Recent Media Appearances: USA Today, Bloomberg radio, BNN TV, and foxbusiness.com

Leveraging off a recent quote in USA Today re investor sentiment (see below), my three most recent media appearances from Friday - Bloomberg radio (Taking Stock with Pimm Fox) and BNN TV (Canadian Business News Network) - and yesterday - foxbusiness.com (with Tracy Byrnes) are posted. The topics of discussion include the impact that rising gas prices are likely to have on consumers; impressions from the early 2012 events; and a very useful technical analysis tool for timing the more important intermediate term trend of the equity markets.

To view and hear the media appearances, click here

USA Today quote: The mood of the Phoenix audience, said moderator Vincent Catalano of Blue Marble Research in the New York area, was more restrained than opportunistic. Catalano said he has noticed the same somber mood lately at forecast dinners hosted by other CFA or chartered financial analyst groups around the U.S.

Motion Is Not Movement: Risk Appetite Still Unchecked

Despite sporting an above large cap P/E (19.1 times versus 12.6, estimated for 2011) and despite having an exceptionally optimistic consensus earnings estimate for 2012 (27.3% versus 9.3%) and despite facing the heightened risk of an era of diminished US consumer demand (which is the primary business space small companies operate in), the emboldened bottom up crowd (see yesterday's comment re the bottom up idol, Warren Buffett) joined by the who-cares-what-direction-the-market-moves-just-as-long-as-the-market-moves momos remain fairly sanguine as they have yet to show any meaningful and sustained reduction in their risk appetite. To see this clearly, just look at the accompanying chart illustrating the performance of the small caps (IJR) versus the large (SPX) and mega caps (OEF) over the past 2 years.

While there have been relatively brief periods of reduced risk appetite (when small caps underperform their larger cap brethren (bottom portion of the accompanying chart), the cumulative result still remains fairly rosy.

Investment Strategy Implications

Today's big market move is yet another example of a point I have made on numerous previous occasions: large moves within trading ranges mean nothing. It is only when the current first wave of the bear (my view) or the bull market correction (bulls view) resolves itself with a clear downside or upside break AND is accompanied by confirming action from other indices that the true trend will be exposed.

One early sign would be if there is or is not a change in the risk appetite investors and their momo cohorts. And that would reveal itself in the relative performance of the small caps. Telescoping that performance into today's action: OEF -2.11%, IJR -2.62%. Applying the point made re the range bound market to todays' performance: motion is not movement. Unless and until this changes on a sustained basis, the risk appetite remains unchecked.

Motion is not movement. In fact, motion often resembles commotion.

Note: Accounts managed by Blue Marble Research presently hold a long/short position in the above mentioned issues and their inverse comparables.

foxbusiness.com appearance

To view the segment, click here.

Talking Head Alert: foxbusiness.com Today

Okay, so I look prescient (at least for 3 days) after last Thursday's appearance on Bloomberg radio's "Talking Stock with Pimm Fox and Courtney Donohoe" some 60 S&P 500 points ago. Now what?

Today's talking head appearance affords me another opportunity to describe my emerging bear call and can be viewed at foxbusiness.com (not on cable) at 1 PM (eastern) today.

In addition to my submitted suggested talking points (below, sent yesterday), I hope to explain why
1 - Big market moves within defined trading ranges mean nothing.
2 - On its own, moves above and below the 200 day average also mean nothing.

Plus the emerging bull market in Komboloi (see accompanying image).

Suggested talking points:

Commentary: Blind Faith

* Bottom up type of investors - those that make investment decisions based primarily (many exclusively) on earnings - have helped drive stocks to current levels.
* Following their lead is a very dangerous practice for investors, as bottom up investors have an investment method that is fraught with danger.
* Last Thursday's stock market rally illustrated just how dangerous their approach to investing is: driving stocks higher on the news of the Eurozone deal without full knowledge of the deal's consequences.
* Their method - earnings matter above all else - is anchored in the belief that what's good for business is good for the economy. To believe this is to believe in laissez-faire economics, that unfettered markets work best, that government that governs least governs best.
* One would think that the recent experience (2007 - 2009) would have put this thinking to bed. But old ideas based on an ideology (dogma) die hard.

Market Assessment

* There is neither a fundamental nor a technical analysis reason to change my early bear call.
* My proprietary Mega Trend is still strongly in the bear category.
* Earnings are on the verge of a serious decline into 2012 (and beyond) as the Eurozone slips into recession.
* At best, stocks should sell at a low double digit P/E, not the current average (15 times) P/E.

