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Key Question: Are Stocks Being Efficient or Noisy? image

Yesterday morning, we played devil's advocate and began looking at reasons why stocks might be ready to go the other way - at least in the near-term. The thinking is that since stocks have been stuck in a trading range for more than a year now, the trend has been for traders to look for opportunities to begin shorting the market whenever rallies become extended.

The first thing we reviewed was the idea that the market's leadership has become narrow and used the fact that the "troops" (small- and mid-cap indices) are lagging the "generals" (the blue chip indices) by a meaningful amount as a reason for caution. The bottom line is that this situation often is a symptom of a not-so healthy market environment.

This morning, I'd like to continue the process and introduce you to a concept that many may not be aware of - the "efficiency" of the market's trend.

S&P 500 - Daily

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Looking at the above chart, it is would appear that the bulls are in control of the game and that stocks are in an uptrend. However, the question becomes whether or not the trend is "efficient."

Efficient or Noisy?

Not surprisingly, there is actually an indicator for this, called the Efficiency Ratio. The indicator was developed by Perry Kaufman as a way of measuring the amount of "noise" in the market. It compares the absolute change in price over a set period to the sum of the absolute daily changes over the same period.

The indicator looks like an oscillator on a chart, with high values indicating that the market is being efficient in its movements while low readings suggests the action is "noisy."

Cutting to the chase, when a market is efficient in its movements it generally means that one team is firmly in control. Yet on the other hand, when a market is "noisy" it tends to chop back and forth without a lot of conviction.

In my humble opinion, the primary use of this type of indicator is to determine whether or not the market is in a trending or mean reverting mode.

What Does The Efficiency Ratio Tell Us Now?

The Efficiency Ratio indicator did a nice job of signaling that the market was being exceptionally "noisy" during the first 7.5 months of the year. The idea here is that when a market is efficient it is trending nicely and we can take more risk but when it is "noisy," we should play the game more cautiously.

While it may surprise you, our version of this indicator, which smooths out the efficiency ratio and then compares the reading to a longer-term moving average (this creates an indicator that can "adapt" to different environments) currently tells us that the market continues to be "noisy."

This should likely produce a response along the lines of, "Wait, what?" as the market appears to be in a beautiful uptrend. As such, you can't be blamed if you question the current reading of this indicator.

But like anything else, we don't rely on a single indicator to make any decision, especially something as important as determining whether or not the market is trending. No, we actually employ three different models designed to tell us whether the market is in a trending or mean reverting environment.

Trending or Mean Reverting?

In addition to the efficiency ratio, we also look at something called the Average Correlation Coefficient as well as a Strength of Trend model. Again, the idea is to try and determine whether we should be focusing on trending indicators or mean reversion indicators in the current market.

To be sure, the Correlation Coefficient indicator gets pretty geeky as it "measures the residuals of a linear regression" in order to tell us whether or not stocks are trending well. And then the Strength of Trend model involves a bunch of other indicators designed to suggest which way we should be playing the game.

So, in looking at the sum of our indicators, the message is quite clear: After trending efficiently lower in August, stocks remain in a mean-reverting mode at this time. At least that's what the math says.

The Takeaway

With all three of our trending vs. mean reverting indicators currently in a mean reverting mode, this tells us to be on the lookout for traders to begin going the other way soon.

So, given that the market is currently overbought and bumping into important resistance, we feel this is probably as good a time as any to avoid getting overly excited with our exposure.

However, should the bulls get their act together and produce a meaningful breakout with some "oomph" behind it (as opposed to the usual "breakout fakeout"), then these indicators would likely flip to a trending mode, suggesting that an "all clear" signal had been given.

But until then, some degree of caution may continue to be warranted.

Today's Pre-Game Indicators

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

Major Foreign Markets:
    Japan: +1.00%
    Hong Kong: -0.01%
    Shanghai: +1.83%
    London: +0.02%
    Germany: +1.04%
    France: +1.13%
    Italy: +0.45%
    Spain: +0.56%

Crude Oil Futures: +$0.05 to $46.37

Gold: +$0.60 at $1106.80

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

10-Year Bond Yield: Currently trading at 2.248%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +6.25
    Dow Jones Industrial Average: +64
    NASDAQ Composite: +12.85

Thought For The Day:

"Walk on with hope in your heart and you'll never walk alone." --Oscar Hammerstein

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

Intermediate-Term Trend: Moderately Positive
(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): Positive
  • Price Thrust Indicator: Positive
  • Volume Thrust Indicator(NASDAQ): Neutral
  • Breadth Thrust Indicator (NASDAQ): Neutral
  • Short-Term Volume Relationship: Positive
  • 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: Overbought
          - Intermediate-Term: verbought
  • Market Sentiment: Our primary sentiment model is Negative

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 Positive

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.