Not Throwing In The Towel!

For the past several months, I have emphatically stated that the equity rally that started in March is a bear market rally. For the most part and because I primarily look at price, it has been my belief that the technical factors normally seen at a market bottom are not present. There were no divergences; time from the last bull market bottom or from the last bull market top had been too short. To make a long story short, this is not the proper launching pad for a new bull market.

Recognizing that I could be wrong - that my indicators just aren't sensitive enough to detect a new bull market in this era of the "new normal" - I arbitrarily chose a close over the simple 10 month moving average in the S&P500 as a reason to turn bullish and embrace the rally. This is the Faber strategy, which is an easy to implement strategy that gets high marks for its aversion to risk.

As we end the month of June, price has closed above the simple 10 month moving average of the S&P500 triggering a buy signal for the Faber strategy. I am writing today that I will not be honoring that signal, and these are my reasons.

First, I want to mention Rule#2 and Rule#3 of my "11 Rules For Better Trading". Rule #2 states:

Be disciplined. The data should guide you in your decisions. This is the only way to navigate a potentially hostile and fearful environment.

Rule #3:

Be flexible. At first glance this would seem to contradict Rule #2; however, I recognize that markets change and that trading strategies cannot account for every conceivable factor. Giving yourself some wiggle room or discretion is ok, but I would not stray too far from the data or your strategies.

Suffice it to say, I am comfortable making this decision. My research still suggests that this is a bear market rally and not a new bull market. Furthermore, this is a very risky time and place to be putting new money to work. So let me give you my reasons as to why I continue to sit and wait, and I will present my reasons from the strongest to the weakest. Of note, I will focus on the things that I do best - that is analysis of price and sentiment. I assume that you don't read me for innovative and insightful fundamental analysis, so I will let others stimulate your thinking in that regard.

The Launching Pad

This is not the launching pad for a new bull market in equities. I have stated this many times over the past 3 months and so let me explain, once again, what I mean.

I asked the following question: what are the technical characteristics seen at market bottoms that lead to secular changes in trend? You have divergences between price and momentum oscillators. The price decline typically has gone on for a period of time from the prior bull market top; it isn't so much the steepness of the decline (y-axis) but how long investors and prices have been underwater (x-axis) that I measure. Of course, prolong periods of consolidation can be a good lift off for stocks too. All this is quantifiable and that's what I do. I quantify those "things" seen at market bottoms, and with the exception of the Russell 2000, none of the major equity indices (i.e., S&P500, NASDAQ 100, or Dow Jones Industrials) display those characteristics seen at past market bottoms. We are close to being in that zone, but I still think it is going to take more time. Without the proper launching pad, I don't see how we can get from here to there.

Inflation Pressures

Whether inflation is real or perceived, the strong price trends in crude oil, gold, and 10 year Treasury yields are telling us that investors are concerned about inflation. Even if they are not concerned about it, I have shown that equities tend to under perform when these trends are strong. Furthermore, I believe there is real serious risk of capital loss when these trends are strong as they are now. The data presented in the article, "Inflation Pressures Are A Legitimate Concern" was pretty clear. We can make the Faber strategy more efficient by avoiding the equity markets when the price trends of crude oil, gold and yields on the 10 Treasury are strong and rising.

Sentiment

The "Dumb Money" indicator is bullish to an extreme degree, and typically this is a bearish signal. Of course, if you believe this is 1995 or 2003, then by all means feel free to buy to your hearts content. After all, "It Takes Bulls To Make A Bull Market".

Seasonal Factors

"Sell in May and go away" does work in a bear market; I believe we are in a bear market. This bit of market dogma does not work in bull markets.

