Nearing the Moment of Truth

SPX – 1115.71

DJIA – 10,403

“Economics is a powerful tool, a lens for organizing one’s thinking about the complexity  of the world around us… If economics is a science, it is more like biology than physics…The bottom line is we should expect less from economists.”

-Russ Roberts, Economics Professor, George Mason University,                       The Wall Street Journal, February 27, 2010

The stock market incorporates all investor knowledge, hopes and fears regarding the economy and corporate earnings. As reflected in the S&P 500 (SPX), stock prices adjust to discount business conditions for the foreseeable future, typically months ahead. By the time the fundamental data is published, the market’s price action has already taken place. Tracking markets for more than 30 years has convinced me there is little the stock market does not anticipate in advance. Although potential developments are sometimes discounted but don’t unfold, the stock market is second to none in leading the business cycle. The majority of money knows more than any economist.

Perhaps the stock market’s efficiency is similar to what Francis Galton (Charles Darwin’s cousin) discovered at a fair in Victorian England. Galton offered a prize to the person who guessed the closest to the weight of a bull at the fair. According to Peter Bernstein, more than 800 people entered the contest and the average of all the guesses equaled the bull’s weight to the pound.

The key to discerning the market’s wisdom is being able to read the tape correctly. Price and time overbalanced for the SPX in late January, indicating the cyclical bull market high is already in. My plan was to watch the technical characteristics of the subsequent rally for confirmation. So far, I give the rally mediocre marks. Breadth is OK but volume is sub-par. Volume and particularly net volume act as a forecasting barometers, important for an early read on the market’s future direction but not necessarily immediate price changes.

There are a cluster of potentially strong harmonic points in early March for a turn or acceleration and less so in April and May. March 6 marks the anniversary of the SPX’s bear market low but it falls on the weekend. Other factors come into play on March 9, which was the DJIA’s low, so I’ve included that date.

Following an inactive, dull stretch, we’ll want to follow the direction that brings out the volume. The main SPX resistance level I’m watching is 1121.44, the halfway level of the SPX’s bear market. There’s another resistance point above that at 1123.96. Be alert for either a reversal or acceleration on volume through these levels. If the market reverses, overbalance tells us the only that the best has already been discounted. It has no bearing on the pattern or magnitude of the next decline.

Harmonic Preview:

(High Probability SPX Turning Point or Acceleration Days)

March 4*         (Thursday)

March 9           (Tuesday)

March 15         (Monday)

March 24         (Wednesday)

*An asterisk denotes a dynamic SPX price square in time; different factors account for the other dates.

For now the Market Trend Indicator (MTI) is signaling UPTREND. The SPX also rallied above its 50-day moving average yesterday and the 21-day rule confirmed the MTI’s earlier signal. When the SPX trades above its highest high for the past 21 days, it indicates an intermediate-term uptrend is underway. That indication stays in effect until the SPX trades below its low of the previous 21 trading days to indicate downtrend. Net volume is in synch with the uptrend.

NASDAQ net volume was already indicating uptrend with a +51.6 peak figure bettering its (50.7) hurdle rate and its peak reading on last week’s short-term decline was only (23.4). The peak NYSE net volume reading on last week’s short-term decline was only (19.7) and the +23.8 figure as of yesterday surpassed that. To confirm uptrend, it wasn’t necessary for net volume to better an earlier (69.6) hurdle rate, only the preceding short-term figure. Still, these aren’t the sort of peak uptrend readings typically recorded in a powerful bull market.

As for the MTI, it remains on an uptrend indication until one of the three key indices closes below its respective 18% weekly exponential average (roughly the equivalent of a lightly-weighted ten-week moving average but I appreciate that it often signals for action at a point different from more commonly followed moving averages). The SPX’s 18% average is 1096.37 this week and the Dow’s is 10,263. The New York Advance/Decline line is 6,893 net advances above its 18% average.

Industrials and Consumer Discretionary were the best performing sectors through the first two months of 2010, up 3.8% and 2.4% respectively while Telecommunications (off 9.4%) and Utilities (off 6.1%) have been the worst, followed by Basic Materials and Infotech, both off 4.6%. As for the leveraged dogs that led most of advance from the start of the bull market, they may have been saved from the pound but they’re still mutts you don’t want to hang with them when the trend changes.

Airlines, Mortgage Finance, Automobiles (Ford up six-fold), Recreational Products and Home Construction are the top five groups as measured by the relative strength weightings I monitor, and in my opinion, are likely candidates to be among the weakest if and when a change in the primary trend is confirmed. There’s no technical evidence that the best growth companies are assuming leadership through outperformance while holding best in a correction. I think a focus on the broad market is more important than group action at this juncture.

In other markets, the rally in the U.S. Dollar index is stalled but the trend remains up. Note how the 50-day moving average is above the 200-day moving average; technically, that’s indicative of bull market action but the fundamental case is much like being the best horse in a glue factory and I remain wary.

Gold, which generally trades contrary to the dollar, is holding well in my view. Bloomberg reported that Soros Fund Management significantly increased its position in the SPDR Gold Trust (GLD) in the fourth quarter. In Davos in January, George Soros said, “When interest rates are low we have conditions for asset bubbles to develop, and they are developing at the moment. The ultimate asset bubble is gold.” His comments match my perception that a parabolic rise in gold prices is underway and that the gold bull market is in its third psychological phase where extreme optimism comes into play. For new positions, I would place trailing stop sell orders just below the February 5 low. For longer-held positions, I want to see more strength before raising my recommended stop level under last September’s low ($989.50 2^nd London fix).

Long-term government bond prices popped last week but there’s been little follow through investment buying. I think short-term traders could initiate short positions with little risk (via a tight stop) but for intermediate-term speculators, I want to see my proxy for long-term Treasuries (TLT) trade below its 50-day moving average before adding to short positions. As for the strength in corporate bonds, has the search for yield gone too far given my interpretation of stock market action? Further down the chain, payday lenders are juicing returns with advances on unemployment checks. Perhaps I’ll check in with a couple at the Roth conference in Dana Point later this month.

Here’s another question. Will strategist group think prove correct and do new recovery highs lie ahead for the stock market? Stay tuned; the answer will be revealed in the fullness of time. Tactics, money management and discipline are the key to speculative profits so it’s best to be prepared for either strength, a reversal or continued uncertainty.

Conclusion:

Technical indicators are least effective in inactive, low conviction markets but harmonics come into play this week and next and my eyes are peeled for a reversal. It’s positive for the market if the SPX can rally back into the upper half of its bear market range and negative if it can’t. In bad markets, monthly highs generally occur early in the month while lows come later; that’s the nature of declines.

I recommend raising trailing stop sell orders on long positions from under the February 8 lows (SPX-1056.61) to a point under the February 25 low (SPX-1086.02). When the trend reverses, I think the best short candidates will be ETFs tied to small cap indexes. Inverse ETFs include ProShares Short Russell 2000 (RWM) and for more leverage, ProShares UltraShort Russell 2000 (TWM).

For investors, I would raise cash reserves when the MTI signals downtrend. The signal for more serious selling comes with a lag when each of the three indices in the MTI close below their respective 5% weekly exponential averages, roughly the equivalent of a 40-week moving average. For traders, speculators and investors alike, be sure to read the Berkshire Hathaway shareholder letter (www.berkshirehathaway.com).

The information contained herein is based on sources that William Gibson deems to be reliable but is neither all-inclusive nor guaranteed for accuracy by Mr. Gibson and may be incomplete or condensed. The information and its opinions are subject to change without notice and are for general information only. Past performance is not a guide or guarantee of future performance. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without consent from William Gibson.