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!!