"This Time Is Different"

Utilizing negative divergences between price and an oscillator that measures price momentum, I have defined the "this time is different" scenario. At market tops we typically see negative divergences. If prices continue to move higher despite the presence of these divergences, often times we find investors saying "this time is different" as prices accelerate much higher. Of course, I think the acceleration in prices is due to short covering. In any case, we now have negative divergences showing up in the major indices. As expected momentum has slowed. Closes over these negative divergences - essentially weekly closes over the current range - will lead investors to say that "this time is different" as none of the issues that I or others present matter. "Stocks are pricing in a recovery." No doubt a close over the current price range will likely fuel a short covering rally.

The Banking Index

I have called the Bank Index the single most important index. Have you seen it lately? Figure 1 is a weekly graph of the S&P Banking Index (symbol: $BIX.X). It hit resistance at $126.80 nine weeks ago, and it is off 16% since. I cannot see the broad market higher without the help of the financials.

Figure 1 $BIX.X/ weekly

Lastly let me state that there is nothing unique about price closing above the simple 10 month moving average. Yes, prices are less volatile above the 10 month moving average (i.e., bull markets) and they tend to be more volatile below this "key" moving average (i.e., bear markets). But a close over the simple 10 month moving average is just arbitrary. The simple 9 month moving average would work just as well. The beauty of the Faber strategy is not its ability to time entries but to limit losses. In general, you don't take the big hit with this strategy. See the MAE graph of the Faber strategy.

My real reluctance here is that it is not the time or place to put money to work. There will be better opportunities ahead. I am NOT throwing in the towel yet! I am invoking Rule #3 for now!!

10 Year Treasury Yields (Update)

I am on record stating that yields on the 10 year Treasury bond will move higher over the next 12 months, and this will represent a secular trend change. This has been a major theme that I have been touting for the past 6 months.

See figure 1 a monthly chart of the the yield on the 10 year Treasury bond. The "next big thing" indicator is in the lower panel suggesting that there is a high likelihood that a secular trend change could occur in the 10 year Treasury yield. In May, a monthly close above a yield of 3.432% was the technical confirmation of a secular trend change. In the first week of June, yields moved to 4%, and as expected, buying of Treasuries ensued at this level of yield (driving yields lower, bond prices higher). As we close the month, it is my expectation that yields will remain above the 3.432% support level.

Figure 1. 10 Treasury Yield/ monthly

The push for higher yields is still on.

The other good news (if you are betting on higher yields), in my opinion, is that the sell off of the past 3 weeks has put yields at support or a favorable buying level; Treasury bonds are at resistance levels. This can be seen in figure 2, a monthly graph of the continuous futures contract of the 10 year Treasury bond. Treasury bonds are just below the simple 10 month moving average.

Figure 2. 10 Year Treasury Bond/ monthly

In figure 3, a weekly chart of the 10 year Treasury yield, the up trend channel remains intact, and yields still remain above the down sloping trend line. For yields, this is a breakout and re-test of that breakout.

Figure 3. 10 Year Treasury Yield/ weekly

And of course the other good news (if you think yields are headed higher) was this article in the Wall Street Journal: "Inflation Fears Seem to Be, Well Inflated". As if on cue, the article appears on a day in which the yield on the 10 year Treasury gaps up over 2%, yet as I write, yields are back to near flat on the day. The article suggests that the recent rise in Treasury yields was due to the unfounded concerns over inflation and the possibility of better economic growth such that investors dumped Treasurys for more risky assets. Of course, China reiterated that they are not selling their Treasury bonds.

We have been hearing the same issues for months. Technical considerations suggest a new secular trend has begun. My theory is that we are starting at such an artificially low level that the coil has been set, and yields are moving higher to reflect a new equilibrium. I think this new equilibrium is the start of a new secular trend that will see higher yields over the next 12 months.

In summary, last month's breakout in Treasury yields appears to be holding; yields have come off a bit yet they remain above support levels.

Inflationary Pressures Are A Legitimate Concern

William Hester, CFA is a Senior Financial Analyst with the Hussman Funds, and he has written an interesting article that attempts to answer the question: "does the current economic backdrop yet have the characteristics that usually coincide with the end of secular bear markets?"

