader who has taken a certain course of action and others follow in his/her steps.

Special Notice: Both yesterday and today’s blog postings are for informational purposes only and should not be construed as a recommendation to buy or sell. Please consult your financial advisor.
Neither Vinny Catalano nor any member of his family owns the above referenced security. Clients of Blue Marble Research have established positions in the above referenced security after yesterday’s blog posting.

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.

The Difference Between Motion and Movement

Allow me to add to yesterday’s blog posting with a thought re the difference between motion and movement.

If Bill Miller’s comment noted on yesterday’s blog posting is correct (that the equity market is “remarkably serially correlated”), then perhaps it would behoove investors to appreciate the forces that swing equity prices to and fro thereby producing what might seem to some as a range bound market. Big up, big down, no net change.

Yet, in the midst of the seemingly manic/depressive mode of equity prices certain clearly defined trends are well established and, given the points made in yesterday’s posting, are likely to enable an investor to capitalize on the market's atmospherics.

Investment Strategy Implications

There’s money to be made in exploiting the behavior of the momentum lemmings. And, as the markets enter their final weeks of 2007, that behavior is very likely to be in the arena of the year-to-date winners, like Tech, especially large cap Tech (XLK).

Bottom line: The mega trend is intact. A top may be in the process of forming but it will take a lot more than the angst and pain experienced by investors stuck in the Financials sector to put an end to the very mature bull.

Key point to remember: As long as there are trillions of actively managed dollars desperately seeking alpha along with massive amounts of global liquidity, supportive valuation levels, and a solid global growth story, nuggets of gold can be found in sectors that benefit from the current circumstances. It’s like knowing the difference between motion and movement.

The Dog Days of Contrarian Investing

In his soon to be published quarterly report, legendary value investor, Bill Miller, makes the following observations:

“This market has been remarkably serially correlated. In plain talk, what has gone up keeps going up, and what has not, does not. Valuation has not mattered at all. What has mattered is price momentum. This is very similar to what we saw with tech, telecom, and internet names in 1999. It is not yet that extreme, but it is pretty extreme.

The best quintile of stocks based on traditional valuation factors such as price to earnings, price to book, price to sales, and dividend yield, has underperformed the market by over 1000 basis points this year. The best quintile on price momentum alone, using 3 and 9 month price trends, has outperformed by 1400 basis points.”

Mr. Miller’s comments highlight several points that have been repeatedly raised on this blog and in my reports – namely the highly correlated nature of the equity markets. Two questions are related to this point: Why are markets so highly correlated and how should an investor exploit the situation?

As noted many times before, the highly correlated nature of the equity markets is due in large part to the enormous sums of actively-traded money that is in the hands of the hedge fund and other momentum lemmings. Bereft of original ideas, many hedge fund managers have little recourse than to chase the trades that ensure their relative performance record does not fall so far behind their counterparts (code for keeping my house in Greenwich).

Naturally, it should be assumed that these very same hedge fund managers believe that they have systems and investment strategies designed to gain alpha. At least that’s what the marketing material says. The sad fact is, however, the results are just not there. Since the proliferation of hedge funds, the performance results has regressed to the mean, so much so that there is little to no difference between the on average underperforming hedge fund manager and the on average underperforming mutual fund manager. (The only real difference is the compensation scheme.)

Moreover, logic dictates that there are only so many truly original strategies thereby limiting the arbitrage and other alpha generating strategies available. Put another way, how many brilliant 20-something money managers can there be? Hence, lemming-like momentum investing.

If this be the case, how does an investor exploit the situation?

Investment Strategy Implications

There is every reason to believe that hedge fund managers pressured to justify their high fees will be even doubly pressured these last two months to produce as much alpha as conceivably possible. Therefore, if price momentum investing is the dominant approach taken by many such market players, the odds are that, from now until December 31st, what has worked will continue to work meaning that bottom fishing and contrarian plays will likely underperform and the winners of 2007 will remain so, if not accelerate until the books close for the year.

The momentum game is here to stay. At least through the end of this year and likely into the early part of next year. Contrarian strategies, like the kind that Bill Miller advocates, will likely remain the least attractive approach to investing for some time.

No doubt, the day will come when being a contrarian will pay. However, for the reasons stated above (and others noted in prior blog posting and reports), I don’t believe that day is today.

Actionable steps: For predominantly US investors stay overweight the weak US dollar and global growth story of Info Tech, Industrials, Energy, Gold, and Large Cap Growth. Stay underweight the US consumer related themes of Financials and Consumer Discretionary. For global players sell China into strength, stay long Europe large and mega cap (Europe 350 – IEV) and a proportionally balanced mix of emerging market issues.

