Monday, November 24, 2008

To Have A Plan, To Speculate, And To Guess

Bounce? Bottom? Bear? Bull? Does anyone in the world really know where the market is headed? While the direction of the market may be unknown, there is one thing for sure: in the history of mankind, there has never been a time when so many people have had an opinion about the markets. Yet what is ironic is that most of these so called experts (and I would include myself here) are really just mediocre. The information overload we all experience really does not provide any sort of edge.

To Have A Plan
So in the absence of trying to predict the market’s direction, let’s at least put a plan together that should help us navigate the meaning of the price action. If there is one thing I can say about technical analysis, which is the analysis I espouse too, it is this: whatever is known or unknown regarding an asset is reflected in the price of that asset. Price and being on the right side of the trend are the only things that matter.

So where are we?
Last week, I wrote about price failures. Price failures are key areas where selling typically occurs, when we should expect buying. In other words, there should be buying at support levels. Instead we have selling and this typically occurs at an accelerated pace. As of last Friday’s close (November 7), the S&P500, NASDAQ, and Russell 2000 had experienced price failures. Five trading days later, these three indices were all down over 8 plus percent, and if it wasn’t for the 5% ramp in the last hour on Friday, these indices would have experienced losses in excess of 12% for the week!!! As I wrote last week, "Increasing Risks" indeed.

The Dow Industrials was the lone index not to experience a price failure, but last week’s price action took care of that. See figure 1 a weekly chart of the Dow Industrials. The red dots over the price bars are the key areas of buying. A weekly close below these levels is a price failure and as you can see, the Dow Industrials is below one of these key areas of support.

Figure 1. Dow Industrials/ price failure

So what does all this mean? The price action is telling us all that we need to know – price failures imply increasing risks. So what is our road map to navigating this market? A weekly close over 8350 on the Dow, 876 on the S&P500, 1565 on the NASDAQ, and 476 on the Russell would be bullish. These are our resistance levels. A bull market cannot start without these levels being taken out.

To Speculate
Can we speculate on buying at lower price levels if they come about? Absolutely, and this is somewhat the premise of buying on bearish extremes in investor sentiment. Lower prices will bring out the bears and this is typically bullish. Currently, the Investor Sentiment Composite Indicator has just turned slightly bearish. Interestingly, the Smart Money remains bearish. Both indicators are shown in figure 2 below a weekly chart of the S&P500.

Looking at 18 years of data, such a dichotomy occurs about 10% of the time, but usually favors the smart money. In other words, we will not see higher prices until the Smart Money indicator turns more bullish. Of note, the Market Bias Timing System is likely to turn bullish next Friday provided investor sentiment remains bearish. We will evaluate this possible signal within the context of all the data available to us.

Figure 2. Investor Sentiment

To Guess
In the short term, the market is oversold and it would not surprise me to see buying in the week ahead. A daily chart of the S&P500 is shown in figure 3 (next page) with the McClellan Oscillator shown in the lower panel. The McClellan Oscillator is based upon the advance decline, and it is much oversold. With the Thanksgiving holiday and end of the month buying on light volume, there is very little reason to think there will be downside pressure on the market.

Figure 3. SPY/ daily

What I have tried to provide you with this commentary is a plan. It is my guess that the markets will have a short term bounce. It is speculation to bet against the prevailing sentiment when there are extremes in sentiment. Now is not a time to speculate.
This is a plan of action to follow when the price action meets certain criteria.
That's TheTechnicalTake!
I hope you have found this commentary insightful and profitable.

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