I have sought answers to a similar question, and this has led to the development of the "next big thing" indicator, which attempts to quantify those technical characteristics seen at market bottoms just prior to secular trend changes. I have written enough in these pages about the proper launching pad and having tailwinds not headwinds.

I believe Hester's real insight is the link between valuations and investors willingness to pay for those valuations. If investors are certain about the future (albeit based upon recent past experiences), then they are willing to pay up for equities. Investors believe the good times will continue, and this is how we get bubbles. If investors are uncertain about the future, then they need lower valuations. Investors perceive that the bad times will continue, and within this period of uncertainty, valuations are driven lower and markets bottom.

To measure investors' "comfort level" with the economy, Hester uses the volatility of inflation. In his own words, Hester states:

It's not only the level of volatility and uncertainty in the economy that matters to investors, but also the trend and the persistence in this uncertainty. Shrinking amounts of volatility in the economy creates an environment where investors are willing to pay higher and higher multiples for stocks, while growing uncertainty brings lower and lower multiples.

One of themes that appears to be on investors' minds is inflation. Even though inflation, as measured by year over year CPI, is low, investors perceive inflation to be a threat as we have rising deficits, a government willing to "bailout" all those who fail, and a government willing to avoid today's pain and "kick the can" down the road, and world central banks willing to devalue their currencies to gain a competitive advantage.

To assess inflation, I have developed a composite indicator that looks at the trends in gold, crude oil, and yields on the 10 year Treasury. When these trends are strong and rising as they are now, equities tend to under perform. Previously, I had shown this in the article entitled, "More Headwinds To Worry About". Going back to 1985, when these trends were strong, equities underperformed - even during the bull market of the 1990's and particularly from 2004 onward.

But let's get back to Hester. He states that "it's important to note that during the current secular bear market, the volatility of inflation has mostly been well contained." The value is less than those seen at past bear market bottoms, but the trend is rising.

"Valuations going forward may show their typical sensitivity to economic uncertainty, and for this reason, the change in the slope of the volatility of inflation over the last two years is troublesome. The level of inflation volatility is still low, relative to the peaks reached during prior secular bear markets. If the level of inflation volatility continues to increase, it will become more difficult to argue that the secular bear market has come to an end."

To summarize by answering his own question from above -does the current economic backdrop yet have the characteristics that usually coincide with the end of secular bear markets? - Hester states:

"...secular bear markets of last century shared three characteristics. They each lasted for more than 15 years, they each ended at extremely attractive levels of valuation (generally about 7-9 times trailing 10-year earnings), and , and they each endured many years of growing volatility in output and inflation, which eventually created the mindset for investors to price stocks at attractive levels of valuation. The current secular bear market can claim none of these characteristics yet."

So how can we use this information? Inflation concerns are legitimate, and the uncertainty of inflation is a headwind. How much so? Let's meld our inflation indicator with the Faber strategy. We will use our inflation indicator as a filter in that no new positions will be established or current positions will be exited when the inflation indicator is in the high inflation zone as it is now. See figure 1 a monthly graph of the S&P500 with our inflation indicator in the lower panel. One note, in the original articles on this indicator, I utilized the trends in crude oil, gold, and yields on the 10 year Treasury bond to construct our indicator. In this article, I replaced the crude oil data with data from the Reuters - CRB Index as this data set goes back to 1971; doing this does not affect the results of this study.

Figure 1. Inflation Trends/ monthly

Let's take a brief look at the Faber strategy. If you remember, the Faber strategy bought and sold the S&P500 on monthly closes above (and below) the simple 10 month moving average. The Faber strategy benefits more from its avoidance of risk than from its ability to pick a market bottom. Since 1975, the Faber strategy generated 1376 S&P500 points; buy and hold yielded 850 points. There were 24 trades of which 63% were profitable; the time in the market was 61%. Maximum equity curve draw down was 17%. The Rina Index, which is a measure of trade efficiency, is 147.