Actionable Items

* Resist the siren call of the bottom up bulls. Keep a low equity exposure (50 to 60%).
* Put on mega cap, small cap hedges (long mega cap OEF, long the inverse small cap RWM).
* Be prepared to drop the equity exposure below 50% when the second wave of the bear emerges.

To view the segment live, click here.

Another Day, Another Opportunity… to Fade the Rally

Memo to the momo lemmings: It’s more than the Eurozone that’s the problem.

Applying simplistic analysis, the momo crowd has unleashed yet another round of risk-on trades this morning. Jacking stock prices back near their 200 day (exponential) moving average – at least when it comes to developed markets. Emerging markets (remember them, the global economic sector where all the growth is supposed to come from?), however, are lagging the party thus far.

Yet, beyond the short-term wiggles and squiggles that the momo crowd tends to heavily influence, the longer-term picture paints a rather different story. As the accompanying chart** shows rather clearly, the Mega Trend* is decidedly in bearish mode. Moreover, both MACD and RSI are hardly exhibiting robust support for the rally, with MACD yet to crossover to the positive side (when the blue line crosses the red).

As the chart shows, the past is fairly clear what happens when the Mega Trend turns negative. Moreover, only when MACD and RSI register an internal non confirmation (as it did so significantly in the winter of 2008 into the spring of 2009) is there cause to believe the establishment of a negative Mega Trend is at the point of reversal.

To be sure, RSI did register a modest divergence last week but MACD did not. And while one indicator is fine, two is always better.

Investment Strategy Implications

The momo crowd is enthused that another round of inadequate political action will save the Euro day. And perhaps the movement they have fostered these past few days has some lasting power to it resulting in the aforementioned reversal conditions. However, with earnings season starting this week, there is every reason to expect the optimistic bottom-up projections will follow the macro economic forecasts for the third quarter, which were well below economists’ expectations. And that reality may trump the momos rationale du jour. Yet, when it comes to the momos, here's something useful to remember:

Being agnostic when it comes to the longer term and the real world of earnings and economics, they will follow whatever short-term trend they manufacture. That's what lemmings do.

*use search function on the top left to read about the Mega Trend.
**click image to enlarge.
Note: the above chart is a weekly chart in which the 50 and 200 day daily moving averages are converted to the equivalent 10 and 40 week moving averages.

What Is A Bear Market?

To many, especially those in the financial media, a bear market is a statistic. For example, during Monday's swoon, the words "The market, down 20%, is now in bear market territory" could be heard early and often. However, to investment strategists and seasoned portfolio managers, a bear market is not a statistic but a trend established or in the process of being established in which lower prices are the dominant trend. How one comes to this conclusion is a process of the methodology employed. And only time will tell if the forecast is correct.

At present, the view here is that the bear is the operative major trend. This is so for reasons described on many previous occasions, most notably the Mega Trend*. If I (and others) are correct and we are in the throes of the bear, then there are three portfolio decisions that need to be made.

First, what is the appropriate asset allocation mix? The answer depends on one's risk tolerance, goals, objectives, constraints, etc.

Second, what is the appropriate sector mix? The answer here depends partly on the answer to first question but also includes a standard reduced volatility exposure (lower beta) via "defensive" sectors. Thus far, in this bear that has produced some good alpha.

Third, what is the most productive tactical approach to take? Here, the answer resides in what phase of the bear we are in. If in the first wave (which is what I believe we are still in), fade (sell) the rallies is the appropriate course of action. Rallies are a feature of the first phase, as the bulls still have considerable residual strength and the supporting argument that we are only in a correction. This is not the case in the second and third phase, when rallies are few and far between.**

There is a related topic to discuss re the bear: "Because."

Like all market factors, the reasons for the bear (or the bull, for that matter) are many and complex. The simple "Because" reasons given so blithely so often in the financial media are the construct of the business dynamics of the financial media industry and human nature. For many, it is hard to believe that cause and effect (the real world reasons for why markets move) is not always the case. The problem with this is simple: the cause is rarely one thing. It is predominantly many issues with many complex dynamics at work.

One last point: the magnitude of a move is very difficult to forecast. Assumptions can (and should) be made. However, given the highly dynamic nature of the markets (see Soros' "Reflexivity" on this*), it is hard enough getting the direction correct let alone how large the move will be and when it will end.

