Sunday, November 16, 2008

Increasing Risks

It has been two weeks since my last commentary, and in this market environment, that seems like a lifetime. The Market Bias Timing System has turned neutral, and despite the widespread belief (hope?) that a trading rally is in the offing as the 2002 -2003 lows are approached during this seasonally positive time of year, the data suggests otherwise. The markets remain weak, and as hard as it is to believe (as I would be the first person to buy into a declining market), I think the risk is skewed to the downside.

The Market Bias Timing System (MBTS) turned neutral at the close of the week ending on November 7, 2008. What caused the change? The Investor Sentiment Composite Indicator is no longer extremely bearish (i.e., bull signal), and the price action remains poor. So can we count on ongoing bearish investor sentiment to propel prices higher? It does not appear that way. So it is the combination of neutral investor sentiment and poor price action that suggests caution.Why did the MBTS turn only neutral and not outright bearish? There is a time component to the system that essentially gives the market 5 weeks (once sentiment turns neutral) to get off the bottom and move higher. This won’t be fulfilled until November 28. This criteria or filter is combined with market breadth, and this part of the MBTS will generate a sell signal as market internals continue to lead the price action lower. This can be seen in figure 1, which is a weekly chart of the S&P500 showing the NYSE advance decline line and NYSE cumulative volume. Both are leading price lower and this is not good.

Figure 1. S&P500 v. Market Internals/ weekly

So we have the MBTS turning neutral and in all likelihood, it should be a bearish signal as market internals remain poor. What else gives me caution? It is this notion of price failures that I have been discussing over the past couple of weeks. I think this is important so I want to try to explain to you in greater detail the significance of a price failure, and why these areas are important areas to focus on. We all can agree that a bullish trend is a series of higher lows and higher highs. Typically what happens in a bull market is that prices make highs, and then prices sell off. Investors become worried on the sell off, and investor bearishness rises. At some point, investor bearishness becomes extreme, and prices find a low as buying ensues, and prices pivot higher. It is the combination of bearish sentiment and the pivot point that forms this important low. This is the “line in the sand”. Figure 2 is a weekly chart of the S&P500, and the boxy looking graph in the lower panel, is a “digital” representation of the Investor Sentiment Composite Indicator. So when this indicator is up, it has a reading of 1, and investor sentiment is extremely bearish. This is a very bullish signal. When the indicator is in the down position, investor sentiment is not bearish.

Figure 2. Price Failures

The pivot points (red dots) on the price chart are those times when investor sentiment is bearish and prices make a pivot. These pivots are unique in that they have become key areas of support or where buying is most likely to take place. And in essence, this is supported by the data. But let me just take you through the graph and show you empirically.Point #1 is the July, 2006 low. Prices traded below the first red pivot and then 2 weeks later traded back above. This was a fake out, and led to a nice 6 month bull run. Pivots #2 and #3 were just points of buying, and note how these points acted as future support. Point #4 failed, and this essentially kicked off the bear market. Point #5 is March, 2008, and is at the time of the Bear Sterns failure. At this point, I suggested risk was increasing as prices had broken below support or this key pivot point. The very next day, the Fed announced its bailout plans, and the market reversed course. But like all Fed interventions over the past 18 months, the bounce was short lived, and within months, prices were trading below these key support levels. Point #6 is July, 2008 and we can see what happened when this area gave way in October, 2008 (down arrows).

The bottom line: breaks of support should be noted. They typically lead to lower prices, but reversals also have to be monitored. And as we noted in the prior commentary, breaks of key support levels or price failures in bear markets are more ominous than in bull markets.

So let’s move to the present situation and this is pivot point #7 in figure 2. This pivot point is at 875.83 on the S&P500 and the weekly close is at 873.29 and below this “key” level. On the NASDAQ, the pivot point is at 1565.72, and the weekly close is significantly below at 1516.85. The Russell 2000 has also closed well below its pivot too. The Dow Industrials is the only major index above its prior pivot low. On the Dow, the pivot point is at 8348, and the Dow closed the week at 8497.31.Ok, to my point. It is clear that the points I have identified are important areas of buying and selling. The fact that a majority of the major indices have breached these areas with last week’s close suggests to me increasing risk. When you combine this with decreasing bearish sentiment and poor market internals, I think risk increases even more.

In my March 24, 2008 commentary, I discussed “Those Four Letter Words”. In particular, I made the point that risk (our four letter word) was increasing, and I based my findings on similar analysis. Of course, the Fed came out with its Bear Sterns’ announcement and the market reversed sharply higher. Could something similar happen again? Certainly. But in the absence of trying to predict the market, let’s just acknowledge that risk is increasing. We know where our important buy and sell points are. If you are feeling uncomfortable at selling at the lows, I don’t blame you. But as the market appears to be weakening (despite being near the lows) I would be a seller into any strength. Furthermore, I would not tolerate too much downside as a breach of support has already occurred in all the major indices except the Dow. Things could get uglier before they get better.

What would make me turn bullish again? Investor sentiment will need to turn bearish again. Therefore, we will need to see lower prices or a long drawn out trading range. This will essentially wear investors down.

Lastly, I want to give you the numbers for the recent signal in the MBTS. The NASDAQ had a draw down of 31.58% with a loss of 24.55%. The S&P500 had a draw down of 30.77% with a loss of 23.25%. The Russell 2000 had a draw down of 37.32% with a loss of 28.27%. As it turns out, the draw downs were about 2-3 times larger than previously experienced by the system and the losses are about 3-4 times larger. Prior large draw downs in the system have typically been met by buying and all that was necessary was to ride out the draw down. In these extraordinary and unprecedented times, this did not happen. Therefore, the increased losses.

Obviously, this is not good market timing. But in my defense, this represents one of those 10% of the times where things just don’t work. Unfortunately, I cannot predict when things won’t work, and I have always made this very clear. The only thing I can control is my risk, and this is why I rely upon money management to reduce the risk of going against the prevailing winds.

For now, the prevailing winds – investor sentiment, market internals, and the price action – suggest increasing risk. This is not a time to go against the prevailing winds. This is not a time to stray too far from the data as price failures can lead to accelerated price moves lower. If this turns out to be a fake out, this may mean selling at the lows and buying back into a rising market. This is unpalatable but it may be necessary to protect yourself against what I believe is increasing risk.

For now, the MBTS has a neutral bias, and I would be a seller into strength.

That's The Technical Take!!!

I hope you have found my commentary insightful and profitable.