The maximum adverse excursion (MAE) graph is shown in figure 2. MAE assesses each trade from the strategy and determines how much a trade had to lose before being closed out for a winner or loser. For example, look at the caret with the blue box around it. This one trade lost 6% percent (x-axis) before being closed out for a 20% winner (y-axis). We know this was a winning trade because it is a green caret.

Figure 2. MAE Faber Strategy

Of the 24 trades, 20 had an MAE less than 7%; this is to the left of the blue vertical line. Of the 4 trades with MAE's greater than 7%, all those trades didn't recover and were closed out as losers; this is to the right of the blue line.

Figure 3 is the equity curve from this strategy.

Figure 3. Equity Curve

Now let's use the inflation indicator as a filter for the Faber strategy. In this case, we will only be in the market (i.e., S&P500) when prices are above the simple 10 month moving average and when the inflation indicator is below the high inflation line. Since 1975, this strategy yields 1479 S&P500 points; as before, buy and hold netted 850 points. There were 40 trades of which 73% were profitable. The time in the market was 52%. Maximum equity curve draw down was 16%. With greater profits, less draw down, and less time in the market, the trade efficiency or RINA index is 50% higher at 218.

The MAE graph for this strategy is shown in figure 4. Of the 40 trades, 38 had MAE's less than 6.5%; this is to the left of the blue vertical line. Only two trades had MAE's greater than 6.5%, and both of these went on to be losers.

Figure 4. MAE Graph

The equity curve for this strategy is shown in figure5.

Figure 5. Equity Curve

Inflationary pressures are a legitimate concern. Hester's notion that the characteristics of a true bull market bottom have not been met are intuitive and insightful. From my perspective, the Faber strategy performs more efficiently when we avoid being in the market when inflation pressures -real or perceived- are high, as determined by our inflation indicator, which assesses trends in commodities, gold, and yields on the 10 year Treasury.

This is the most compelling evidence that suggests the impending signal from the Faber strategy will be a false signal. Avoidance of equities in times of uncertainty -as measured by strong trends in gold, commodities, and yields on the 10 year Treasury bonds - is unlikely to lead to under performance.

Investor Sentiment: Summer Doldrums

It is the end of the month. It is the end of the quarter. It is the week before a holiday. This gives the market a slight upward bias for the coming week. In the intermediate term, the "Dumb Money" indicator remains bullish to an extreme degree, and typically this is a bearish signal. This is a real head wind for the market. Since the "dumb money" turned bullish 8 weeks ago, the S&P500 has lost a little more than 1%, the NASDAQ 100 is up about 6% and the Russell 2000 is flat. For the week ahead, I suspect the shorter term bullish bias and the longer term bearish bias will make the markets choppy and range bound. It is the summer doldrums!

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money" Indicator/ weekly

The "Smart Money" indicator is shown in figure 2. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders. The "smart money" is neutral.

Figure 2. "Smart Money" Indicator/ weekly

6 Leaders For The Next Rally Phase

It has been about 3 months since I last highlighted the 6 sectors or industry groups that could lead the next bull market. The group of 6 were the following: semiconductors, airlines, housing, retail, healthcare information, and networking.

First, I was particularly drawn to this group because it seem to provide a good cross section of the market; there is tech, transportation, the consumer, and an Obama favorite in healthcare information. Second, several in this group of 6 have been down and out for years -think semis, airlines and housing. Investors are focusing on the last bull market winners such as energy, metals, and financials; this group of 6 focuses on new leadership. In other words, I attempted to answer the question: what will the new leadership look like for the next bull market?

Of course, when I wrote the initial article 3 months ago, I was under the assumption that we were in a bear market rally. I am still operating under that assumption as this is not the launching pad for a new bull market. A retracement of the current rally that turns sentiment bearish (i.e., bull signal) could lead to that higher low that would suggest to me that a new bull market is beginning. So with regard to our group of 6, they still look like potential leaders for the next bull market when that opportunity arises.

