The question that I have been asked more today than almost any other time in the past month has been “Is This The Time To Start Buying Back In?”. With the recent rally off of very oversold conditions in July and August, a reflex rally has been in the offing. Also, with this being the end of the month, we are seeing portfolio window dressing for mutual funds.
However, a brief review of our technical indicators is in order to determine where we are in this current market environment and what the potential “risk” versus “reward” of being fully invested currently is.
Back on April 25th of this year we stated that: “Our proprietary risk metric is beginning to throw off a warning signal which comes just as the markets are about to enter their seasonally weakest 6 months of the year. The risk ratio indicator is a weighted average for bullish to bearish sentiment, the volatility index, the rate of change for the S&P 500, and the new highs/new low ratio of the NYSE. This weighted average is then smoothed with an 8 week rolling average to eliminate a lot of the noise. While most analysts look at these indicators individually, we combine, weight and smooth them to provide a more global look at market psychology and sentiment. Currently, that outlook is very bullish which, as a contrarian investment manager, this is a time to begin raising cash and hedging risk in portfolios.”
Raising cash and fixed income levels back in April has played very well for us during this summer’s “Market Madness”. As you can see above the indicator is now moving into the extremely bearish territory which certainly perks up our antenna that an better buying opportunity is soon approaching. With all the psychological indicators that are measuring market emotions – “the markets can remain irrational longer than you can remain solvent”, which is why we always combine our psychological “fear” guage with more standardized technical indicators in order to “confirm” turns in the market.
As asset managers for mostly retired individuals it is not our job to catch the exact bottom or top in the market. Our job is to manage risk in the specific portfolio allocations and to minimize losses while capturing gains during volatile markets. Therefore, we look at weekly charts and indicators to strip out the daily “noise” from price volatility to better determine when and by how much to adjust portfolio market exposure. As you can see in our weekly chart the markets are continuing to trace out a very similar patter that we saw during the last topping process in 2007-2008.
While I am not saying that we are about to enter into the great financial crisis, I am pointing out that the markets are currently exhibiting very similar behavior that should be paid attention to. The current rally that started in March of 2009 ended in June. The completion of the topping process is identified by the break of both the previous uptrend (purple dashed line) and the break of the neckline (blue dashed line). The market proceeded during the summer to become VERY oversold by exceeding a level of 2-standard deviations of the 50-week mean. This is no small feat. We accurately predicted in our weekly newsletter (pg 15) at the beginning of June that this could possibly occur as federal stimulus in the form of QE 2 came to an end. As you can see in the weekly chart the most logical point of this advance in the next couple of weeks will be the old neckline as well as the 50-week mean.
This should theoretically be the extent of this reflex bounce in the short term as the daily charts will be approaching, or already in, overbought territory.
This is shown at the bottom of the daily chart which is the Relative Strength Index of the market. It is already 3/4ths of the way back to overbought conditions on a daily basis. This is equivalent to driving a car down the freeway and only having a 1/4 tank of gas left.
As the car runs out of gas it should give way to a pullback to some level of support and provide a much better risk based opportunity to re-enter the markets for a potential end of year advance.
Still On A Weekly Sell Signal
So far, none of this takes away from the larger fact that the economy is slowing down, corporate profits are weakening, and there is a lot of risk contained in Europe that could back-splash very rapidly into the U.S. This is clearly a bounce within a negative market trend at the current time and is not a new bull market to chase. With fundamentals of stocks deteriorating along with the economy, we see NO reason to take on excessive speculative risk at the current time. We are most likely witnessing end of the month portfolio rebalancing as the markets head into a long labor day weekend market. The light volume rally also does not invoke confidence in a continued push higher.
This analysis is all in advance of QE 3, which could certainly change the complexion of the market and the analysis. However, that will also clearly show up in our signals and we will adjust accordingly. It is ALWAYS better to wait for the signal to change rather than trying to anticipate the change…many people have been hit by buses trying to jump the light. Therefore, we don’t recommend chasing this rally until signals clearly provide a better opportunity.
Our primary buy/sell indicator is still firmly in SELL territory which automatically reduces equity exposure by 50% from normal allocations and increases fixed income holdings and cash. Until this indicator turns back to positive we will remain underweight in our models in equity and simply use the shorter term signals as noted above as trading opportunities to create additional alpha until such time as the risk/reward ratio is clearly aligned back in our favor.
Have a great Labor Day weekend.