THE CORRECTION BEGINS?

In last week's Market Analysis, I opened the editorial with the question, "Is the Party Over?" Much of that editorial was spent discussing why the 1,150 level on the S&P 500 would be a critical resistance level for the U.S. stock market with a forecast that a correction was imminent and stock market prices would fall very soon.

I put my reputation on the line by making that call in print for all to see. Obviously, I would look pretty foolish if I spent most of last week's newsletter, as well as parts of several recent Action Alerts making the case for a near-term top in the market and then it didn't happen. There was always the possibility that 1,150 would simply be another short-term weigh station on the road to higher returns in one of the most powerful bear-market rallies of our lifetimes. What would I have said this week if I was so wrong?

Well, there's no need to worry about that now: the market collapsed right on cue. Because my call for 1,150 as a near-term market top, we were in cash most of last week and side-stepped a significant loss. I feel that avoiding a loss is just as valuable as making sizable gains. Many say that it's more valuable because perfect timing of market swings cannot be done consistently. IntelligentValue utilizes cash at appropriate points when trends are not clear.

Our forecast last week was for a change in market trends, from higher to lower, and therefore, we moved our stops tighter and allocated a higher percentage of the portfolio to cash. We entered the week about 65% in cash and closed the week 100% in cash.

No less a stock-market giant than Warren Buffett has suggested two simple rules for those wishing to duplicate his incredible investing success:

We have taken the two rules to heart, and thus, make every effort to avoid losing money in our model portfolios. Therefore, in our Market Trends portfolio we were in cash from mid-day Tuesday through Friday last week, avoiding the losses that buy-and-hold / complacent investors experienced.

Aggressive Portfolio, October 9, 2007 Market Top -to- present.

Our Aggressive Portfolio (right) has been able to outperform the broad market by +80% through the worst bear market of our lifetimes (so far) via the prudent allocation of cash. The portfolio has risen steadily higher from the market high on October, 2007. The portfolio simply didn't participate in the bear market!

Much of our outstanding performance can be attributed to our determination to avoid losses - and only then to make profits when conditions are optimum. This has to be your approach when trying to make a return on your money in such risky circumstances. Cash is our friend when the path forward is unclear. This approach has worked out well as the Aggressive Portfolio has achieved a return of 732% since it was launched in May 2006. Every year has been a winner with an average annual return of 85%.

MARKET TRENDS PORTFOLIO

We've 'batted a thousand' so far in the Market Trends portfolio with every pick making gains. To date, the portfolio has made a return of 8.80% compared to the underlying S&P 500 index (on which it's based), which has returned 2.47% during the same period. So we beat the market by 256%!

I know that a return of 8.80% is not a show-stopper on first impression. But it's early (just 2- 1/2 months) and if we are able to continue on this course, we'll be on track for a 40%+ annual return. But I think we'll do better than that. Since we launched the portfolio at the first of November, the market has been fairly flat (with the exception of a surge higher at the start of November and another move higher the first sessions of January).

The Market Trends portfolio puts volatility to work for you by investing in a 2X (leveraged) ETF based on the S&P 500 when the market is rising, then fading the position as the market becomes overbought. When the direction is unclear, we will hold cash, as we are doing currently. When the primary trend is down, we will reverse the process using an inverse, leveraged ETF based on the S&P 500. Liquidity is vast and the bid/ask is small in these ETFs which trade about 110 million shares daily.

Prior to the public launch of the Market Trends Portfolio at the start of November, we tracked a portfolio based on this system for two years and it produced positive returns in 20 out of 22 months with a compound annualized return of about 80%:

Pre-Public Monthly Results

Actual Monthly Results (available to subscribers)

Our goal over the long haul, in any market environment, is an annual return of 65%. At this rate, a starting investment of $10,000 will return close to $1.5 million in just 10 years. Remember that past performance is not indicative of future returns and when investing in stocks, especially with leverage, it is possible to lose all your investment.

TECHNICALLY SPEAKING

Since the market began its climb from the depths of despair last March, it has traded based almost completely on technical price action. Individual stocks as well as market indices have moved to technical support and resistance levels like clockwork.

Consequently, we've had to spend a lot of time talking about these indicators in our editorials. Our call of a near-term market top at 1,150 on the S&P 500 was a perfect example of how these levels can be identified and used to inform our investment decisions.

S&P500: 1,150

After reaching 1,150 on three days over the last two weeks, on Thursday the S&P 500 index broke below the support level at 1,130 which was established in the narrow consolidation that started two weeks ago.

S&P500: 1,116

The market sold down to 1,116 at the close on Thursday. Closing right at 1,116 (the resistance level of the last consolidation) was important as it once again showed that the markets are trading strictly on technical price action. Therefore, we need to weight technical analysis higher than value criteria for the time being.

From late 2004 to late 2007, I ran a screen to find stocks with incredible value criteria and then from that list I picked stocks with the best technical patterns. But since the middle of last year, it has paid off better to screen for strong technicals first and then rank those stocks by value.

In the last market consolidation, from mid-November to mid-December, resistance was established at about 1,116. Prior resistance becomes support once broken and that's exactly what happened on Thursday afternoon. Traders (not investors) played the game and ended the day right on the support mark previously established at 1,116.