Semiconductors

I first mentioned the semiconductor sector in the article, "Semiconductor Sector: Potential For Secular Run", back on March 20, 2009. At that time I stated:

"I like to seek out assets or sectors where the secular winds will propel prices higher. In other words, I am looking for the "next big thing", and the semiconductor sector would qualify. From a technical perspective, this sector has all the right attributes to undergo a prolong run."

Since that time, the $SOX or semiconductor sector is up about 20%. See figure 1, a monthly graph of the Philadelphia Semiconductor Index ($SOX). The "next big thing" indicator, which attempts to identify those assets with a high likelihood of undergoing a secular trend change, is in the lower panel. This indicator is in the zone where one expect a secular trend change to occur. The $SOX has found support at the prior lows of 1998 and 2002, and it is now trading above its simple 10 month moving average. It has run into resistance at the down sloping trend line. The recent bounce from the support lows represents a retracement back to the breakdown point. I would look for the $SOX to mark time between the simple 10 month moving average and the 300 level on the index.

Figure 1. $SOX/ monhtly

Housing

Figure 2 is a monthly chart of the Philadelphia Housing Sector Index (symbol: $HGX). Once again, the "next big thing" indicator is in the lower panel, and it is in the "zone". The housing index is down about 8% since we highlighted the sector back in April. The index remains bullish as prices have closed above the down sloping trend lines, and at present it is above these levels. A monthly close above the simple 10 month moving average in the context of a new bull market would provide bullish confirmation. Failure to remain above the trendlines would be a negative.

Figure 2. $HGX/ monthly

Retail

Figure 3 is a monthly chart of the CBOE S&P Retail Index (symbol: $RLX.X) with the "next big thing" indicator in the lower panel. Since our mention in April, the retail index is essentially flat. This is a controversial pick because the "consumer is dead" argument certainly has an ounce of truth to it especially with poor wage growth, high unemployment, rising gas prices at the pump, and a need to increase savings. But technically, the story remains bullish as long as prices remain above the simple 10 month moving average.

Figure 3. $RLX.X/ monthly

Airlines

Figure 4 is a monthly chart of the AMEX Airline Index (symbol: $XAL.X) with the "next big thing" indicator in the lower panel. I have highlighted the airlines sector several times over the past 3 months, and a monthly close below the pivot point at 16.08 would be bearish. Until that happens, this looks like a bottom.

Figure 4 $XAL.X/ monthly

Healthcare Information

Figure 5 is a monthly chart of the Healthcare Information sector; this data comes from the Morningstar Industry Groups. Back in April, I had noted the significant and prolong price consolidation going on, and I stated that this is an "excellent launching pad for a new bull market". Since our highlight in the article, the Healthcare Information is up a little over 20%. Looking at figure 5 we see the sector has "broken out", and the 2000 highs are within easy distance.

Figure 5. Healthcare Information/ monthly

Networking

Figure 6 is a monthly chart of the AMEX Networking Index (symbol: $NWX.X) with the "next big thing" indicator in the lower panel. The indicator indicates the potential for a secular trend change. The Networking Sector is up about 6% since our mention in April. Prices have run into resistance at the 200 level and at the two pivot lows identified by the blue arrows on the graph. Nonetheless, the price action has been bullish. A monthly close above the simple 10 month moving average and above the down sloping trend line are bullish. Prices have been consolidating for two months now, which is a positive. A monthly close above the 200 level would likely catapult prices to 240 and possibly 300.

Figure 6. $NWX.X/ monthly

Our group of 6 still has the potential to provide market leadership if and when the next rally phase begins.

7 Reasons To Expect A Short Term Bounce

I can think of at least 7 reasons why the equity markets may bounce over the short term.

