Market Rally: Oversold Bounce In Downtrend
A couple of weeks ago I discussed that on a longer term basis (weekly data) that the market had thrown off an initial "sell" signal. I stated then that:
"...in last weekend's newsletter this initial 'Sell Signal' is a warning that a further correction is likely to come. This is a wake up call to pay attention to your portfolio. However, this is not a signal to 'panic sell' and make emotional based investment mistakes."
However, since these signals are working on slower moving weekly data, by the time a signal is issued the market is generally getting very oversold on a short term basis and is due for a bounce. As I stated in this past weekend's newsletter:
"The good news is that the market rallied off of some very minor support last week after getting oversold on a daily basis as shown in the chart [below].
However, the bad news is that, on a daily basis (which is very short term and more for traders rather than investors), the market has registered all three critical short term 'SELL' signals with the short term moving average cross below the long term moving average. This suggests that the most likely trend of prices in the short term – is lower.
Furthermore, though the market did rally last week it failed to break above resistance at the downward trending short term moving average (blue dashed line.)
The market is still oversold, although less so, on a short term basis which could provide fuel for a continued rally in stocks next week. However, as we will discuss in a moment, the current downward trend is still intact and any advance above the short term moving average will be met by the longer term moving average, which is also now trending lower, at 1630."
I have updated the chart from this past weekend to include the rally on the first trading day of July.
On a short term basis the market was able to break above the short term moving average and is now likely going to test the longer term moving average at 1630. However, the markets are still confined within a negative downtrend channel so traders should remain more cautious about adding exposure currently. However, there is also no indication to drastically reduce exposure at this point either.
If the market is able to break out of the current negative trend above 1640 then the market will make an advance towards the previous highs.
With the Fed still fully engaged in their bond buying program (no tapering on the schedule as of yet as $45 billion in bonds is slated to be bought in July) the liquidity injections are likely to push the markets higher short term.
It will take a sustained move higher to reverse the weekly "initial sell signal" that are currently in play as discussed previously. Much of the sustainability of the current advance will come from continued improvement in the economic landscape. While there has been some improvement in the macro-economic backdrop in recent days - there is little evidence that such improvements are anything other than bounces within negative data trends. For example, take a look at the most recent release of the ISM Manufacturing data which showed an increase from 49.0 in May to 50.9 in June.
However, when smoothing the data with a 6-month average we find that manufacturing activity peaked in early 2011 along with real economic growth. The problem is that the markets are extrapolating bounces in economic data as the beginning of the long expected recovery. However, actual economic growth continues to muddle along at less than 2%.
Even with the ongoing liquidity push from the bond buying programs, the markets, and in particular valuations, are tied to long term corporate profitability and economic growth. The eventual reversion of prices to underlying fundamental realities is inevitable. With the debt ceiling/budget debate rapidly approaching, China showing increases signs of economic stress and the Euro-zone trapped in an ongoing recession there are plenty of risks to market participants in the short term.
The technical indicators are currently sending up warnings that should be paid attention to. In the past these warnings have generally kept investors out of more severe trouble. When these signals turn back to positive, and issue an "all clear" signal, it will provide a more risk adverse entry point for equities.
For longer term investors, it is important to remember that we are very late in the current economic expansion. As I stated last week in "Investors Continue To Make The Same Mistakes:"
"The biggest problem currently is that there is virtually no expectation, or analysis that incorporates the impact, of an average economic recession ever occurring again.
What is important for investors is an understanding that, despite claims to the contrary, a recession will occur in the future. It is simply a function of time. These recessionary drags inflict lasting damage to investment portfolios over time. The table above shows the start and finish dates, prior peak, and peak to trough price declines during previous recessionary periods. The average draw down for all recessionary periods was 30.76% with an average recovery period of 43 months. For someone close to, or in retirement, this can be devastating."
Has the correction that begin in June run its course or is there is more to come? The next two weeks should answer that question.