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Another Important Signal Or A False Alarm? image

With Greece apparently "fixed" (well, until the next do or die meeting, which is set for Sunday, that is) and Chinese government officials doing everything they can to put in a "fix" for the recent plunge in stock prices, it appears that everything is hunky dory this morning. Eurozone stock markets are up more than 2% across the board and the Shanghai index spiked up 5.75% overnight, its best single day gain in more than six years. And U.S. stock futures look like they are getting ready to rock.

So, from where I sit, the questions of the day include: Is this it? With the S&P 500 sitting at the low end of the recent trading range and just below the all-important 200-day moving average, has the next big buying opportunity arrived? Will stocks once again put in a V-Bottom and now just rocket higher? Sure looks that way in the early going today, right?

To be sure, this is the way the game has been played for quite some time now. Traders and their computers overdue things in one direction and then once the market gets oversold - BAM! - they run the indices the other way with reckless abandon. And since Wall Street traders do indeed enjoy their trading trends (it makes telling the computers what to do so much easier), there is little reason to expect that this time will be any different.

Or is there?

Will It Be Different Next Time?

While I may be breaking with the bull camp here, there may actually be some reasons to believe that things could be different the next time the bears gain control of prices from more than a day or two. And lest we forget, the S&P 500 is only 10 days out from its most recent attempt at all-time highs. As such, I don't think we can put a bearish label on the recent action just yet.

Although the central bankers of the world and their political counterparts appear to be doing anything and everything in their power to make darn sure that stocks don't ever go down more than a couple percent or so, here are a few reasons the bears are hopeful that their day in the sun might soon be forthcoming:

  • This bull market is now 6.25 years old
  • There have only been 2 periods in history when the market went longer without a 10% correction
  • There have only been 3 periods in history when the market went longer without a 20% correction
  • Stocks are now overvalued in terms of P/E (price-to-earnings), P/D (dividend), P/B (book value) and P/S (sales)
  • The Fed is getting ready to raise interest rates
  • Earnings growth is slowing
  • Momentum indicators have been weakening for some time

It is the last point that I'd like to spend a few minutes elaborating on this morning.

During "healthy" rallies, the moves are generally accompanied by strong momentum in the market. In fact, traditionally when a bull move begins (or resumes), stocks experience a "momentum thrust." This is usually evident in terms of price, breadth, and/or volume indicators. And history shows that it definitely pays to "trust the thrust" as the major indices tend to move higher in the ensuing 3, 6, and 12 months after a momentum thrust occurs.

Important Signal

The key to this morning's missive is that just the opposite is occurring now. Instead of the momentum indicators looking robust, these models are, at best, limping along. Instead of our favorite momentum indicators confirming the latest run to new highs, they have actually been going the other way. In other words, there is now a divergence between the price action of the indices and the momentum indicators.

One such indicator is our Volume Relationship model. This model compares the relationship of "demand volume" to "supply volume" (a more sophisticated version of advancing and declining volume). As you might suspect, when things are going well in the stock market, "demand volume" tends to exceed "supply volume" by a rather wide margin as buyers tend to control the action.

However, this is not the case at the present time. In fact, the relationship between "demand" and "supply" volume turned negative on June 30th.

This is important because this indicator is one of the 4 key models we use to control exposure in our long-term risk management services. Thus, when ANY of these 4 indicators give a sell signal, we sit up and take notice.

Below is a chart showing the historical buy and sell signals from this model.


View Larger Image

As you can see, the model issued VERY timely sell signals before the technology bubble burst in 2000 and again before the credit crisis produced losses of more than 50% in the S&P 500 between late 2007 and March 9, 2009 (see the two thin red arrows on the chart).

In addition, it is worth noting that speaking hypothetically, if one would have gone long the S&P 500 on buy signals and then moved to cash on sell signals since the end of 1981, nearly 90% (89.5% to be exact) of the signals would have been profitable. And over the past 33+ years, following these signals would have produced an average annual compound rate of return of 12.0% before fees and commissions, which represents a 33% improvement over the buy-and-hold return of the S&P 500 during the period of 9.0%.

Another way of looking at the effectiveness of this model is to recognize that since late 1981, the S&P 500 gained ground at a rate of +16.4% when the model was on buy signals and lost ground at a rate of -5.6% per year when on sell signals. So again, when this model issues a sell, we definitely pay attention.