1) End of the month mark-ups.

2) End of the quarter mark ups.

3) Coming into the July 4th holiday and trading will be light, so it should be easy to push the markets around.

4) The markets are oversold. Figure 1 is a daily chart of the S&P Depository Receipts (symbol: SPY) with the McClellan Oscillator in the lower panel. The McClellan Oscillator measures market breadth (in this case the NYSE advancing and declining issues). This is deeply oversold but not to the levels of March, 2009.

Figure 1. McClellan Oscillator

5) Assets in the Rydex leveraged bear funds are now exceeding those in the leveraged and bullish funds, and recent extremes in this ratio have led to moves in the opposite direction of the consensus. See figure 2, a daily chart of the S&P500 (symbol: $INX). So too many bears (red line in graph) relative to bulls (green line) like now has led to short term market up swings; too many bulls relative to bears (like last week) has led to market downdrafts. See this article for the most recent mention of the Rydex leveraged assets.

Figure 2. Rydex Leveraged Assets

6) The 200 day moving average. I cannot forsee any scenario where the market will rollover without a fight at the 200 day moving average. This is the bull's "line in the sand", and the Pavlovian response of traders around this "key" level is what makes a bounce a bounce.

7) While there is always risk ahead of the Fed meeting today, I cannot imagine that they will say or do anything that will harm share prices. In fact, the purpose of most statements from our public officials is to instill market confidence, and I don't see this dynamic changing anytime soon.

From my perspective the ensuing short term bounce is just market noise. This is still not the proper launcing pad for a new, sustainable bull market. However, I am on record of how I would "play" the market if the S&P500 closes the month above its simple 10 month moving average.

Seasonal Factors Likely To Influence Share Prices

As we wind our way into the summer doldrums, much has been written of seasonal factors. "Sell in May and go away" is an often heard refrain, and this bit of market lore suggests market under performance during the summer months and early fall. Like most things market related, there is some truth to this dogma, but of course, there are always exceptions.

So let's design a study that emulates the "sell in May and go away" strategy. But for our purposes, we will "buy" the S&P500 on April 30 and "sell" our position on October 30. This is the opposite of the "sell in May and go away" strategy.

Since 1961, such a strategy actually lost 157 S&P500 points. 31 of your 48 trades were winners. Over this time, buy and hold S&P500 netted 830 S&P500 points. On the surface, market timers who use seasonal factors appear to have it correct. Why be in the market during the next 5 months when you don't make money?

Now let's look at the equity curve from our above strategy where we bought in May and held through October. See figure 1. From 1987 through 1999 and from 2002 through 2007, buying in May and selling in October actually was a pretty good strategy. These two periods alone would have netted about 600 S&P500 points, and such returns, relative to buy and hold, would make many question the validity of the seasonal strategy of selling in May. Of course, the two periods highlighted -where seasonals didn't matter - were part of a bull market.

Figure 1. Equity Curve

So do seasonal factors only work in certain kinds of markets? It appears so. If we buy the S&P500 in May and sell in October only when the 10 month moving average (i.e., equivalent to 200 day moving average) is rising, we get the equity curve shown in figure 2. In this instance, we are buying the seasonally negative period when we are in a bull market (i.e., rising 10 month moving average). Such a strategy yields almost 600 S&P500 points on 42 trades since 1961. The strategy is a bit bipolar in the sense that it works best post 1987.

Figure 2. Equity Curve

Bottom line: with the 10 month moving average still heading down on the S&P500, it would seem that seasonal factors of "sell in May and go away" are likely to have a negative effect on share prices.

Lastly and for the record, let's get it right, and in this case we will "buy" the S&P500 on October 30 and "sell" on April 30. Since 1961, such a strategy generated 975 S&P500 points, which exceeds buy and hold. 74% of the trades were positive and the equity curve for such a strategy is shown in figure 3.

Figure 3. Equity Curve