Specific investment recommendations can be found in the Model Growth Portfolio (MGP), which is available only to subscribers. MGP performance results are noted on the upper left portion of this blog.

The Year End Rally in Waiting

Now that we are well into the current earnings season several earnings trends are matching recent stock performance, most notably the polar ends of the performance scale - Financials and Tech. As the table* to your left shows, however, the overall earnings picture ex Financials is about in line with expectations - low single digit growth.


Investment Strategy Implications

Once tomorrow's Fed rate decision is behind us, the year end price action for equities will depend in part on the answers to three key questions:

• Will the US economy experience a soft or hard landing?
• Has the global economy decoupled from the US to a sufficient degree that will enable global growth to remain robust?
• How far along are we in the black hole of credit derivatives discovery process?

Notwithstanding all the issues that threaten to derail the aging bull, with liquidity so abundant, corporate and nation state finances in excellent shape, valuation levels reasonable, and technicals in compliance, should all three questions be answered in the affirmative the odds for a decent if not strong end of year rally are high.

*Click image to enlarge.
Source: Wall Street Journal

Info Tech, Growth Investing, and the Crowded Trade

“…every monetary tightening cycle has almost always produced a financial or economic crisis, which in turn has marked the beginning of a new reflation cycle.”

Bank Credit Analyst
Strategy Outlook Part 1 – Fourth Quarter 2007, September 14, 2007

The reflation cycle is well underway. The Debt Supercycle (see report October 15, 2007) underpins the perpetual rise in assets, rolling from one to the next, producing bubble after bubble only to have the bursting bubble be resolved with more liquidity. And so the story goes.

Accompanying the Debt Supercycle is the tendency of sectors to get overowned producing a crowded trade. And an opportunity for keen-eyed investors to exploit.

I made this point several times before but it bears noting again, particularly in light of the very solid earnings news eminating out of one of my favored areas – Info Tech: Growth investors need to find growth issues to own. One of their favored areas, Financials, is now toxic. Yet, the money allocated to growth not only remains but is actually increasing as investors shift money from value to growth plays. So, what do growth money managers do when one area goes from favored to toxic? They find another area to overown. Enter Info Tech.

Investment Strategy Implications

With an end of year rally setting up nicely, the momentum lemmings are poised to act like Santa’s little helpers and get busy, busy, busy driving prices higher once we get the spookiness that is October out of the way and 2007 comes to a close. In the process, Info Tech (and Industrials) should remain very solidly in the upper quartile of performers.

Amidst the joy, however, there is one style area that certain investors still remain confused with – The Smids

Yes, large cap and specifically large cap growth appears to be the better place to invest. However, converting an underperforming Smid group into a negative return group is a mistake and runs the risk of leaving lots of money in selected areas on the table.

For reasons stated previously (including what is noted above), excess liquidity, decent earnings growth, reasonable valuation levels, and the pressure to perform will continue to help drive prices higher in the Smids. Therefore, don’t overlook the opportunities that may be buried in the Smids, particularly in the Info Tech and Industrials sectors.

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: Dow Transports – The Technical Canary in the Bull’s Mineshaft

Throughout the nearly five-year bull market, the technical support beams for higher highs have remained solidly intact. No major market top, no major divergences, and moving averages trending nicely to the upside. There is, however, an issue of concern that has emerged recently that bears noting: applying the Moving Averages principle, the Dow Transports is flirting with a trend change signal that has overall market implications.

First, a refresher re the Moving Averages principle:

As noted on August 2nd, “When the 200-day (moving average) slope is set (up or down), the current price and the 50 day tends to lead in that direction (above or below). In other words, a mega trend contains two elements: the current price and the 50-day moving average must lead the 200-day and the slope of the 200-day must point in a clearly defined direction. 

A preliminary warning signal to a mega trend occurs when the current price crosses the 200-day. A slightly more significant warning signal occurs when the 50-day crosses the 200-day. BUT, it is only when both current price and 50-day cross the 200-day AND the 200-day changes direction that the existing mega trend can be considered over.

Now, let’s take a look at the two charts above*.

The first chart shows the Dow Transports over the past five years. What is clear is the fact that by adhering to the Moving Averages principle an investor would have stayed long the Transports and, presumably, the market as a whole. For, at no time did the Transports violate the Moving Averages principle noted above. That is, until now.

As can be seen more clearly in the second year-to-date chart, the underlined points noted in the above Moving Averages principle have occurred. Price is below the moving averages, the 50 day has crossed the 200 day, and both the 50 and 200 day are now downwardly sloped. Now, here is where a little judgment (and history) must come into play.

