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Did Stocks Rally For the Wrong Reason? image

Good morning. Don't you just love this game? The very moment the price action begins to make sense - bam! - Something happens that causes traders to reverse course in a big way, leaving many scratching their heads in the process.

Of course, I'm referring to the decline in the S&P 500 seen over the past couple of weeks versus the spirited bounce on Monday. If you will recall, the excuse du jour for the latest pullback in stock prices has been the worries over global growth. So, after a series of gruesome attacks in Paris on Friday, why did the S&P 500 spike higher 1.5% on Monday?

Some will argue that stocks had become oversold and the decline had been overdone to the downside. Therefore, Monday's rebound was merely the latest in a long string of mean reversion moves - meaning that it was simply time for traders to go the other way again (or at the very least, cover some shorts!).

S&P 500 - Daily

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While I am hesitant to ever argue with what Ms. Market does or why, I have a theory that, at least in my feeble brain, seems to make some sense.

First, let's start with the understanding that traders tend to have their fancy computer algorithms tied to something. Remember, computer algorithms are really just a massive series of if-then statements. For example, if XYZ moves down, then computers are programmed to automatically sell SPX futures and vice versa. Then once a move gets started, the trend-following algos jump onboard. And before you know it, the stock market has moved 1% on the day - again.

The trick is to figure out what the triggers for traders are. I.E. what exactly are they focused on? And while I could very well be out in left field on this one, it looks to me that traders are tying their equity trading right now to the price of oil.

On the surface - and prior to Friday afternoon - this concept makes some sense. Since oil is a poster child for the "issues" surrounding global growth and global growth is indeed the focal point of the market, then one can avoid reading all those economic reports and cut to the chase by simply buying and selling stocks based on what oil is doing.

Think I'm nuts? That's certainly your prerogative! However, compare the price action of the S&P 500 from October 27 on the chart above to that of the USO shown below. It will suffice to say that when oil has gone up, stocks have followed suit. And when oil went down, well, you get the idea.

U.S. Oil Fund (NYSE: USO) - Daily

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But back to reality here for a moment. I'm imagining a great many investors are wondering why on earth stocks would go up the first day after a terrorist attack and the first day after a new "war" had been announced? After all, don't stocks usually fall in these types of situations?

First off, let's recognize that from a fundamental standpoint, this particular war - disturbing as it may be on an emotional level - isn't likely to have much of an impact from an economic standpoint. So there's that.

But for those traders following oil around like a little puppy dog, the game didn't require much thinking on Monday. Oil bounced right where it needed to and enjoyed a nice gain. So naturally, stocks followed suit. Because, well, that's what they've been doing. But the rub here is the reason oil bounced would appear to make this particular correlation trade a bit confusing.

To be sure, oil almost always moves higher when "geopolitical issues" arise. And with French and U.S. war planes dropping bombs and drones killing terrorist leaders in the Middle East, it wasn't surprising to see a "risk premium" applied instantly to the price of oil. You see, there is always a risk that some nitwit and their hand-held rocket launcher will interrupt the flow of oil.

Furthering the argument that Monday's move did not represent a change in sentiment toward global growth was the action in copper. Yep, that's right, Dr. Copper fell again on Monday - this time by -1.8%.

Ipath Copper (NYSE: JJC) - Daily

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So, from my perch, it would appear that while stocks did indeed sprint higher on Monday, they may have done so for the wrong reasons. But then again, I could always be off my rocker at the moment and misreading the situation! Time will tell. But given that the market had been focused on global growth fears, I thought it was a theory worth exploring for a few minutes.

Today's Pre-Game Indicators

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

Major Foreign Markets:
    Japan: +1.22%
    Hong Kong: +1.15%
    Shanghai: -0.05%
    London: +1.72%
    Germany: +1.93%
    France: +2.30%
    Italy: +1.75%
    Spain: +2.12%

Crude Oil Futures: -$0.60 to $41.13

Gold: -$5.90 at $1091.60

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

10-Year Bond Yield: Currently trading at 2.291%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +4.60
    Dow Jones Industrial Average: +55
    NASDAQ Composite: +15.40

Thought For The Day:

"Joy depends on perspective, not circumstances." --Robert Jeffress

Here's wishing you green screens and all the best for a great day,

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

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 Global Growth
      2. The State of Global Central Bank Policy
      3. 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: Moderately Negative
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Neutral
(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: 2020
  • Key Near-Term Resistance Zone(s): 2135

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): Negative
  • Short-Term Volume Relationship: ModeratelyPositive
  • Technical Health of 100+ Industry Groups: Low Neutral

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: Neutral
  • Market Sentiment: Our primary sentiment model is Neutral

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

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 is the owner of Heritage Capital Management (HCM) a registered investment adviser. Advisory services are offered through Heritage Capital Management, Inc. For a complete description of investment risks, fees and services review the HCM firm brochure (ADV Part 2) which is available from your Investment Representative or by contacting HeritageHCM also serves as a sub-advisor to other investment advisory firms. Neither HCM or Heritage 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.