Monday, April 20, 2009

When Signals Fail

In the most recent post on sentiment, I ended the commentary with the following statement:

"If wrong, there is always important information in failed signals."

This was my way of saying that no one really knows where the market is headed, and we always have to acknowledge the possibility of being wrong. Yes, I have conviction in my market research, but I always recognize that the market beast has a way of humbling even the best.

So how will I know if my analysis - that the current rally from the March lows is just a bear market rally that will fail sometime in the next couple of weeks - is wrong? Despite the neutral sentiment and overbought conditions, the market will just keep going higher.

What would be the significance of being wrong? In all likelihood, failure of these signals would signify the start of a new bull market. And to see why I would make such a statement, let's take a look at a few examples.

Figure 1 is the percentage of NYSE stocks trading above their 40 day moving average; this is an indicator found in the popular TeleChart software package developed by the Worden Brothers; the "T2108" indicator is shown in figure 1, and the current value is slightly above 92% -meaning that 92% of NYSE stocks are trading above their 40 day moving average. The current indicator value is the highest reading since 1991 and the second highest reading ever.

Figure 1. % Of Stocks Above 40 Day MA

I showed this graph several weeks ago and stated: "Within the context of a bear market or down sloping 40 week moving average, this is an extreme, overbought number that has typically signaled an intermediate term top." The one noteworthy exception was the March, 2003 bottom. The indicator failed as over bought became more over bought and the bull market was launched.

Another example of failed signals providing important information can be seen in the Rydex asset data. I last discussed the short comings of the Rydex asset data in this article. In figure 2, I present a weekly chart of the amount of leveraged assets in the Rydex bull oriented funds versus the amount of leveraged assets in the bear oriented funds. This is one of my favorite Rydex indicators. Not only can we see how these market timers are betting on market direction, but we can also see if they are doing so with conviction (i.e., leverage). The indicator takes the rate of change of this ratio and then looks for extremes in this value over the prior 52 week period.

Figure 2. Rydex Leverage Bull v. Bear/ weekly

For the most part, the indicator does a reasonably good job of identifying intermediate market tops, and these are noted with the gray vertical bars. The most noteworthy failure (maroon vertical bar) is April, 2003 when the bull market was launched. In other words, excessive bullishness did not lead to an intermediate term top. The signal was a failure as overbought became more overbought, which is the sign of a bull market advance.

I recently saw a lecture where a hometown hero was interviewed about her life and adventures. Tori Murden McClure was the first American and woman to row across the Atlantic Ocean, and she chronicles this effort in her book, A Pearl In The Storm. Ms. Murden actually did this twice having failed on her first attempt being some 300 miles from the shores of Europe. Interestingly and according to Ms. McClure, 80% of her book is about that first failed attempt.

Why was this so? Why write about failure?

As she stated in the interview, it was more important to write about failure because we can learn so much from our failures. What good would a book be if we only presented our triumphs? Good points!

For our purposes here, I expect this rally to fizzle just like the other bear market rallies of the past decade. This is the high odds play. If I am wrong, then it is likely the market is undergoing a secular change. In the markets (as in life), we must continue to learn from our failures.

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