Initial Sell Signal In - Confirmation Is Likely
In last weekend's newsletter we wrote,"The good news is that the market is currently hovering just above support at 1360 with further support at 1350 just below it. This has been the case for the bulk of the current correction and consolidation process. The bad news is that the market has now issued an initial 'sell' signal as of Friday’s close which brings our level of alert up sharply.
It is rare that our initial weekly sell signal does not give way to a confirmed sell signal – it can happen, it just does not happen often, so we need to pay attention. The market is currently playing out very similar to 2010 and 2011. Whether that continues is not important - however, with Fed support ending in June and economic numbers weakening the environment is not currently supportive of higher stock prices."
Tuesday's correction actually broke the 1350 support level intra-day but recovered towards the end of the day and closed back above the 1360 level at 1363. One of the short term effects of the selling over the past few days is that the market is oversold on a very short term basis while holding key support levels. More importantly the intermediate term overbought condition continues to resolve itself. This is very important for a better risk / reward entry point for longer term investors.
The chart above shows our portfolio management signals as they are currently standing. The initial sell signal that kicked off last week acts an early warning indicator for investors. This signal is an alert that the current correction is substantially more than just a minor pullback in a continuing uptrend. If you review the buy and sell signals in the chart above you will see the importance of this indicator for investors. The confirming SELL signal, bottom indicator, will most likely cross within in the next couple of weeks particularly if the markets continue in this corrective consolidation process.
The purpose of this model, which we update in each week's newsletter, is to assist individual investors with some measure of portfolio risk management. The signals are simply a measure of the psychology of the current market. Regardless of the mainstream media's bias that you should always be invested in stocks on a buy and hold basis - all active portfolio managers and investors have measures to manage portfolio risk. I,n the chart above you can clearly discern that during the last correctionary cycle in the summer of 2011 that the market declined, and ultimately held major support, after two major sell signals were issued. In April of that year we issued instructions in our weekly missive to reduce equity, or risk, exposure and increase bonds and cash. This advice greatly benefited investors during the summer decline. When the initial buy signal was issued in October of 2011 we recommended cautiously increasing exposure back into equities. The rally that started in October, failed in November, and it was not until December, as the market broke above important resistance, that the confirming "buy" signal was issued giving investors the lowest risk entry back into the equity markets.
What is important to understand with these signals is that they are designed to move somewhat slowly in order to reduce portfolio turnover. For many investors whose primary investments are in 401k plans there are trading restrictions which limit turnover. For most others who work for a living - they need a manageable model for controlling their investments. This model is not intended for those who enjoy sitting in front of trading screens all day long. With that context in mind - the purpose of the model is to capture 80% of the advances and only 20% of the declines over the long run. If that goal is accomplished an investor will outperform an all equity index over time. Using a risk management tool to manage portfolios like a rheostat, rather than a light switch, to increase or decrease exposure to risk based assets during market advance or declines can reduce investment risk and increase returns over time.
The second chart shows the compression that is currently occurring between the previous broken uptrend (green dashed line) and the support lines at 1360 which converges with the current uptrend (purple dashed line). This cluster of support has proved to be very strong so far. Our inclination at this time, due to deterioration in market internals, is that this level will not hold. Furthermore, with the events unfolding in Europe there is likely to be a flight to safety in the near term [read: out of equities and into bonds.]
What To Be Doing Now
Currently, the markets are oversold on a short term, or daily, basis and we will likely get a rally on Wednesday or Thursday of this week. That rally, which could take the markets to the peak of the "Apple Earnings" related rise to 1400 on the S&P Index, should be sold into. However, this DOES NOT mean selling everything and running into cash. As stated previously we only have an initial warning signal that something in the market environment is changing. Therefore, we need to take moderate, not extreme, actions during the next rally. Those actions are listed as follows:
- Liquidate weak and underperforming positions
- Rebalance winning positions by taking profits and resizing positions back to original weights.
- The cash raised should be stored in safe and highly liquid positions for the next buying opportunity when it comes.
This correction process, which is playing out very much like last summer, could last from 4-12 weeks depending on many variables. However, we do NOT necessarily need lower prices in the equity markets in order to have the next lower risk entry point. The only thing that we are looking for, as investors and money managers, is the reduction of investment risk so that invested capital has the highest potential risk/reward profile. A larger price correction in the markets or the continued sideways consolidation process will achieve the same goal of working off the extreme overbought conditions that developed during the January through March rally.
There are many risks currently prevalent in the market from the resurgence of the Eurozone crisis or weakening domestic economics. However, it is the psychology of market participants that ultimately drive prices higher and lower as they respond to the external stimuli of economic, fundamental or political landscape. The outcome is that unless something changes in very short order we will get a confirmed sell signal in the weeks ahead and will be required to take further action. The one aspect that can not currently be accounted for, which could quickly reverse this analysis, is the introduction of additional stimulative programs by the Fed. While I currently have little doubt that we will see further easing programs - I do not think that they will come about until we see further economic weakness and a more substantial market decline which would give the Fed the "permission" it needs to take action.
When that happens - it will be time to start buying again, however, in order to "buy" something you need to have cash available to buy with. Remember, getting back to "even" is not an investment strategy in the long run.