Bottom Line: A bear market is not just a statistic. It is the view (followed by the reality) that a downward trend is in effect that results in significant loss in value or time. It's a bear until it ain't. Or, to quote the famed philosopher, Yogi Berra, "It ain't over 'til it's over."

*Use search function to find prior posts on this and other topics.
**When entering the 2nd and 3rd phase, the asset allocation should be at the desired level.

Nothing To Hang Your Bullish Hat On

Following on yesterday's market intelligence (what I believe quality technical analysis actually is) posting, a longer term view of the market reveals the erosion in strength that took place this past spring when the market made new highs. The accompanying chart illustrates this quite clearly: non confirmation from all three price momentum related indicators. This helped set the stage for the subsequent and current decline.

To be clear, as noted on numerous prior occasions the absence of external divergences (use search function for prior blog postings) + the modest (not over) valuation levels for stocks + the manner in which the bear got started (from bull to bear rapidly and not in rollover fashion) = a delayed recognition by yours truly to the current bear market conclusion. As Lord Keynes once said, "when circumstances change, I change my views. What do you do Sir?”

Going forward, a look back at the chart shows no signs of strength from MACD. This is perhaps the most reliable of the three indicators in confirming market direction. As is plainly shown, the crossover to the downside is solidly in place with no positive (bullish) crossover in the offing. Until that occurs (and it will, eventually), investors are advised to assume that the current rally is highly suspect.

Somebody Is Going To Be Real Right...

...and somebody is going to be real wrong.

If you have not heard from your friendly technical analyst, maybe it's time to find someone else in that field.

In what can only be described as coming straight out of the Edwards and Magee technical analysis bible (“Technical Analysis of Stock Trends”), the accompanying chart is a classic example of not one but two technical analysis chart pattern icons: Head and shoulders top and a bearish pole and flag.

This plus the fact that nearly 90% of the global indices I track are flashing bearish Mega Trends (use the search function on the top left for prior blog postings explaining this tool) is about as bearish as one can get.*

The first wave of a bear market almost always looks like a correction. Bulls will argue convincingly that key metrics like earnings and interest rates support this view. However, the anchor for this argument - solid earnings - can be easily undermined should the global macro story develop into something far worse than the bulls currently envision. For a recent example of this, just look at what happened from 2006 (S&P 500 operating earnings at a record $87) to 2007 ($82) to 2008 ($49). In this regard, the MERI (use search function again) is practically screaming earnings disappointments beginning next month. That could start the chain reaction of doubt, which is a strong characteristic of the second wave of the bear (as price crashes below the previous lows).

For a market priced for an economic muddle through, the worse case scenario is yet to be realized. Moreover, with limited flexibility to provide meaningful counter cycle actions, governments will be in no position to act effectively. Then there is the self fulfilling aspect of the negative wealth effect on the global macro environment that declining equity values tend to produce, which will almost certainly accelerate the downward pressure on the global economy (and earnings). Lastly, there is the unknown. Can anyone say with absolute certainty that all is good in China?

There's more. But suffice to say, an uncertain environment is hardly the prudent time to be fully invested.

Investment Strategy Implications

The advisable strategy appears to be to move as close to the exit door as possible. In portfolio strategy terms that means

1 - Reduce the equity exposure to a safe level, which for accounts managed and advised by Blue Marble Research is 60%. This means fade (sell) the rallies to, at least, maintain a constant percent equity exposure, but to preferably reduce down to the close-to-the-exit door level.
2 - Shift assets holdings to high quality dividend paying stocks.
3 - Be prepared to reduce the equity exposure to below 50% once the second wave gets underway. This means sell into the declines. The first wave of the bear gives you ample opportunity to sell the rallies. ("Looks like a correction to me.") The second and third waves do not.

Like I said, somebody is going to be real right and somebody is going to be real wrong. Of all things so uncertain in these times, one thing I am certain of: we will find out soon enough.

*Previous blog postings describe the unusual nature as to how we entered the bear (use search function). But the past several weeks have made it all the more traditional.

Vintage Farrell

Yesterday, legendary technical analyst, Bob Farrell, published a one pager describing the extremes the market has come to in a very short time frame. The title says it all: "Capitulation".

