Asset Allocation Road Map: US Equities

Before getting to my outlook for US equities, I feel that I first must explain why my methodology did not anticipate this monstrous move off the March, 2009 bottom.

In short, the explanation is that I don't have an explanation. Now I could consider this a failure of my methodology or the tools that I use to navigate the markets, but I don't. To understand why I feel this way, I will take you on a quick review of the past 6 months.

On March, 2009, I wrote the following:

"So here we are with the "smart money" bullish and the "dumb money" bearish. Beautiful! According to the back testing process, the optimal time to buy would be after this Friday's close.

Lastly, if equities do rally, I believe this will be a counter trend rally within an ongoing bear market. This will not be "the bottom", and it is my belief that "the bottom" will take time (i.e., many more months) to develop."

I was in at the bottom, but little did I know at the time that the S&P500 would embark on a 50% rally! As many of you may remember, I kept saying that this was a bear market rally and that this was not the launching pad for a new bull market. Now after a 50% rally in the S&P500, the best I can do is state that this is a cyclical bull run in an ongoing secular bear. I will be right, but once again, I did not anticipate the last 20% of this rally.

I was basing my observations on the fact that the "next big thing" indicator, which is a tool that I use to identify those technical conditions seen at market bottoms prior to secular trend changes, had not gotten into the correct position, and it would be unlikely to do so for a long while. Furthermore, a strong snapback rally was expected as sentiment had gotten very bearish (i.e., bull signal), and prices were very oversold by all known metrics, but bear markets rarely end in a "V" shaped bounce. Typically, there is a basing period before secular trends reverse.

Towards the end of April, I was tightening up stops and looking to sell strength. Bear market rallies generally move a certain period of time (weeks on x axis) and distance (percent gains on y axis), and this one did not appear any different. So you get out while the getting is good. The market did not rollover and in fact, the S&P500 traded higher than I had expected, which was based upon similar situations in the past. Maybe this was a sign: when the market doesn't behave as you expect, you should take notice.

Although my "call" to sell strength at the end of April wasn't looking good in the first parts of May, by the early parts of July, the S&P500 was actually trading back at the levels seen on May 1. My "call" was looking a lot better as the S&P500 hadn't gone anywhere for 10 weeks. Yes, the S&P500 had managed to get over the falling simple 10 month moving average by the end of June, but even this positive sign was looking like a failed signal. As we all know, the market took off from this point as the "this time is different" scenario unfolded. Like all good rallies, it started with short covering and has gone on further than most anticipated. What was looking like an extraordinary bear market rally that was rolling over in early July - or maybe just a normal bounce back given how far prices were oversold- turned into a bullish stampede and trampling of the bears as the S&P500 moved 18% higher over the last 7 weeks.

So that brings us to today. Our bear market rally has turned into something more, and one of the key tools that I use to navigate the markets (i.e., the "next big thing" indicator) appears to have failed to identify this important turn for the better in the markets. Or has it?

I say "appears" because I still could be correct; in this environment, we could just as easily find ourselves at new lows or new yearly highs within 6 months time. Either way, I would not be surprised. I say "appears" because the indicator did work well in identifying several key sectors and the Russell 2000 index that have been market leaders over the past 6 months. So I am not ready to throw the "next big thing" indicator in the junk pile, and in fact, I still think it has great validity that is supported by the data across multiple market eras and many different asset classes.

So what went wrong? Honestly, I am not sure. The idea behind the "next big thing" indicator is that it assesses not only how far prices have dropped but how long investors have been underwater. We are looking at the y axis as much as the x axis. The price drop in the S&P500 was rather significant yet it occurred over a relatively short time period. The time component really has not been there, and that still leaves the notion on the table that this very "V" shaped rally may rollover. In other words, what we are really witnessing is a very strong bear market rally or the indicator was not sensitive enough to pick up the potential for this market move. Be that as it may, what we call it or how we react are really two different things.

So what do I see for equities going forward? On a purely price basis alone, the equity markets have bottomed. Now that may sound like a stupid statement after a 50% move, but the price evidence is there to suggest that March, 2009 was an important market bottom. What is the evidence? If we look at figure 1, which is a weekly price chart of the S&P500, we note the blue up arrows. It was at this point that we had a weekly close over 3 pivot low points, and looking at over 50 years of S&P500 data, this kind of price action has tended to define bear market bottoms leading to secular trend changes. Conversely, a close below 3 pivots (like we have seen in the Dollar Index) is another good measure of a market top.

Figure 1. S&P500/ weekly

In any case, even within the confines of a bull market, the price cycle -or that cycle of fear and greed that the "Dumb Money" indicator attempts to quantify - will exert itself. Although I don't know when, I am pretty sure at some point in the future that there will be a buying opportunity where investors turn bearish (i.e., bull signal). If following that signal the markets do not achieve new highs for this price cycle or trade below the levels seen at the time of the signal, then there is a high likelihood of prices trading much lower.

Think about it this way: with the S&P500 so far above its 200 day moving average, it is unlikely that the market will rollover without this key metric being defended. We will get a sell off, sentiment should turn bearish (i.e., bull signal), and we will get a bounce. The nature of that multi -week bounce will be the tell.

The bigger question remains and it is the question we can only answer with the passage of time: Will the events of the past 6 months be seen as a new secular bull market or a cyclical bull market within an ongoing secular bear market?

In sum, March, 2009 was an important bottom for equities that was not expected by my methodology. The nature of the price action and the extent of the rally would suggest a prolong period of time before the market rolls over. This is not meant to be a prediction that the market will roll over, but to suggest that the markets will need to go though the normal price cycle, which is dictated by fear and greed, before rolling over. This will take time to manifest itself.

In the next installment of this series, I will discuss why I like commodities over equities and Treasury bonds.