Posted |
Are The Indicators Still Reliable? image

While there are many issues weighing on the minds of investors these days including what the Fed is going to do next (and more importantly, when they are going to do it), the state of China's economy/stock market (last night's data wasn't good), and whether or not the bear market in commodities is the tail wagging the dog, perhaps the biggest question at this stage of the game is if we've seen the worst of the correction in the stock market.

To be sure, there is no way to know the answer to the latter question without a healthy dose of hindsight. However, given that (a) Ms. Market appears to be wearing her "waterfall decline" costume right now and (b) these moves tend to follow a similar pattern, we do have some idea as to what to expect next. And as I wrote last week, the odds would seem to favor stocks being in the "bottoming phase" at this time.

I saw some additional research on the subject last week from Ned Davis Research where Ned Davis himself compared the price action and the volatility levels of the global stock market's dive to past waterfall declines on a global basis. Once again, the "nearest neighbor" to what we've seen in the stock market since the middle of August appears to be the 2011 decline, which many deemed to be a "mini bear market."

So, if stocks continues to mirror the 2011 decline, we can expect to see (a) volatility stay very high for the next couple of months, (b) a lower low on the major indices, and (c) a traditional year-end rally, which tends to make everyone feel better by the time New Year's Eve rolls around.

However, there may be a fly in the ointment here.

Something has been bothering me for quite some time and the action in the coming weeks/months may tell me whether or not my concerns are justified.

Does It Matter?

Cutting to the chase, I question whether the August decline was a corrective phase in the traditional sense or simply another bout of high speed trading gone wild.

More specifically, the combination of this year's long, sideways consolidation phase and then the ensuing dance to the downside in August has done a fair amount of what used to be called "technical damage." Since May, we've seen all kinds of longer-term indicators waive yellow warning flags, which in the past has meant that all was not right with the world.

To be clear, we're not talking about a couple indicators. No, we're talking about all sorts of indicators, looking at all kinds of things in the stock market game. For example, the volume relationship indicator is negative. The leading indicators model is negative. The risk-reward model is negative. And my "desert island" indicator is a whisker away from turning negative as well.

But the question is, does it matter? With markets now moving 10% (in both directions) within a matter of days, are these time-tested indicators still as meaningful as they were in the past? Or has the algo-driven, millisecond trading environment changed the game completely?

A Two Handed Argument

On one hand, I can argue that the new, new normal (where trading machines dominate the stock market) will wind up causing a great many indicators to be "fooled" as the algos have displayed a distinct tendency to chase their tails in one direction for a matter of days and then simply reverse and go the other way when the mood strikes.

Yet on the other hand, the sheer number of indicators that have issued warnings this summer is worrisome. And while the indicators do not suggest that another severe decline, such as we saw in 2000 or 2008, is on the horizon, the history of these indicators tells us that caution is definitely warranted and that the current corrective phase may not be over.

So which is it? Will Wall Street's mad scientists wind up fooling everyone and everything as they "play" with the market indices on a daily basis? Or will the market succumb to a more meaningful decline, as the indicators seem to be warning?

Honestly, I don't know the answer to this question. But sometimes understanding the question is half the battle, right? So, I for one will be watching the action in the coming days/weeks more closely than normal. If the market breaks down from here and the price discovery phase begins anew, then I can breathe a sigh of relief and rest assured that the time-tested models and indicators are still worthy of my attention.

However, if this decline winds up reversing quickly and then merrily bouncing up to new highs, then we may have to start asking some difficult questions about the effectiveness of many indicators.

From a near-term perspective, the current dilemma can be easily seen on the chart of the S&P 500. The index is clearly coming to an important juncture from a technical standpoint.

S&P 500 - Daily

View Larger Image

In case the situation on the charts isn't obvious, the opposing trendlines represent each team's important lines in the sand. A break above the downtrend line that began in mid-August would likely give the bulls a boost while a break below the rising trendline could be a harbinger of more weakness ahead.

In closing, I recognize that this missive raises more questions than it answers. Please accept my apologies if this causes confusion. But the key point I'm trying to make is that the character of the market may be changing. And the key to surviving these inevitable changes over time is to keep an open mind and not to become entrenched in a single investing methodology. Therefore, asking questions and keeping your eyes open may be one of the most important aspects of this game we call the stock market.

Publishing Note: I am traveling again this week and will publish morning missives as time and energy levels permit.

Turning To This Morning

Renewed concerns about global growth is the story this morning as China's Industrial Profits came in well below expectations (-8.8% year-over-year versus -2.9% in July). However, there was additional talk of "policy support" in the way of a detailed article in Economic Information Daily - a state owned newspaper. Not surprisingly, European bourses are lower and as is usually the case, U.S. futures are following Europe. Thus, it looks like a weak open on Wall Street.

The Pre-Game Indicators

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

Major Foreign Markets:
    Japan: -1.32%
    Hong Kong: closed
    Shanghai: +0.28%
    London: -1.42%
    Germany: -1.34%
    France: -2.16%
    Italy: -1.90%
    Spain: -0.91%

Crude Oil Futures: -$0.91 to $44.79

Gold: -$14.90 at $1130.70

Dollar: higher against the yen and euro, lower vs. pound

10-Year Bond Yield: Currently trading at 2.134%

Stock Indices in U.S. (relative to fair value):
    S&P 500: -15.20
    Dow Jones Industrial Average: -117
    NASDAQ Composite: -29.90

Thought For The Day:

The only thing that interferes with my learning is my education. - Albert Einstein

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 Fed/Global Central Bank Policy
      2. The State of Stock Market Correction
      3. The State of China's Economy
      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 6 months, and long-term as 6 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: Negative
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Neutral
(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: 1930, 1867
  • Key Near-Term Resistance Zone(s): 1990-2000

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(NASDAQ): Negative
  • Breadth Thrust Indicator (NASDAQ): Neutral
  • Intermediate-Term Bull/Bear Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Moderately Negative

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: Moderately Negative

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.