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I saw a quote the other day about the way the stock market functions that rang true with me. Retired portfolio manager Arnie Mori said, "In the long run, intelligently diversified portfolios reflect a reasonable approximation of underlying value. Traders, on the other hand, are at the mercy of irrational price swings and anomalies."

While we could argue for days about the first half of the quote, there is no denying that the short-term price action in the stock market can be a wee bit irrational at times. This has been especially true in 2015. Prices swing manically day in and day out, often times with little to no impetus. And then when something comes across the wires for the algos to grasp on to, well, things can get out of hand pretty quickly.

In our shop, we've gone so far as to put a label on the really violent swings. We call the big, one-way spikes "redonkulous" days and we are now trying our darndest to avoid trading in the direction of the trend on these days. The simple fact of the matter is that these moves tend to become overdone by the time the closing bell rings and then often they are either fully or partially reversed the very next day when traders fire up the algos for the new session. As such, Arnie's words appear to be spot on these days.

Looking at the Bigger Picture

While dealing with the short-term trends of the market (and I use the word "trends" here lightly), has been a nightmarish endeavor since the start of 2014, the bigger picture trend has been quite clear as the chart of the S&P 500 has been moving steadily from the lower left to the upper right for many years now.

As Mori points out, the market appears to represent a "reasonable approximation of underlying value" over the long term. Thus, every once in a while it is probably a really good idea to force yourself to step away from the blinking screens and focus on the bigger picture.

We do this by monitoring a series of models, charts and indicators that are designed to do just that - focus on the long-term, big picture of the stock market. In fact, these models are the drivers of our Long-Term Risk Manager service, where the goal is to stay in tune with the really big, really important moves in the market.

A Long-Term Approach To Managing Risk

To be sure, such an approach will NOT be of much, if any, value in trying to manage the shorter-term hysterics in the market. No, the goal here is to try as hard as we can to avoid as much of the carnage as we can when the bears come to call.

To be specific, we utilize 4 independent, long-term market models to guide our overall market exposure levels for this system. Each model controls a set percentage of the portfolio's exposure to market risk. Thus, the idea is to employ a "weight of the evidence" approach and a "graduated" method of adjusting exposure (as opposed to the all-in/all-out "timing" approach).

Here's the way it works. When all 4 models are on "buy" signals, the system tells us to be 100% long (or more, depending on the risk tolerance of an investor). When there are 4 green lights from the models it suggests that all systems are go, that the market is under a green flag, and that historically, the bulls have controlled the market.

But when any of the 4 models issues a "sell" signal, we change our tune and reduce exposure to market risk. This can take the form of eliminating any leverage being used and/or raising cash. The thinking is that as conditions weaken and a bull market begins to morph into a bear (they always do at some point), our long-term models will keep us in tune with the overall conditions.

During big, bad bear markets such as 1987, 2000, and 2008, using such an approach would have first raised a yellow warning flag well in advance of the start of the brutal declines and then created a net short position (for those with a higher risk tolerance) during the majority of the bear period.

Is this approach perfect? Of course not! Remember, there are positives and negatives to ALL investment approaches - especially when dealing in the arena of risk management. For example, as I stated earlier, employing a long-term approach is useless during a short-term pullback - regardless of the severity of the decline. In addition, using a graduated, long-term method is prone to "false alarms" where conditions weaken and a defensive stance is called for, but the bears never get their game on. Such an occurrence can make one look and feel dumb at times but I prefer to file this possibility under the "better safe than sorry" category.

However, for a portion of an individual's portfolio, utilizing a system that tries to stay in tune with the overall conditions makes sense. Well to me, anyway.

And while I hate sound like a pitch-man, if you are interested in learning more about this long-term approach offered by both Heritage Capital Research and Sowell Management Services (where I was recently hired as the Chief Investment Officer), you can check it out here. Again, sorry for the commercial interruption, but I really think this idea makes sense for a part of people's risk management allocation.

Another One Bites the Dust

Now for the key point in this morning's missive. For the third time in less than 2 months, one of our long-term, risk management models has issued a sell signal. This time, it was our Risk/Reward Environment Model that issued a warning.

This particular model is designed, as the name implies, to indicate the overall environment of the U.S. stock market. And looking back at the date to June 1980, this model would have produced 6 VERY important sell signals. For example, the model would have flashed a "sell" well before the Crash in 1987, before the first Gulf War bear of 1990, before the emerging markets crisis of 1998 began, before the tech bubble of 2000, and in advance of the credit crisis of 2008.

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

View Larger Image

Looking at the signals from this model on a hypothetical basis, since the middle of 1980, 83.3% of the trades would have been profitable. Not bad. And if one had gone long the S&P on "buys" and to cash (T-bills) on "sells" the hypothetical annualized growth rate (before fees and trading costs) would have been +13.8% per year, which compares favorably to the buy-and-hold return of the S&P 500 of +8.6% during the period - especially on a risk-adjusted basis.

Yet, it is also critical to recognize that the model has issued a fair number of "false alarms" over the years. Remember, just because an indicator says things aren't hunky dory doesn't mean the market is going to get crunched. Again, no indicator is perfect. What these "warning flags" mean is the odds of a problem are much higher than normal.

The Takeaway

With our Risk/Reward Environment model having turned negative on July 8, this means that only 1 of our 4 long-term, risk management models remains positive at this time.

To review, on May 18th, our Leading Indicator model, which includes a host of indicators that have historically flashed warnings well in advance of trouble, turned red. Then on June 30th, our Volume Relationship Model, which measures the relationship between demand and supply volume in the market, flashed a sell. Then on July 8th, the Risk/Reward Environment Model raised its hand in class to make a point. So... are you sensing a trend here?

I should point out that the model that carries the most weight in our system, the model I refer to as my "desert island indicator" (because if I were stranded on a deserted island and had only one indicator to manage money with, it would be this one) remains on a buy signal. And while the current reading isn't robust (it hasn't been for some time), it is also NOT close to issuing a "sell" signal at this time.

So, will the confluence of warning signs be a prelude to the next big, bad bear market? Or... will this up-and-down, back-and-forth market manage to simply "fool" the models that have issued warnings so far?

Of course, only time will tell. But, with the weight of the evidence suggesting all is not well with this market, it might be time to, at the very least, take your foot off the gas for a while. Remember, we can always add exposure back if the bulls right the ship and get their act together. But for now, we are going to recognize that risk levels are elevated and play the game accordingly.

This Morning's Pre-Game Indicators

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

Major Foreign Markets:
    Japan: +0.25%
    Hong Kong: +1.00%
    Shanghai: +3.50%
    London: -0.18%
    Germany: -0.25%
    France: +0.09%
    Italy: -0.12%
    Spain: -0.08%

Crude Oil Futures: -$0.17 to $50.74

Gold: -$0.70 at $1143.20

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

10-Year Bond Yield: Currently trading at 2.347%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +1.10
    Dow Jones Industrial Average: +31
    NASDAQ Composite: +31.10

Thought For The Day:

Failure is the condiment that gives success its flavor. -Truman Capote

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 Earnings Season

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: Moderately 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: 2080
  • 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: Negative
  • Volume Thrust Indicator: Neutral
  • Breadth Thrust Indicator: Neutral
  • Intermediate-Term Bull/Bear Volume Relationship: ModeratelyPositive
  • 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: Moderately Overbought
          - Intermediate-Term: Oversold
  • 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

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.


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.