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Understanding How Ms. Market Thinks image

A great many investors (professional and amateur alike) follow a similar process when considering how to invest. They start the process with their take of the economy and then go from there. The general consensus here is that earnings drive stock prices and the state of the economy drives earnings. Simple, right?

As such, this crowd, along with those viewing the stock market's glass of water as at least half empty, might be wondering what the heck is going on in the stock market right now. The argument I heard this week is how can stocks be near all-time highs when, according to the government, the economy grew at a rate of just 1.5% in the third quarter?!?

The follow-up point, which has tended to be delivered with a fair amount of hand gesturing, is that the Q3 growth rate for the U.S. economy was less than half the rate that was seen in the prior two quarters. So how on earth can the market be at such lofty levels, I was asked. "It's a bubble!" said another. And then a colleague subscribing to this fundamental(ish) approach suggested, "Make no mistake about it Dave, we are in for trouble!"

If you are rolling your eyes right about now, join the club. It is truly astounding how many investors (again, both professional and amateurs alike) simply don't have a solid understanding of how Ms. Market's game works.

You've Got To Understand The Game

For starters, it is important to understand that from an uber-big picture, longer-term standpoint, the stock market tends to be a discounter of future expectations - not a mechanism that reacts to what has already happened. And while I run the risk of oversimplifying what can be a very complex subject, the 1.5% GDP number we saw yesterday, probably explains the sloppy, sideways action seen the market during the first eight months of the year. You see, everybody who follows the economic data KNEW that the GDP number was going to be weak this quarter - and they've known this for some time now.

So, one argument for the current joyride to the upside is that the outlook for both the U.S. and global economy has actually upticked since everyone thought the world was coming to an end in the middle of August. Recall that at the time, China's economic troubles were beginning to accelerate and the devaluation of the yuan was going to change the economic landscape. Therefore, stocks course-corrected to the downside to adapt to the idea that the future of global growth might be a problem.

The key here is the recent realization that, as I've been yammering on about lately, if global growth isn't going to be a problem in the future, then the downside correction in stock prices that was attributable to the worry about that future needed to be "corrected" to the upside. Bam, just like that, the S&P 500 is back to where it was before the worry about global growth began. Why? Because the worry about the future has been largely removed thanks to the efforts of the Yellen & Co., the Europeans, the Chinese, and the Japanese.

Below is a graphic example of what I'm talking about here. This is my take on the drivers - or moods - of the market for much of this year.

S&P 500 - Daily

View Larger Image

First there was uncertainty about the weakening economic picture here in the us. Then in August, we saw the market "correct" the view that things were simply slowing down a bit. And then this month, we've seen the sigh of relief rally in response to (a) Ms. Yellen telling us the economy is doing fine, thank you, (b) the ECB's decision to continue its QE program, and (c) all the talk of more stimulus out of both China and Japan.

Don't Confuse Me With the Facts!

Now let's spend a moment and look at those pesky GDP numbers. Try not to throw things at your screen after you read this, but the data really wasn't that bad!

According to Brian Wesbury and his economic team over at First Trust, something they call "core GDP" continues to look pretty solid. In a research note out yesterday, Mr. Wesbury wrote:

"We follow something we call "core GDP," which is real GDP growth after excluding inventories, international trade, and government purchases, none of which can be counted on for long-term growth. What's left is consumer spending, business investment, and home building. Core GDP grew at a 3.2% annual rate in Q3, is up 3.3% from a year ago, and is up at a 3.4% rate in the past two years."

Brian's team also pointed out that Nominal GDP grew at a 2.9% rate over the last year and is up at a 3.8% rate over the past two years. Wesbury then reminds us that this rate is very close to the Federal Reserve's long-term projection of 4%. And for the big finish, the Chief Economist at First Trust wrote, "No wonder a December rate hike is back on the table."

So there you have it folks. While the short-term fluctuations in the stock market may regularly drive a person to drink, if one steps back from the blinking screens, the bigger picture view will oftentimes make an awful lot of sense - IF you understand how Ms. Market tends to think

Have a great weekend!

The Pre-Game Indicators

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

Major Foreign Markets:
    Japan: +0.78%
    Hong Kong: -0.79%
    Shanghai: -0.13%
    London: -0.39%
    Germany: -0.34%
    France: -0.30%
    Italy: -0.08%
    Spain: -0.96%

Crude Oil Futures: +$0.12 to $46.18

Gold: +$0.50 at $1147.80

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

10-Year Bond Yield: Currently trading at 2.170%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +3.35
    Dow Jones Industrial Average: +43
    NASDAQ Composite: +7.35

Thought For The Day:

"Do what you can, where you are, with what you have." --Theodore Roosevelt

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): Positive
  • 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: Slightly Overbought
  • Market Sentiment: Our primary sentiment model is Moderately 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

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 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.