Going into Friday, there was still a chance that this could be just another test of the market's willpower to move higher. A bounce higher was possible, so making a call to buy or sell stocks for our Aggressive Portfolio the evening before would have been a mistake. The Market Trends portfolio did not have the option of buying an inverse ETF (SDS) because the primary trend of the market was still up. More on this in a moment...

S&P500: 1,091

Then on Friday, market indices dropped again with the S&P 500 recording a loss of -2.21% to close at 1,091. The total loss in three days is 5.13%. As shown in the chart below, 1,091 is the prior support level of the prior consolidation, which lasted from the second week of November to the end of the second week of December.

The chart below shows the technical levels that have been important the last few weeks and the ones that we feel will be important in the coming days:

The stock market has been trading based almost 100% on technicals since the March 2009 low. And that has certainly been the case over the last two weeks as stocks traded down to support levels exactly. Chart courtesy of StockCharts.com.

So once again, going into the coming week, we are in a tough place to make a decision on the market's direction. Will this support level hold and the market resume moving higher after the current drop of about 5%?

Or will the market move lower, perhaps down to the 1,030 level (see the chart below), which was the last major market low recorded at the start of November? As noted in last Wednesday's Action Alert, a move to the 1,030 level would be a decline of about 10%, which is a normal, healthy correction in a market rally:

Intermediate-term support is 10% lower, at about 1,030. Chart courtesy of StockCharts.com.

Going into this Monday, the primary trend is still up - but just barely. The Primary (weekly) trade signal is at 0.88 - its lowest level since it moved to "hold long" status in the middle of July. The chart below shows that a buy signal occurred the second week of March and the long-term signal has been bullish ever since:

The Long-Term (weekly) Indicator is still positive. Chart courtesy of StockCharts.com.

Buying against the primary trend is a very dangerous game, so we don't play it. The chart above shows that the S&P 500, which is the basis of the Market Trends portfolio, is still indicating that the IVTI long-term (weekly) indicator is in the "long/bullish" area. It has been signaling long/bullish since the rally began last March.

As long as the IVTI long-term indicator is bullish, we will only use SSO (the 2X long ETF) or cash. If the indicator heads below 0.8, then we can use SDS (the 2X short ETF) in the portfolio. The highest profits are made when both indicators are moving in the same direction, rebounding from a dip.

There is a 50-50 chance that the market could go lower, and by that I mean substantially lower to at least 1,030, which is another 5% from the current level. Using a 2X leveraged inverse (short) ETF based on the S&P 500 (SDS), that 5% decline could provide a quick 10% return to us.

There are a significant number of headwinds that have developed this past week which may continue to put downward pressure on the market. I'm sure you've heard all about it by now: Federal Reserve Chairman Bernanke may be given the boot; President Obama is on a populist mission to punish 'Wall Street' and destroy the banking system; Google's founders announced quietly on Friday at 6PM that they were selling billions of dollars of their shares (at the top?); China is tightening their stimulous to avoid a bubble; etc., etc. These headwinds could be a harbinger for additional severe declines unless there is counterbalancing positive news soon.

OVERSOLD

On the other hand, market indices have moved from two standard deviations above the 50-day moving average to one standard deviation below the 50-day moving average and is now oversold - in just three days.

Chart by Bespoke Investment Group

GOING FORWARD

Since the start of this year, the market has been flat (-2.2%); a reflection of the fact that the prior leadership in the market, including technology, materials, and consumer discretionary sectors became overvalued and have now correcting. Bellwether companies such as Intel, IBM, and Goldman Sachs are knocking the earnings ball out of the park, but the price action following those good reports has been terrible because the earnings growth is already priced in. A classic case of 'Buy the rumor/Sell the news.'

More concerning data: The number of advancers versus decliners, a declining number of stocks above their 200-day moving average, the number of stocks declining from 52-week highs, the concerning selling action of corporate insiders, the concerning percentage of bullish advisors (the highest since 1987), the spike in the VIX (volatility index), etc., are all confirming ndicators that stock prices are seeing serious downward pressure.

But if we repeat the pattern of the market off the business-cycle bottom in 2003/2004 (which I think is likely), for the next 6-9 months we will have volatility around a flat or slightly downward trend line. This correction - if it continues - may reveal some excellent values in individual stocks and better opportunities for entry going forward.

And now that I've correctly picked the near-term market top at 1,150, I will stop patting myself on the back. It's a new game now.

NEW FORECAST

Oscillating indicators are already close to oversold levels, and its possible that the S&P 500 index could bounce back to 1,150 before too long. If you see a lot of headlines like the one at the top of this page, its an indication that the market will be heading upward soon. We can probably expect a bounce on Monday, but it is unlikely we have already resolved the downside market movement. My new call is that a range around 1,150-1,165 will continue to be an important top on the market for some time to come. Remember that volatility is our friend as we can make money in either direction.

OUR PORTFOLIOS

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Which direction is the market headed? The answer may surprise you! Click here to see our take on the market and a portfolio that's produced a 733% return in 4-1/2 years!

Sincerely,

Christopher Michaels
IntelligentValue.com

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