Now that the DJIA has reached a new all-time high and the S&P 500 is getting close to doing so as well, it seems that the big topic in the press these days is picking the top. While history shows that new highs tend to lead to more new highs, the problem is the last time the Dow reached the Promised Land in 2007, the bears then started mauling everything in sight. And since 40%+ declines tend to stick with people for a while, everybody and your grandmother are looking for the top right now. In short, nobody wants to get fooled again.
Frankly, I can’t blame anyone for being wary of the market at this juncture. After all, the market has taken at least one nasty spill during each and every calendar year since 2007. Therefore, anyone looking for something bad to happen in the near future does have history on their side. And since the drivers of the recent corrections (Europe and Washington) haven’t exactly gone away, it isn’t surprising that folks might be getting a little nervous at this stage of the game.
Normally, this is where I’d climb up on my soapbox and start preaching about staying in tune with what is happening in the market instead of listening to the guru’s and their crystal ball-based prognostications. But since I gave that sermon as recently as yesterday, I should probably give it a rest for a while.
So, since everyone seems to be so sure that stocks are about to take a dive, this morning I thought I’d offer up an indicator that does a pretty good job of ‘calling’ big declines. And no, I’m not going to pitch you on my market-model approach again. But I will tell you that the indicator I’m going to describe is one of the inputs to our Market Environment Model.
But first, a couple caveats: The first is I would never suggest anyone use a single indicator to make any type of investment decision. Second, market “sentiment” indicators can be more than a little tricky and I do not have time or space this morning to do a thorough explanation of the ins and outs. However, I think this one indicator is worth your time. So let’s get started.
Ned Davis is famous for saying, “Beware of the crowd at extremes.” The idea is that when everyone is bullish (or bearish) they have already made their move in the market. This naturally leads to the question of: who is left to buy (or sell)? I’m guessing most everyone in the game these days has heard some version of this concept. And frankly, this in and of itself makes sentiment indicators less valuable – especially on a short-term basis.
But what you may not have heard about the idea of trying to gauge investor sentiment is that to be really effective, one needs to wait for sentiment to reverse after it has reached an extreme. You see, an extreme sentiment reading by itself isn’t a sell signal (extreme readings can and often do become more extreme!). However, if a move is strong enough and lasts long enough for the sentiment indicators first reach an extreme and then start to reverse – now we’ve got something. In short, this is an indication that a move has gotten very crowded and is starting to go the other way.
Here’s a specific indicator that you can follow to help you identify these situations. Each week Investor’s Intelligence publishes the results of their sentiment survey (we republish the data each week on StateoftheMarkets.com). Respondents indicate whether they are bullish, bearish, or expecting a correction. Now, open up your favorite spreadsheet and create a column for bulls, a column for bears, and then a column that adds the two together. In the next column divide the number of bulls by the number of bulls plus bears. Then add one more column – to create an average of the number of bulls/bulls+bears over 10 weeks.
Here’s the deal. When that 10-week average is above 69, history shows that since 1970, stocks tend to lose ground. (This is due to the fact that by the time the average gets this high, most people have already bought and the market is ripe for a correction.) But, on the other hand, when the 10-week average is below 53, stocks tend to perform quite well. (Again, this is due to the fact that when the 10 week average is extremely negative, most people have already sold).
But that’s not the “signal” I first alluded to. So, here it is: When the 10-week average moves below 67, a sell signal is triggered. This scenario occurs after a period of extreme optimism has been achieved and then has reversed. While not perfect (what is?) only 2 of the 15 sell signals given since 1970 have been wrong (which, of course, means that 87% were right). And what’s impressive is that this signal occurred before the declines seen in 1974, 1977, 1984, 1987, 1998, 2008, and 2011. As such, this is one indicator I like to check in on every once in a while.
What’s the indicator saying right now, you ask? The bad news is that the current reading of the 10-week average is 69.5, which is above the level that is considered “extreme.” The good news is that the 10-week average has not reversed and fallen back below 67 yet. If (and when) the 10-week does fall below 67, it would be an indication that risk is rising and that another encounter with the bears may be close at hand.
