OCTOBER 11, 2015
WAITING FOR THE 'FAT PITCH'
MARKET IS NOT QUITE THERE YET
After completing this week's Intelligent Market Risk Analysis (IMRA), we had planned to add new stocks to our portfolios in anticipation of a continuing rally. We expected that the indicators we monitor would continue in a positive direction along with the market. However, after reviewing the stocks selected by our value-based fundamental criteria this weekend, we found very few companies that passed the second step of our 2-step, stock-selection process: a qualitative examination.
Because we were unable to find quality, undervalued stocks, we took further steps to re-analyze how our value-based stock-selection systems might have performed had we stayed in the market following our June 28 Sell signal. The results were not pretty, and in this brief edition of the Intelligent Value Alert we will show you what we found.
THE TREND IS YOUR FRIEND
One of the basic assumptions we make regarding both the overall market and individual stocks is that a trend tends to continue until something occurs to change it. This thesis harkens back to Newton's first law of inertia:
||An object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction unless acted upon by an equal or greater force.
– Sir Isaac Newton
In other words, when we identify a trend we expect that trend to continue until it changes course or reverses because of an equal or greater force.
To reduce the subjective part of chart analysis, we incorporate trend-following indicators that remove some of the guesswork. No matter what is happening on the chart, these indicators provide a black and white interpretation of the trend. It is either rising or falling. We are bullish when it is rising and bearish when it is falling.
MOVING AVERAGE DIRECTION
A good example of this is the following chart, which shows the 3-period slope of a 10-period exponential moving average (EMA) of the S&P 500 on a monthly basis. In the top window of the chart below we show the S&P 500 monthly bars in light gray. The purple line represents the 10-period EMA of those prices.
While we can see that the 10-period EMA is changing direction subtly, we can make those changes stand out more clearly by adding a 3-period, linear-regression measure of the slope in the lower window. When this slope line crosses below the zero line, it is bearish. When it crosses back above the zero line, that is a bullish signal. We can see that although the signal line has turned up a bit, presently the trend is still bearish:
3-period slope of the 10-period EMA can give bullish/bearish signals
based on the direction of the trend. A cross above or below zero is the signal.
STOCKS ABOVE/BELOW 20-DAY MOVING AVERAGE
Another approach to determining direction looks at the market breadth and involves identifying the number of stocks in an index that are above or below various thresholds. In the case of the chart below, we're using the 20-period Exponential Moving Average (EMA) as the threshold. The parameters we use to identify turnpoints in the graph below work like this:
If the percentage of stocks below the 20-day EMA drops below 30%, then the market can be considered oversold. A trigger to buy would occur when that number reverses course and moves back above 40%. The opposite holds true also; if the number of stocks above the 20-day EMA moves above 70%, the market is considered to be overbought. When that number drops back below 60%, it is very likely that a downturn is beginning.
In the current chart of the S&P 500 (below), we can see that the percentage of stocks above the 20-day EMA stands at 85.20%. This level is quite overbought. While many might expect the upward trend to continue (based on simple extrapolation) and a buying opportunity is obvious, quite the opposite is true. Stocks have moved to far, too fast in the last two weeks, and it is very possible we will see a downturn this week to work off that overbought condition.
The chart below shows the S&P 500 Index in the upper window and a measure of the number of stocks above their short-term (20-day) moving average in the lower window. Any reading above 70 is considered overbought and any reading below 30 is oversold. These levels establish the setup, and a drop back below 60, or a rise above 40 is a trigger for a short or long purchase, respectively:
Stocks in the S&P 500 are currently overbought according to the number above the 20-period
At this time, we will hold off on adding new positions to our portfolios until the indicators we watch are providing a more favorable buying opportunity. While many subscribers want to be in the market at all times so as not to miss out on the 'action,' we believe that action in the near term has a better-than-even chance of being downward.
Quite frankly, with Q3 earnings set to dissapoint based on consensus estimates, it is difficult to imagine what the catalyst would be that would ignite a strong rally to break through that resistance.
Even if the market does continue higher from here, there is massive overhead resistance at the 2040 to 2060 area on the S&P 500 that must be broken for the market to reach new highs. Yes, you can always count on the 'trend being your friend.' However, in this case, it may only be your friend if you are short the market.
We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach. If you have any questions or comments, please contact us with a support ticket.
Best Wishes for Another Week of Intelligent Value Investing,
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