But before you run out and start loading up on those leveraged inverse ETFs, it is important to note that (a) momentum divergences can stay in place for LONG periods of time during some bull markets and (b) indicators can provide "false alarms" at times.

Take a look at the wider red arrow in the middle of the chart above as well as the multiple signals given in 2010 and 2011. Note that from 2003 through 2006, there were a series of four "false alarm" sell signals issued by this model. Sure, 3 out of 4 of those signals would have been profitable from a short-term perspective. However, keep in mind that these models are intended to be long-term in nature. And this leads us to conclude that these, along with the latest signal given in the fall of last year, were "false alarms" from a big-picture point of view.

So, will the current signal turn out to be a harbinger of bad things to come or merely another "false alarm?" While I'm sorry to disappoint, we can't know the answer to this question in advance and only time will tell, of course.

However, it is also worth noting that this is the second longer-term, big-picture model to issue a sell signal in the last month and a half. Note that our "Leading Indicators" model issued a sell signal on May 18th. And it is worth noting that we haven't seen more than one of our models on a sell at the same time since the fall of 2012.

The Bottom Line

While heaven only knows whether or not the current sell signals issued by two of our four longer-term, big-picture market models will be correct and/or timely, the key is to recognize that the underlying momentum of the market is anything but strong here. In fact, our indicators have weakened considerably during 2015. As such, the bottom line is investors need to recognize that the risk of a meaningful correction (I.E. a decline of more than -10%) remains elevated at this time.

However, with traders apparently busy buying the dip(s) this morning, it appears that all is right with the world. So, as the saying goes, "Party on, Wayne!"

Publishing Note:I have an early meeting on Friday and will not publish a report. Have a great weekend!

This Morning's Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: +0.60%
    Hong Kong: +3.73%
    Shanghai: +5.75%
    London: +1.30%
    Germany: +2.01%
    France: +2.33%
    Italy: +2.75%
    Spain: +2.76%

Crude Oil Futures: +$1.31 to $52.18

Gold: -$1.90 at $1161.60

Dollar: lower against the yen, euro and pound

10-Year Bond Yield: Currently trading at 2.255%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +23.57
    Dow Jones Industrial Average: +199
    NASDAQ Composite: +54.50

Thought For The Day:

"When you combine ignorance and leverage, you get some pretty interesting results." - Warren Buffett

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of the Greek Crisis
      2. The State of China's Stock Market
      3. The State of Fed/ECB/PBoC Policy
      4. The State of the U.S. Economy

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Negative
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Moderately Negative
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Moderately Positive
(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 2040
  • Key Near-Term Resistance Zone(s): 2080-2100

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Negative
  • Price Thrust Indicator: Negative
  • Volume Thrust Indicator: Negative
  • Breadth Thrust Indicator: Negative
  • Intermediate-Term Bull/Bear Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Moderately Positive

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:
          - Short-Term: Oversold
          - Intermediate-Term: Oversold
  • Market Sentiment: Our primary sentiment model is Positive .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Neutral

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
Heritage Capital Research


Indicator Explanations

Trend and Breadth Confirmation Indicator (Short-Term) Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates an All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.

Price Thrust Indicator Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.

Volume Thrust Indicator Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.

Breadth Thrust Indicator Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.

Bull/Bear Volume Relationship Explained: This indicator plots both "supply" and "demand" volume lines. When the Demand Volume line is above the Supply Volume line, the indicator is bullish. From 1981, the stock market has gained at an average annual rate of +11.7% per year when in a bullish mode. When the Demand Volume line is below the Supply Volume line, the indicator is bearish. When the indicator has been bearish, the market has lost ground at a rate of -6.1% per year.

Technical Health of 100 Industry Groups Explained: Designed to provide a reading on the technical health of the overall market, this indicator takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.

Weekly State of the Market Model Reading Explained:Different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Market Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.


Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided “as is” without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning, an advisor representative of CONCERT Wealth Management Inc. (CONCERT), is founder of Heritage Capital Advisors LLC, a legal business entity doing business as Heritage Capital Research (Heritage). Advisory services are offered through CONCERT Wealth Management, Inc., a registered investment advisor. For a complete description of investment risks, fees and services review the CONCERT firm brochure (ADV Part 2) which is available from your Investment Representative or by contacting Heritage or CONCERT.

Mr. Moenning is also the owner of Heritage Capital Management (HCM) a state-registered investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Neither HCM, Heritage, or CONCERT is registered as a broker-dealer.

Employees and affiliates of Heritage and HCM may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or Heritage/HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.