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posted on 31 October 2017

Finding The Exit

by Jim Welsh

Macro Tides Technical Review 30 October 2017

Know Where the Exit Is Located

Most investment professionals like to say ‘markets are a discounting mechanism". Markets must be since so many people believe they are and confirmation comes almost daily if one listens to CNBC or Bloomberg. No one ever questions whether the supposition is correct.

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Are markets truly a discounting mechanism?

The belief that markets are a discounting mechanism seems reasonable as it implies that the sum of what any market ‘knows’ is greater than what the individuals that comprise that market know. This is a variation of the theory that sum is greater than its parts. This certainly makes sense to a sports fan. Professional sports teams are made up of great players, but it is the best Team that usually wins the Championship.

However, the theory that markets are a professional discounting mechanism doesn’t mesh with this reality: at every top or bottom the market is wrong.

Heresy! Yes it is, but the reality of how the stock market has performed since 2007 does provide an answer. In October 2007, the DJIA and S&P made a new all-time high. Within a year, the financial system was on the edge of an abyss, so the market didn’t discount that too well.

As the S&P was in freefall n March 2009, what was the stock market discounting?

In June 2009, the economy began a recovery that has persisted for more than 8 years, so the stock market didn’t discount that too well either.

The stock market has been making a new high for seven consecutive months which has never occurred since 1928. Should we assume from that record that the economy has several more years of growth ahead? For those who are true believers in the market’s capacity to correctly discount the future the answer has to be yes. For many other markets, the reality is the same. Think of the condo buyers in Miami or home buyers in Las Vegas in 2006, gold in September 2011 when it topped at $1920 before falling to $1040 in December 2015 or Technology stocks in 2000.

The message is pretty clear: at every top or bottom the market is wrong.

Why then do so many people accept hook, line, and sinker that markets’ are a discounting mechanism?

  • Part of it is repetition. Investors are told over and over that markets discount the future. It’s hard not to become a believer when the ‘experts’ keep repeating the same mantra.
  • Part of it is human nature. It is much more comfortable to believe the same thing as everyone else. Misery loves company and believing the market is a discounting mechanism certainly provides that opportunity when a market’s trend changes.
  • Part of it is that markets trend over time. As a trend continues, and the fundamentals continue to support the trend, whether the trend is up or down, it sure seems that the market is discounting the trend. The reasons for the trend become known by an increasing number of market participants, which causes the newbies to buy or sell. When just about everyone who can buy or sell has acted on the known information, there are far fewer sideline investors to buy, or sellers left who haven’t already sold.

The problem in believing that markets are a discounting mechanism is that it does a really poor job of identifying trend changes. This means the majority of the participants in any market are positive near the top and negative as a market is bottoming. The answer lies in the problem. Since most are optimistic near the top and negative near the bottom, one has to develop a sense for adopting a position that is contrary to the majority of investors. This is not easy since it is human nature to want to be part of a group or group think, and markets represent group thinking based on the trend and news.

There are four clues as to when taking a contrary stance is warranted. The first is sentiment. When various measures of sentiment reach an extreme, whether it is extreme optimism or pessimism, it’s time to be on the lookout for a trend change. The timing of the trend change is dependent of technical indicators that measure how overbought or oversold a market’s price has become. Often, prices will make a higher high or lower low, but measures of price momentum will fall short of their prior extreme. This divergence between price and momentum is another sign that a trend change is developing.

A further confirmation occurs when the market’s price breaks below a prior support or above a previous high. In doing so, one can observe a pattern of lower highs and lower lows to confirm a top, or higher highs and higher lows to confirm that a price low has been established.

Fundamentals provide the cover ‘story’ that investors have embraced, which is why a market has been trending for months or years. It is human nature to look for information that supports our personal views and discard or discount information that is not in agreement. At a top, everyone knows why a market has been going up and assume that it will keep trending higher. Conversely, when the trend has been down for a lengthy period, the majority of market participants know why it is not a good idea to invest since they expect the downtrend to continue. The final clue is discovered by distancing oneself from the ‘story’ and looking for cracks in the story. The evidence is always there if one is open minded to look for it.

When the cracks in the fundamentals are modest, but sentiment is extreme, momentum divergences have occurred, and prices have broken support or resistance, the primary trend will be interrupted for a period of weeks or months. After the brief counter trend interlude, the primary trend will reassert itself. However, if the fundamental cracks are significant, a major trend change is likely.

welsh.tech.2017.oct.30.fig.01

Sentiment is like a pendulum which swings from one extreme to the other over a period of years, as the nearby diagram illustrates. Since sentiment is most often the leading edge of a trend change, it is important to monitor whether sentiment is neutral or reaching an extreme.

Based on the weekly Investor Intelligence survey of bulls and bears, the pendulum of sentiment is at least approaching the Exuberance stage. Last week, there were 62.3% Bulls and just 15.1% Bears.

​Click on any chart below for large image.