Given the fact that the magnitude of the above trend change points noted are at the earliest of stages, the potential for a whipsaw cannot be ruled out. For, when it comes to more cyclically oriented sectors (the Transports being such a sector), whipsaw moves are more common than in less cyclically sensitive sectors (or in a broader index such as the S&P 500).

Investment Strategy Implications

The primary point of drawing your attention to the potential trend change in the Dow Transports is that it suggests a certain fraying of the market’s broad technical strength. For example, over the past months, the technical readings for several economic sectors (Financials, Consumer Discretionary, and Healthcare) have either turned negative or are close to doing so. In other words, the Transports recent market action is an early warning sign that should be ignored.

As stated several times before, it’s a bull market ‘til it ain’t. However, as any prudent investment miner knows, if the canary stops singing, it’s time to stop the digging.

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

Out with the Old, In with the Relevant: Sectors in the Thematic Spotlight

With 3Q07 earnings season about to unfold, perhaps a far more productive use of investor time is to turn away from the well known and the insignificant and focus instead on identifying the themes that are playing out in the market and their prospects of continuing. For the well documented and the largely irrelevant issues (credit squeeze and the GM strike, respectively) may be vital to media ratings but they have the effect of taking the investor eye off the more productive alpha ball when they have past their useful investment value. Like the shelf life of any product, when news is old and quite well known (or in the case of the GM strike, irrelevant), it’s time to shop elsewhere.

With that said, let's consider the year to date performance of the 10 economic sectors that comprise the S&P 500 and any investment insights we can glean.

What is noticeable in the above chart (click on image for larger view) is how neatly the performance of each sector is tracking various identifiable themes. For example, at the top of the performance list are Energy (XLE) and Basic Materials (XLB), both major beneficiaries of the global growth/Asian infrastructure build story.

Next are a trio of growth issues that are clustered very tightly around the +15% category: Tech (IYW), Telecom (IYZ), and Industrials (XLI). Tech and Industrials have both a touch of the global growth dynamic as well as the weak US dollar/export benefit, while Telecom remains in its long term, undervalued recovery mode.

In the middle of the pack, out on its own, is the Utilities (XLU) sector at +10%, staging a rebound from its recent interest rate/over valued driven correction and subject to its sector specific forces.

Then we have the two “defensive” plays – Consumer Staples (XLP) and Healthcare (XLV) – crawling along at the +5% level, with the Healthcare sector being dragged down by big Pharma’s woes (Hillarycare, depleting pipelines) while Consumer Staples is still unable to realize in the minds of investors its feed-the-world potential.

Finally, the bottom of the performance barrel is inhabited by the two toxic economic sectors – Consumer Discretionary (XLY) and Financials (XLF) – solidly in negative territory, both heavily impacted by US consumer issues with Financials getting the extra kick in pants from the aftermath of the excesses of financial innovation.

Investment Strategy Implications

Insights will be gained over the next month as the themes noted above and other important sector forces become revealed via 3Q07 earnings reports. Contrarily, insights will not be gained by a continued fixation on yesterday’s macro news. Out with the old, in with the relevant.

Exploiting the Growth Investor

Growth investors invest in growth stories. Therefore, when the growth story of financial innovation dropped from favor, the growth investor had a choice – stick with the losing position or seek out alternative growth opportunities.

The chart* to your left highlights the performance change that taken place over the past several months (since the credit squeeze took center stage) for two growth stories: financial innovation and technology.

We all know the individual stories each sector has experienced. What may have gone unnoticed by some, however, is the shift forced upon growth investors as many such oriented investors abandon the financial innovation growth story and, out of mandated necessity, seek out other, more reliable growth opportunities. In other words, out of Financials (XLF and the broker/dealers, IAI) and into Tech and Telecom (XLK).

Investment Strategy Implications

With earnings season upon us and as the macro story on credit problems and the Fed’s rate action fades from the front page (and most investors’ minds), the focus will now shift to the micro stories of individual economic sectors and investment styles. One aspect of this shift is the growth part of the style equation.

There are several economic reasons to overweight Tech and Telecom, especially the big cap issues. Global growth and a weak US dollar are two. Then there is the above noted style factors: A pattern that is likely to remain intact, particularly through the upcoming earnings season.

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

Bernanke Blinks

As the cost of money went down yesterday, so did the credibility of Ben Bernanke.



Since when did John Kerry become Fed chairman? Talk about flip flops. How do you go from being an advocate of the market discipline and exude confidence in holding the line against bailouts and then do exactly the opposite in less than 2 weeks!?!?

