Buy the Dips? Sell the Rallies? An "Inflection Day" Rally Update

There is little doubt that many counterbalancing forces are at work in today’s equity markets. The bulls argue that March 17 (“Inflection Day” – see prior blog postings) was the turning point for the longer-term bull market correction that began in earnest last October. The worst is behind us and whatever market action investors are currently experiencing presents a buying opportunity (consolidation range), as the US economy (and, therefore, the world economy) will weather the current economic slowdown. For a testament to this view one need only look at the bottom up earnings numbers generated for confirmation that late 2008 will usher in a return to growth.

The bears would counter that the decline from October 2007 to March 17, 2008 was the first leg of a bear market and the current market action is little more than a distribution range that will end sometime late summer/early fall when the second leg of the bear emerges.

There are many arguments that support both views. Let’s look at a few of them from both a fundamental and technical analysis point of view.

From a fundamental perspective, we have the following items on the plus side of the equation:

• 2Q08 earnings (ex Financials) are likely to be decent (especially in light of today’s retail sales numbers, a point mentioned on this blog weeks ago).
• Valuation is okay with the BMR proprietary Expected Return Valuation Model* at the ever so slightly overvalued point of -2.32% (S&P 500 at 1351, 10 year US Treasury at 4.17%).

From a technical analysis perspective, the following indicators are positive:

• SMIDS, specifically Small and Mid Cap Growth have outperformed the broad market since inflection day (see chart above).
• Shorter-term Momentum has not confirmed the recent lower lows of the market and Slow Stochastics have entered oversold territory.

The major negatives, from a fundamental perspective, are twofold:

• The US economy may experience a rebound this summer as the stimulus package helps the US consumer. However, once the stimulus fades, various forces will drive the US economy into a more meaningful decline beginning 2009.
• The credit crisis is far from over as much toxic paper remains on the banking books and once generous covenants in the high yield arena are lifted (largely beginning in 2009) the odds are that the subprime meltdown will look like a dress rehearsal.

From a technical analysis perspective, the major negatives are:

• Most sectors, styles, regions, and countries have flipped into mega trend declines (Moving Averages Scorecard*)
• MACD, a short-tem indicator, is solidly negative.

Investment Strategy Implications

There are obviously many other factors one can put into the investment strategy mix*. The conclusion I come to is the following:

• The US equity markets are in a range-bound distribution phase.
• Investors can capitalize on both selling the rallies and buying the dips for as long as the range-bound distribution phase is in effect, which should end sometime late summer/early fall as 2009 comes into view.
• 2009 will likely experience a confluence of very negative forces (new administration in the US, economic hangover effects of the stimulus package, and the second, and much larger, wave of the credit crisis into numerous other areas such as credit default swaps on corporate debt).
• Financial institutions will remain at the epicenter of the credit crisis and the direct effects of deleveraging coupled with the negative wealth effects from housing and equities will produce a real economy recession, possibly far greater than only the most pessimistic economists are calling for.
• Stagflation will be a contributing factor to economic difficulties, with the increasing probabilities of significant social unrest throughout the world (something has already begun in various emerging economies)

If one believes, as I do, that equities are in the eighth year of 14+ year secular bear market, then the current environment is an opportunity to trade the range-bound rallies and declines and a time to consider rebalancing one’s portfolio for the much rougher times ahead.

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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.