The advice Bob renders is to avoid trying to catch the falling knife but the extremes reached yesterday are a reference point from which a test will likely ensue in the coming days. Should that test succeed, then the odds are favorable that a multi week rally will follow. Or as Bob puts it: "An initial rally will likely be a one or two day affair because all those who were buying the dips will now be selling the rallies. If the benchmark lows hold on a retest, then the market could set up for 2-3 weeks of recovery."

To be clear, Bob does note that a lower low may occur and that may set the reference point at a lower price point (his avoid catching the falling knife). However, my take of his advice is: if the 1 to 2 day rally is followed by a probing of yesterday's closing of 1200 and that does not produce another wave down, then the retest would be considered successful.

Great Britain: The Expansionary Austerity Canary in the Economic Coal Mine

When it comes to Expansionary Austerity, the UK has had a full year head start over the US, having implemented a series of cuts advertised to produce fiscal order, which will then produce a robust economy and jobs growth. So, it seems quite logical to look at how that's going in the real economy and, more importantly for investors, how the market perceive the situation.

From a real economy perspective, the most recent data from the St. Louis Fed shows quite clearly that the "cut to grow" philosophy at the heart of Expansionary Austerity has yet to deliver as promised. Half of the indicators tracked (industrial production, real retail sales, real compensation, real private final consumption expenditures, and real gross fixed capital formation) are all headed in the wrong direction (down), with the other half not exactly exuding the robust economy and jobs growth advocated for.

From a markets perspective, as the accompanying chart shows, the picture is fine - for now. If, however, price crosses to the downside and the two key moving averages (50 and 200) head in the same southerly direction, it will be hard for the bulls to draw any conclusion other than a bear market has begun.

Investment Strategy Implications

The conservative government in the UK adopted its version of Expansionary Austerity a year ago. Therefore, investors would be well served to consider it a test case (both economically and in the markets) for what the US may experience. Based on the record thus far and considering the global macro implications that the much larger US economy is likely to have the global economy, the prospects do not look encouraging.

Is It A Bear Market Yet?

To rephrase Orson Welles from the accompanying 1970s commercial, "We will sell no stocks before it is time."

As noted in my Timing the Bear Market blog posting last month, bull market tops are different from bull market bottoms. Tops tend to have a rounding pattern to them in which sideways action leads to a rolling over phase during which price breaks below its 50 and 200 day moving averages and both moving averages cross and head downward. This action signals the end of the bull market, which is eventually followed by a cascading down of price in an accelerated fashion. Market tops also tend to produce divergences, both internal (intra market) and external (inter market).*

Do any of these conditions presently exist? In a word, no.

There is some evidence of this process underway but not to the extent needed to ring the bear market bell. But what of the big price swings these past months, investors might ask? It is fruitful to remember that big moves within trading ranges rarely have market trend changing qualities. Yes, there are the rotational aspects that can be exploited (sector to sector). However, when it comes to a market directional change, big price movements at key inflection points (including the aforementioned moving averages) have greater significance than intra trading range swings - regardless of the magnitude.

Investment Strategy Implications

Is a bear market headed our way? Most definitely. When? When the above related conditions are met.

The macro picture looks pretty dismal. Yet, it is vital to remember that stocks are primarily driven by two factors: valuation and financial market liquidity*. Only when the macro picture begins to impact these two factors will stocks be poised for a trend change: at the nexus of fundamental and technical analysis.

What might be the catalyst that provides the impact? Expansionary Austerity is the leading candidate.

*To learn more about the Mega Trend and Divergence Principle as well as the two factors, use the search feature at the top left of this blog.

Destination Resolution

From a technical analysis perspective, the initial stock market reaction to today's dismal jobs data (on all levels, most notably the 0% wage growth) does little more than move equity markets away from the top end of their multi month trading range. In the process, it moves stocks closer to the more important issue: a resolution of the sideways action.

As the accompanying chart implies (click to enlarge) and the historical information provided by S&P's Sam Stovall suggest*, price and moving averages are likely to converge in the not too distant future (did someone say August 2nd?).

At present, the Mega Trend (use search function on top left for information re the Mega Trend) is bullish. The interplay between price and its moving averages are positive. However, as noted several times previously, market tops tend to be quite different than market bottoms. The sideways affair is almost always the precursor to the rollover phase (which is when the Mega Trend reverses and the bear market is confirmed) followed by the tumble and the OMG moment for far too many investors.

An accompanying set of market action circumstances almost always occurs when the resolution takes place: divergences.