In October 2007, the percent of Bulls exceed the Bears by more than 40%. In late 2008 and early 2009, the percent of Bears swamped the percent of Bulls by more than 25%. The intermediate lows in 2010, 2011, and in early 2016 were all accompanied by the percent of Bears outnumbering the percent of Bulls by 10%. In late 2013, the percent of Bulls exceeded the Bears by more than 40%, just as they are now. Greed is less intense than Fear which is why extremes in Fear are almost coincident with price lows, while tops can take months to form. This is why technical indicators must be used to identify when a top in prices is forming.

The Advance / Decline line did not confirm the price high in October 2007, which represented a negative divergence. The S&P broke below support in November 2007, and the fundamentals turned negative in January 2008. As discussed often in recent months, the A/D line has continued to make higher highs.

Although the A/D line is in good shape, the recent rally in the S&P has been dominated by a few high priced stocks. The Equal Weight S&P 500 weights each stock in the S&P 500 equally so it provides an insight as to whether a rally in the S&P is balanced among most of its components or not. It has been lagging behind the S&P 500 since its relative strength peaked last December. On Friday, it broke down as the big name tech stocks soared and helped the S&P 500 to gain 0.81% versus just 0.15% for the Equal Weight S&P 500.

As noted last week, the percent of stocks recording a new 52 week high was beginning to roll over and fall. This suggests that the market is showing signs of weakening.

Although sentiment is excessively optimistic, the technical action of the market suggests that the market is still in decent shape. The S&P has been making higher highs and higher lows for months, so there has been no price breakdown. The economy continues to grow above 2.0% so the risk of a trend change is low.

The ECB, the Euro, and the Dollar

The ECB was expected to reduce the amount of its monthly purchases from E60 billion a month and make no change in its policy rate which is -0.40%. As I noted last week:

“If there is a surprise it would be the ECB extending the end of its QE program from September 2018 to the end of 2018 or a later date. Given Mario Draghi’s enthusiasm for QE and negative interest rates, a decision to extend the QE program shouldn’t really be a surprise."

The ECB lowered its monthly purchases from $60 billion a month to $30 billion, but also decided to extend their QE program beyond September 2018.

I expected the Euro to close below the horizontal trend line near 1.1670 which it did. A decline below 1.150 seems probable, as long liquidation in the large long position in the Euro futures runs its course.

The Dollar was hovering just below the neckline of an inverse head and shoulders pattern and I expected the Dollar to close above 94.28, which it did on Thursday. This triggers a measured move to 96.00 and maybe 97.00. Based on instructions, traders are long the Dollar index from 92.44 and should use a close below 92.40 as a stop.

Treasury Bonds

Yields fell on Friday in response to the ECB’s slow-mo ‘calibrating’ as Mario likes to call it, and Catalonia’s secession vote. The yield on the 10-year German Bund dropped from 0.48% on Wednesday to 0.369% today. Today, word that the corporate tax cut in the U.S. might be phased in helped yields to fall more. I think the bigger trend in yields is up. A close above 2.94% should lead to a quick run to 3.01% to 3.05% (black down trend line). A move up to 3.17% to 3.20%, the highs last December and in March is likely before year end.

Gold and Gold Stocks

The nature of the decline from the recent high of $1305.72 cash opens the possibility that Gold could test $1306 - $1310 before falling below $1260. If Gold does rally to $1310, an equal decline of $97 would bring down to near $1220. This process could take 4 to 6 weeks.

If Gold does make another run to $1310, the Gold stock ETF (GDX) could rally back up to $24.00.I expected GDX would at least test the blue trend line near $22.26 which it did last week. If Gold does fall below $1260, my guess is that trend line won’t hold and GDX will fall to the green trend line currently near $21.50. If Gold falls to near $1220, GDX could drop to the black trend line near $20.75.

Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking

The Sector Relative Strength Ranking is based on weekly data and used in conjunction with the Major Trend Indicator (MTI). As long as the MTI indicates a bull market is in force, the Tactical Sector Rotation program is 100% invested, with 25% in the top four sectors. When a bear market signal is generated, the Tactical Sector Rotation program is either 100% in cash or 100% short the S&P 500.

The MTI crossed above its moving average on February 25, 2016 generating a bear market rally buy signal. The MTI confirmed a new bull market on March 30, 2016. The MTI continues to indicate that a bull market is in force.

Although the Major Trend Indicator is positive, the MTI has been posting lower highs since peaking in early March. Since late July, the odds of the S&P continuing the streak of no corrections of either 3% or 5% seemed quite low based on historical patterns and signals from a number of reliable technical indicators. The Tactical U.S. Sector Rotation Model Portfolio has been 100% in cash since July 24 based on the probability of a 5% correction. In my judgment (so far incorrect), upside potential has been limited relative to the level of risk. Through September 30, the Tactical Sector Rotation program is up 8.52%.

The Major Trend Indicator continues to hold above the green horizontal line which is another sign that the market is not yet vulnerable to a major trend change.

Disclosure

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Nasdaq 100 is composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange. All indices, S&P 500, Russell 2000, and Nasdaq 100, are unmanaged and investors cannot invest directly into an index

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