So, if you are going to insist on joining in on the game of picking the market top, I’d suggest waiting for this indicator to go negative first.
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/blindsided 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 U.S./Global Economy
2. The State of Fed/Global Central Bank Policy
3. The State of European Debt Crisis
The State of the Charts
While stocks are once again overbought and sentiment might be getting a little too optimistic again, the chart action is still strong and supports the bulls.
- Current Support Zone(s) for S&P 500: 1525-35
- Current Resistance Zone(s): 1550-65
S&P 500 – Last 3 Months
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: Positive
- Intermediate-Term Trend: Positive
- Long-Term Trend: Positive
S&P 500 – Last 12 Months
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: Positive
- Price Thrust Indicator: Moderately Positive
- Volume Thrust Indicator: Neutral
- Bull/Bear Volume Relationship: Positive
- Technical Health of 100 Industry Groups: 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.
- Overbought/Oversold Condition: The S&P is once again overbought from a short-term perspective and remains moderately overbought from an intermediate-term view.
- Market Sentiment: Our sentiment indicators remain are back to moderately negative on balance.
The State of the Economy
The overall health of the economy is a major input to the stock market. In order to help you stay up to date on all the important economic data, we publish a “State of the Economy” roundup each day. The report summarizes the day’s important economic data in an executive summary, quick-read format and then provides links to the most recent data, sorted by category. Here is a snippet from the recent report:
Most Recent Key Economic Releases:
- ADP Employment Report: Job Growth Above Expectations
Job growth in the private sectors isn’t half bad at the moment…
- Factory Orders Down in January
While this is clearly “old news” at this point…
Today’s economic releases: Nonfarm Productivity and Unit Labor Costs, Weekly Jobless Claims, and Bloomberg Consumer Comfort.
Here is the latest State of the Economy Report
You can also sign up to receive an email alert whenever the “State of the Economy” report is published.
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 because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets 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.
Weekly State of the Market Model Reading: Positive – Our weekly model tells us to continue to give the bulls the benefit of the doubt.
If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.
From The Equity Research Department
At StateoftheMarkets.com, our goal is to provide investors with everything they need to be more successful in the stock market. Here are the latest reports from our research department:
- The Risk Manager Report – March 6, 2013
- The Chart of the Day: Westlake Chemical – WLK
- The Focus List: Harbinger Group and Polyone are on our watch list
Remember to sign up for email alerts whenever our research department issues a report.
Turning To This Morning…
With the DJIA sitting at fresh all-time highs, it appears that traders are content this morning to wait on word from the ECB’s Draghi as well as next batch of economic data here at home. At this stage, the U.S. futures are a smidge below fair value and are following the movement of Europe’s markets, which have halved the day’s gains in the last hour.
Here are the Pre-Market indicators we review each morning before the opening bell…
Major Foreign Markets:
- Shanghai: -0.99%
- Hong Kong: -0.03%
- Japan: +0.30%
- France: +0.24%
- Germany: +0.05%
- Italy: +0.18%
- Spain: +0.31%
- London: +0.16%
Crude Oil Futures: +$0.44 to $90.87
Gold: +$6.80 to $1581.70
Dollar: lower against the yen, euro and pound
10-Year Bond Yield: Currently trading at 1.94%
Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -0.76
- Dow Jones Industrial Average: -4
- NASDAQ Composite: -2.80
Thought For The Day…Once the game is over, the king and the pawn go back in the same box. -Italian Proverb
Wishing you green screens and all the best for a great day,
David D. Moenning
Founder and Chief Investment Strategist
Positions in stocks mentioned: none
Wondering what your short-term risk management strategy should be right now? Let Dave M. walk you through how his Daily Decision system works (a 100% rules-based system designed to guide your risk management strategy) Click Here to see Daveâ??s latest video presentation on the â??Adaptiveâ? Daily Decision System
For up to the minute updates on the market’s driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)
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