Inter-market divergences** signal broad market weakness. Confirming action signals broad market strength. At present, most markets are moving in sync with the US large cap group and are or are close to confirming a prospective new high. That said, further sideways action or a premature upside breakout could produce a deteriorating condition between and among markets.

Destination Resolution

The resolution of the sideways action should signal the next major stage for equities: a resumption of the bull or the return of the bear. The fact that the timing of the current resolution will likely occur in August is eerie. For August is the month that precedes the historically poorest performing time of the year: the fall.

Funny how these things seem to work out.

*see blog posting below, "If Sam Is Right".
**Intra-market divergences also signal market weakness, just to a lesser extent.

If Sam Is Right…

“From April 29, 2011 through June 10, the S&P 500 recorded six straight weekly declines and fell a total of 7.2% in price, spooked, in our opinion, by a potential debt default by Greece and the projected downshifting of global economic growth. Since 1950, the S&P 500 experienced 14 other times in which it declined six weeks in a row. In the seventh week, the “500” gained an average ½ of 1%, and advanced in 11 of 14 observations. Last week’s performance made it 12 of 15 times, as the market rose 0.04%. History now says, but does not guarantee, that in the coming six weeks the S&P 500 will rise slightly more times than it falls, but that the market will end up slipping around 1% from where it concluded its six week selloff.”

Sam Stovall
Chief Investment Strategist, Standard and Poors
“SECTOR WATCH: Does Volatility Offer a Clue to Market Declines?”
June 21, 2011

On Friday, I wrote "Timing The End of the Bull Market", which put a Mega Trend* timeframe on the end of the sideways market and prospective end of the bull market. Now, along comes the above information from that fountain of historical analysis, Sam Stovall.

As the above excerpted quote describes, we now have the historical context from which the current market can be framed. Now, let’s tie what Sam has provided with my Friday posting:

If Sam is right, the timing will be uncanny. A convergence will take place in which the historical will meet the technical at the junction of time and space (price and moving averages - the Mega Trend*). If this unfolds in anything close to this manner, the resolution of the sideways market (consolidation or distribution) will be all the more clear.

*Use search function above left to read more about the Mega Trend.

Timing The End of the Bull Market

''Let me tell you about the very rich. They are different from you and me.''
F. Scott Fitzgerald, "The Rich Boy"

Like the very rich, bull market tops are different than bear market bottoms.

Whereas bear market bottoms tend to be panicky affairs (probably has something to do with real losses versus opportunity costs), bull market tops tend to be drawn out affairs. In the process of forming its top, the dying bull experiences 3 distinct phases – sideways, rollover, and breakdown. The time period between each phase varies but a look at the last 2 traditional market tops during the first two phases - sideways and rollover - should help time the next market top.

The first 2 charts illustrate that the time period of sideways to rollover was 11 months (1999 – 2000) and 8 months (2007), respectively. The third chart shows that the current sideways US stock market action (S&P 500) is six months in the potential top making. If sideways evolves into the rollover phase (when price crosses the moving averages, the shorter term moving average crosses the longer term one, and both moving average point downward – a/k/a my Mega Trend*), one could assume it would take place sometime in the not too distant future (did someone say September?).

Until we get a definitive rollover of the sideways action, only the amazingly clairvoyant know for certain that the current sideways market is a distribution (meaning top) and not a consolidation phase**.

*Use the search function on the top left to find prior commentaries describing the Mega Trend.
**A consolidation phase is the pause that refreshes as the resumption of the bull market gets underway.

Bottoms Up?

I received an email this morning re some analyst's view advising investors on the prospects of a market bottom. I may have it ass backwards, but talk of a "bottom" needs to be clarified.

A 4.9% drop (closing price to closing price) from the May 31 close within a sideways market (since the spring for US and the fall of last year for most emerging markets) is hardly the stuff of market corrections (5 to 10% or more).

With Momentum, MACD, and RSI in full retreat, more time is needed for a "bottom" to be formed (first chart).

What would be ideal (for a "bottom") is a non confirmation of Momentum, MACD, and RSI versus price. That could then lead to a good rally but not necessarily a "bottom" (as in something more than one that leads to a tradable rally) as the sideways market we have been experiencing may turn out to be a distributional range and not a consolidation phase. Technical analysis support for this possibility (distribution leads to market top) rests in the deterioration (and non confirmation) in Momentum, MACD, and RSI on a longer term (weekly) basis (second chart).

