Since We’re Still Waiting…

Daily State of the Markets
Wednesday, January 16, 2013

Good morning. Since the S&P 500 has managed to close at almost the exact same spot for the last four days running, I think it is safe to say that the thesis presented in yesterday’s missive was on target. In my humble opinion, traders are currently waiting on the next theme to develop. And my guess is that the next theme is likely to come from either the earnings parade (which FINALLY starts to roll this morning) or the state of the budget/debt ceiling debate. But in any event, it is clear that the market is waiting on something, which leaves us time to discuss a little investing strategy this morning.

As long-time readers know, I consider myself a “market environmentalist.” In short, this means that I focus on the overall market environment. While I use charts extensively (who doesn’t in this day and age?), I’m not a pure chartist. While I believe in using dozens of technical indicators each day, I’m definitely not a pure technician (technical analysis is great when it works, but like anything else in this game, nothing works all the time). And although I do pay attention to earnings reports, valuations, monetary policy, and the economic data, I’m also not a pure fundamentalist. No, I like to combine all of the above in order to help me stay in tune with the market environment.

As I’ve mentioned a time or two hundred, I believe in trying to stay on the right side of the big moves. To be sure, this isn’t sexy as we don’t make predictions and we don’t even try to “call” the tops and bottoms of moves. But history has taught me that if you can consistently get the majority of the really big moves right, you’ll do just fine.

So, how does one stay in tune with the market environment, you ask? There are any number of approaches, but I prefer to employ modeling. The idea is to lump together a bunch of your favorite indicators that have proved successful over time in terms of getting the market environment right and then look at the “weight of the evidence.” Obviously the mix of indicators is vital and you do have to know what you are looking to accomplish with your models, levels, signals, etc. However, from a big-picture standpoint, this approach provides me with a “guide” to the market environment.

So, whenever the markets aren’t doing much or I don’t have much to say, I’ve decided that I will spend my pixels reviewing an indicator that is included in my Market Environment Model. I’m going to call this section of the report “In Focus” as I’ll take a close look at one of our main indicators. And this morning I thought we would spend a couple minutes reviewing what I call our TBC Indicators.

In Focus: The TBC Indicator

TBC stands for “trend and breadth confirmation.” The idea is simple. If the trend of a market index is confirmed by a similar trend in the Advance-Decline Line (i.e. market breadth), the returns in the market are FAR superior to the times when trend and breadth are diverging.

For example, over the past 15 years when our stock-only multi-cap equity index is above its 45-day moving average AND the Advance-Decline Line of that index is also above its 45-day ma, the market index has gained ground at a rate of +18.3% per year. And when both indices are below their respective moving averages, stocks have lost ground at a rate of -2.7% per year. And then when the trend and breadth indicators diverge (one above the ma and one below) then the index gained ground at a subpar rate of +6.2% year.

For me, this is a pretty darn good indication of the “state of the tape.” And since the indicator has clear-cut positive, negative and neutral readings, it functions well in our Market Environment Model. But, is this a perfect timing signal to buy and sell? Frankly, no. However, it does give us a very good indication of when the market environment is “in gear.” And because of this the indicator makes it into my “top 10” that comprise our Market Environment Model.

If you want to take this idea up a notch (or three), you can increase the effectiveness of the indicator. By replacing the 45-day moving average with a 25-day on the price index and then replace the 45-day ma on the A-D Line with a 5-day, the returns are much more robust. For example, if both price and breadth are above the MA’s then the stock index gains ground at a rate of +34.5% per year. And when both are below, stocks lose ground at a rate of -25.5% per year. Not bad, eh?

The only drawback to this approach is that since you are using a 5-day ma on the A-D Line, the neutral zone (one above the ma and one below) is less effective. In fact, the market gains at a rate of +12.7% per year in the neutral zone, which is actually higher than the average rate of return for the buy-and-hope approach to the market itself. As such, the neutral zone is not nearly as useful in my model. So, while I do watch this indicator each day, this “faster” version isn’t actually in my market environment model at the present time.

Currently, both of my TBC indicators are positive. This tells me that the “state of the tape” isn’t too shabby right now and that we should continue to give the bulls the benefit of any doubt. Well, for now at least.

Turning to this morning… After a stellar run of late, Japan’s stock market was hit hard overnight and the rest of the Asian markets followed suit. Adding to the mood in the overnight activity was the World Bank report that cut global growth expectations for both 2013 and 2014. Here in the States, JPMorgan Chase is trading lower as revenues came in light while Goldman Sachs crushed their report and is trading higher. As such, there does not appear to be a compelling “theme” from earnings yet. But futures are pointing to a lower open at this time.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell…

Major Foreign Markets:
– Shanghai: -0.70%
– Hong Kong: -0.10%
– Japan: -2.60%
– France: -0.33%
– Germany: -0.32%
– Italy: -1.47%
– Spain: -0.59%
– London: -0.61%

Crude Oil Futures:

+$0.03 to $93.31 !========>!========>