Frankly, I am less stunned by the ½ point Fed Funds rate cut and more so with the unanimous vote that supported it. Accordingly, I am sensing that this is not Bernanke’s Fed. The dynamics of the Fed board bear studying and the minutes of yesterday's meeting will be most illuminating re Bernanke’s leadership skills (release next month). Until then, upcoming economic and earnings data points will shed light on just where the US (not the global) economy stands. For now, a useful exercise would be to consider what the rate cut means to valuation models, which is where all economic matters must lead investors to.

From a valuation perspective, what yesterday’s Fed action implies is that we have taken a step back toward the PE (private equity) valuation model*. And in doing so, has put back in play (to some degree) the takeover premium and hot money game that the global liquidity drainage action of the past year was slowly taking away. Therefore, valuation metrics and earnings expectations for 2008 must now come into view.

Once again, the simple, elegant yet very effective modified Fed model that I use (see update table above - click on image to enlarge) provides a guide to possible scenarios. It is the yellow zone of the table that I wish to draw your attention to. Specifically, the prospects that a $96 S&P operating earnings number is a reasonable earnings expectations for the next 12 months. If rates rise (thanks to concerns of rising global inflation), then the enlarged yellow box implies a high single digit return for US equities from current levels.

This, of course, assumes that the credibility damage created by yesterday’s Fed action does not produce unintended consequences. And in a highly uncertain world, unintended consequences should always be assumed.

Investment Strategy Implications

With the strong rally and the expected rise in longer term rates, the valuation gap to full value has and will continue to close. Accordingly, the recent 100% invested position expressed in my Model Growth Portfolio (see performance data in left column) will be reduced at the next re-balancing (Monday). Until then, the trade recommendation made nearly two weeks ago (buy Homebuilders – XHB) has achieved its target and is hereby removed. Other changes are forthcoming.

*see prior blog postings on Private Equity via the Topics Discussed listings in the left column of this blog.

"The Fever Will Break. It Always Has."

excerpts from this week's report:"

"So said the Maestro during yesterday’s 60 Minutes interview referring to the current credit squeeze. And despite the run-on-the-bank visuals of British depositors of Northern Rock standing on line, passbooks in hand, the growing impression from this desk can be summed up in two words – Old News. In fact, we seem to getting to the point where it's time to say, in the words of the Chris Matthews show, “tell me something I don’t know.”

"Without a doubt, other shoes will drop. But it’s going to take a very big shoe (global growth slowdown, for example) to impact the overall market. Anything less will simply damage the affected area in question and not likely bleed into sectors of the global economy. "

"The large economic issue is Decoupling. That is now the key area to focus on. It is about to get its long awaited test. All indications point to a US economic slowdown, or worse. The US consumer will likely cut back spending. But the investment strategy question to answer is “Just how much does that matter?"..."

"Model Growth Portfolio re-balancing:
Reductions
-2% Consumers Staples
-2% Oil Equipment and Service
-1% Gold

Additions
+2% Homebuilders
+1% each Telecom and Utilities
+1% Europe 350"

also in this week's report
• Valuation Model
• ETF Model Growth Portfolio
• Model Growth Portfolio re-balancing
• Key Economic Indicators

Note: To gain access to this week's report (and all previous reports), please click on the Blue Marble Research Subscription link to your left.

Technical Thursdays: Homebuilders – Building a Base for a Dead Cat Bounce

The Divergences principle is an anchor of technical analysis and one of its most reliable tools. The logic is simple: price alone tells half the story and is an incomplete measure of a given trend. Price must be confirmed by other relevant indicators that must confirm the given trend otherwise a trend change is likely to occur. When price is not confirmed by other indices, a divergence has occurred and a potential trend change becomes the most likely next move.

Applying the Divergences principle with price, Momentum, and MACD, is an excellent short-term timing tool. If price is not confirmed by Mo and MACD, the odds of a trend change rise substantially. Such is the case with, of all things, Homebuilders!

As the chart above shows, XHB fits the Divergences principles quite well. Price (new lows) is currently not being matched by a confirming low in either Momentum or MACD. What would make this trade even more compelling is if XHB made a new low over the next few days and Mo and MACD improved further. Unless that new low were a plunge to say 20, the Divergence signal would be even stronger.

Investment Strategy Implications

Nothing’s perfect but when the news is both old (on the verge of getting stale) and bad, an investor should begin assuming that the market value reflects most of the current bad news. To be clear, this call is little more than a trade. But placing a modest bet on a beaten down sector is what a contrarian investor (that’s me) is supposed to do.

P.S. The wide gap between price and its 200-day moving average also argues for a bounce.

Note: At publication time, neither Vinny Catalano nor clients managed by Blue Marble Research had a position in XHB.
**Follow up note: Position removed. See September 13 blog entry.

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