It must be noted, however, that these momentum indicators (which is what Momentum, MACD, and RSI are) are warning signs only.

The key inflection point is IF the Mega Trend reverses (price, moving averages, and their relationship to each other). That could occur late summer or early fall if the sideways markets resolve to the downside (by price breaking below its moving averages, shorter term moving average crosses longer term one to the downside, and the slope of both moving averages is downward).

These are the signs investors and traders might consider as markets debate if the real economy is experiencing an economic soft patch or something else. In other words, soft patch = consolidation, something else = distribution (followed by bear market).

A Head and Shoulders Bottom?

If you have read any of my technical analysis work over the past years, you know that I am not a pattern recognition guy. However, there are times when one can't help but notice the emerging pattern involving long term interest rates. Specifically, the head and shoulders bottom that appears to be forming in the 10 year US Treasury (see accompanying charts).

When you add into the equation the following recent comment in an Economist article - "Since mid-November America’s Treasury has issued some $589 billion in extra long-term debt, of which the Fed has bought $514 billion." - it is hard not to conclude that once QE2 ends and the Fed stops buying long term Treasuries that a major demand factor will be removed from the mix.

The obvious equity market impact of rising rates is in valuation models, which will note that the cost of capital has just gone up thereby making equities less attractive. Could this explain why stocks have recently traded sideways?

Is Technical Analysis Dead?

Something very peculiar is happening with equities.

For more than a year, stocks have not performed according to technical analysis Hoyle. Stock markets have risen on far below average volume. Correlations for virtually all economic sectors and many asset classes hover just below 1.00. And many technical analysis tools have been rendered impotent. Why is this so? Perhaps the answer lies in the nature of the beast: the structure of the market.

Over the past several decades, the structure of the market has changed. In the 1960s and 70s, traditional institutional investors (mutual funds, pensions, insurance companies, and large asset managers) replaced individual investors as the dominant traders of the day. Recently, hedge funds and now high frequency traders (with algorithmic traders in tow) have supplanted traditional institutional investors as the dominant volume drivers in equities. At the same time, products and services such as dark pools, derivatives, and structured products operate outside the traditional norms of equity investing.

Yet, most investors and many in the financial media operate as though there are virtually no effects, no consequences – intended and otherwise – that have occurred in this new environment. All is as it was. Or is it?

As for technical analysis, of all the tools that have worked with a reasonable degree of accuracy, perhaps none have been impacted more by the brave new financial innovation world than sentiment indicators.

Once the bastion of sound investment strategy, the human emotions of greed and fear afforded astute investors and traders with the opportunity to exploit the polar ends of investment human behavior. Ride the greed and fear train for as long as possible then, when things go too far, shift to other side (the contrarian side) of the equation. Not easy to do but highly rewarding if done correctly. However, given the changed world equities operate in today, the question has to be asked, Do such tools work in a world dominated by black box methodologies? A financial world without humans?

When it comes human emotions such as greed and fear, does a hedge fund manager, an algorithmic trader, or a high frequency trader base their decisions on judgment? Do they feel anything? Do they get swept up in the emotional tide of the times? Or is virtually every action taken done based on a set of rules and parameters that do not rely on such human qualities?

And that brings us back to the issue of technical analysis and, specifically, sentiment indicators. Do they still work? Has technical analysis lost a key tool in its toolbox?

Based on the evidence at hand, in the case of sentiment indicators, the answer has to be yes. In the case of volume indicators, the answer is also yes. In the case of momentum indicators, the answer is no.

The one market variable that is least impacted by our financial innovation brave new world is price. And price changes over time, which is what momentum indicators are all about, are tied to the real world of valuation, which is, in turn, tied to the real economy.

Is technical analysis dead? No. But I find it hard to argue for the status quo when so much has changed. Or Keynes once said, “When the facts change, I change my mind. What do you do, sir?”

Time To Digest

Those who heeded my Thursday last blog posting warning not to take the bait have been rewarded with +167 basis points thus far and are likely to benefit further in the coming days and weeks as the near term indicators tracked – momentum and MACD – are now even more solidly entrenched in pullback mode as the accompanying chart clearly illustrates.

Poised to close below last Tuesday’s closing price of 1175, the S&P 500 would join its major global markets brethren (EAFE (EFA) and emerging markets (EEM)) with downside price confirmation of the negative momentum and MACD trends warned of last Thursday. With the short term indicator (slow stochastics) well above its oversold territory (below 20), a pullback target to the average of 5 to 10% is more than achievable and would drop the S&P 500 to the most interesting price of 1133, or just above its head and shoulders neckline and 200 day simple moving average right around the 1125 price level before then signaling an end to the pullback.

Why Not More (Or Less) Of A Decline?

Since the market action that preceded this pullback lacked any external divergences and considering the fact that 100% of the 30 indices tracked are in bullish Mega Trends, the market only had the less serious internal divergences to work off. Accordingly, the magnitude of the current decline should be muted.

As for the decline stopping right here, that is not likely as the internal divergences are so solidly tilted to the downside plus the fact that the other major indices are also performing in like fashion. Such action rarely stops dead in its tracks and reverses itself without first producing signs of trend change.

Why Do Divergences Work?

It is important to remember that this divergence stuff I keep emphasizing works because of the nature/structure of the market. With so many market players operating in the short term space dominated by the need to match performance and with a philosophy of momentum investing, trends that get established tend to stay that way until they are exhausted thereby producing divergences. It is for we investors and traders who can correctly exploit this momentum lemming-like behavior by either joining or going against (contrarian) the crowd that can reap the absolute and relative performance rewards.

When Will It Stop?

The key bullish signs to watch for are the same ones that warned of the market decline we are now experiencing: divergences both internal and external. Specifically, the point at which momentum and MACD do not confirm lower lows will be time to consider increasing the equity exposure. Whether external divergences develop will factor into the decision process at that time.

Like a Thanksgiving meal, it is always good to digest some of what you ate before gorging yourself again on the simplistic “don’t fight the Fed” tune.

Note: My appearance yesterday on foxbusiness.com with Tracy Byrnes is available on my media blog Beyond The Sound Bite.

click image to enlarge

Don't Take The Bait

US Stocks are poised to produce a nice upside opening today. Investors might therefore be tempted to conclude that the staple of this bull rally - buy the dips - is back in action and short term profits are in the offing. However, as the accompanying chart shows, when certain market conditions exist any upside move tends to be little more than a bounce followed by a resumption of the pullback. Here are the facts:

Thus far this year, the chart shows that whenever the two primary near term indicators tracked - momentum and MACD - both turn negative - mid January, mid April, mid August, and now - the stock market experiences a bounce that turns out to be a failing rally with a lower low in stocks shortly thereafter. This is made all the more likely this time as an internal divergence (between price and momentum) has occurred twice this year - mid April and now. It is only when MACD then turns negative that price then declines in a sustained manner.

In the April to early July pullback, US large cap stocks dropped more than 10%. The current pullback, however, is unlikely to repeat that magnitude decline (due to the absence of any external divergences). More likely in the 5 to 10% range, with a mid point of 1133, which interestingly sits right above the reverse head and shoulders neckline and 200 day simple moving average of 1125.

Of course, nothing is flawless and works perfectly all the time. But the odds of a healthy market pullback are highest when the above conditions exist.

click image to enlarge

Seeing Is Not Believing

Confused over this morning’s initial US stock market reaction to the poor employment data? Don’t be. Here’s why:

In the eyes of the cyclical bulls (who currently rule today’s market thinking, with the underperforming momentum lemming hedge funds in tow), the poor employment numbers are a twin win for the following two reasons:

1 – The Fed’s dual mandate includes the goal of full employment. Accordingly, QE2 is headed the economy’s way. This ensures another flood of money thrown at the problem, much (most?) of which will bleed its way into the financial assets.

2 – Today's employment data is the last report before next month's mid term election. Anything that damages the reviled party in power, the Democrats, enhances the chances of a Republican win next month. Gridlock will ensue, something the cyclical bulls believe is good for the economy and markets.

From a corporate profits perspective, third quarter results will be just fine – at to slightly above consensus expectations. This will provide the expectational foundation for future earnings results at consensus expectations at a minimum, which puts the 12 month forward operating earnings outlook for the S&P 500 at or above $84.

With an above average P/E of 17, the future fair value of the S&P 500 is 1428, or 1286 in today’s market.

Seeing Is Not Believing

Other than 3Q10 earnings results, I do not subscribe to any of the above views as presented but offer them as the rationale for this morning’s initial stock market action. That said, the technical analysis deterioration noted over the past weeks (see blog postings below) is unchanged. Unless reversed, a 3 to 5% stock market pullback is likely.

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