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Trying to predict markets more than a couple of days into the future is nothing more
than a “wild ass guess” at best but, that being said, we can make some reasonable assumptions about potential outcomes based on our extensive analysis of these 6 specific price trend and momentum indicators.
The above introductory comments are edited excerpts from an article* by Lance Roberts (streettalklive.com) entitled Sell Signal Triggered.
The following article is presented courtesy of Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.
Roberts goes on to say in further edited excerpts:
I rely heavily on price trend and momentum because it tells you what investors are doing versus what you “hope” will happen [and] it is from this basis that I developed…[the following] 4 signals to drive portfolio allocation models…based on weekly data to smooth out portfolio volatility and position turnover.
Alert Signal – Pay attention
Sell Signal 1– Reduce equity allocation by 25%
Sell Signal 2– Reduce equity allocation by 25%
Sell Signal 3– Reduce equity allocation by 25%
- Ride the Market Waves With These 6 Momentum Indicators
- Yes, You Can Time the Market – Use These Trend Indicators
If all of the sell signals were in place it would only reduce the allocation to equities in portfolios by 75% in total [and, truth be known,] I would most likely never recommend going below that level of exposure. [Why? Because] fully exiting the markets leads to emotional biases that make it extremely difficult to re-enter markets near bottoms. By always maintaining a small piece of exposure to equities in portfolios, it is easier to add to existing positions when the sell signals above begin to reverse back to buy signals.
A history of the S&P 500 & relevant “initial sell signals”
The chart below shows the history of the market and the relevant “initial sell signals.”
(The selloff in the market over the last couple of weeks was sharp enough to trigger both sell signal #1 and #2.)
Our portfolio allocation model
The portfolio allocation model, the same as we use for the 401k plan manager below, shows how the migration works to reduce overall portfolio risk and conserve investment capital.
The current “sell” signal does not mean “panic sell” everything you own in your portfolio and run to cash. As shown in the chart above, these initial sell signals can be short lived particularly when the Federal Reserve is still intervening in the markets.
Furthermore, by the time a WEEKLY sell signal is issued the markets are generally OVERSOLD on a short term basis. It is very likely, that a rally will ensue in the markets over the next week back to resistance which could be used to re-balance portfolios and reduce risk more prudently.
The chart below is a daily chart of the S&P 500 going back to the beginning of year.
There are several very important things to note.
- ALL indicators are currently “oversold” on a short term basis. This oversold condition provides the “fuel” necessary for a stock rebound such as was seen at the end of last week.
- The short term moving average (red dotted line) has now crossed below the longer duration moving average which now creates strong resistance at 1940. Any rally back towards 1960 next week should be used to re-balance portfolios. (I will provide guidelines below for this exercise.)
- The current correction is very similar in nature to what was seen in February of this year. The main difference between that correction and now is the continued extraction of the Federal Reserve from the markets. Less liquidity suggests that the easiest direction for prices in the near term is likely lower.
- It will likely require a move in the markets back to “new highs” in order to reverse the current sell signal. While this could happen, it is likely that with the Federal Reserve extracting liquidity from the markets – the highs for the markets this year have already been seen.
It is very likely that the recent sell-off has reached a short term bottom. A rally back to the moving averages is very likely. A failure at those levels will be very important.
How Big Could a Longer Term Correction Be?
[To arrive at an answer to that question below are a number of analyses of the market:]1. A simple trend-line analysis
The first chart is a simple trend-line analysis of the weekly S&P 500 index.
As shown, the bull market trend that began in 2009 remains currently intact (dashed blue line).
- A correction from current levels back to the bull market uptrend line, which occurred in both 2011 and 2012, would entail a decline to 1700. That would be a 14.6% decline from the recent intra-week market peak. While not technically a “bear” market, for many investors it will certainly “feel” like one.
- However, in December of 2012, Ben Bernanke launched the latest round of monetary stimulus at a whopping $85 billion dollars a month. At that point, the markets elevated away from the previous bullish trend to establish a new trend (black dashed line). At the current time the intersection of that elevated bullish trend, which has repeatedly acted as support for the markets since the end of 2012, is at 1900. There is also some more minor support just below at 1850.
2. A Volatility (VIX) Index Analysis
Currently, there seems to be nothing on the horizon to intensify the current “pullback” into a selling “panic.” Geopolitical events, weak underlying economic data, and extremely stretched market valuations have posed no immediate threat to the markets. This is clearly shown in the 6-month average of the Volatility (VIX) Index (a 6-month average is used to smooth the volatility of the volatility index.)
The 6-month average of the VIX is currently at the lowest levels of this century. Understand that it is NOT the decline in the VIX that is important, but rather the point at which the 6-month average turns higher. If you look at the chart you will see that 6-month average of the VIX turned, and begin to trend higher, just prior to the peaks of the market in 2000 and 2007. The same occurred in 2011 and 2012.
Currently, the 6-month average of the VIX is still trending lower which suggests that the current correction, at this point, is just a pullback within the current uptrend. However, as you can see above, that can change very rapidly.
Should volatility begin to accelerate, this would be coincident with a much larger correction that would bring into focus the 2009 bullish trend line, as shown in the chart above.
3. A “Fibonacci Retracement” analysis
Another way to look at potential corrections is to use a “Fibonacci Retracement” analysis as shown in the chart below. As defined by Investopedia:
“The Fibonacci retracement is the potential retracement of a financial asset’s original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.”
As identified in the chart, the 23.6% retracement level basically confirms the 2009 bullish uptrend line around 1700 currently. If the market begins a more serious correction, this level should provide support for a short-term bounce that should be used to “sell” into to decrease equity risk in portfolios. The bounce from this support will most likely fail in short order. The markets will then either:
- retest support at the bullish uptrend/23.6 retracement level and turn higher allowing equity risk to be increased, or
- support will be violated, and the market will likely seek out the 38.2% retracement level at 1490.50. Such a decline would increase the magnitude of the correction to 25.14%. This would officially push the markets into “official” bear market territory.
While it is entirely possible, it is unlikely that (2) will happen outside of the onset of a recession. When the eventual “recession” does return to the economy, it is very likely that the markets could test the lower Fibonacci bands of 50% and 61.8% retracement levels.
4. A “2-standard deviation” analysis
The chart below, providing a “2-standard deviation” analysis of the weekly chart of the S&P 500…[shows that] it is unusual for the markets to consistently push 2-standard deviations above the 50-week moving average for a long period without a correction back to it. A correction back to the 50-week moving average at this point would entail a decline to 1829.31, a 8.12% decline from the recent peak.
Importantly, a decline to 2-standard deviations below the 50-week moving average would converge at the 1700 level, which as discussed above, is also home to the 2009 bullish trend line and the 23.6% retracement level.
5. A “relative strength” analysis
The lower part of the chart above is the “relative strength” index (RSI). This index has turned lower as of late with the recent correction and is currently posting a reading of 60. Levels of 80 represent “overbought” markets and levels below 40 represent periods of being “oversold.”
I have notated (vertical red lines) points at which the RSI had peaked and turned lower. Historically, the RSI tends to oscillate between 80 and 40 on the index. However, since the beginning of the latest round of Quantitative Easing (QE) by the Federal Reserve, the range has remained between 80 and 60.
6. An analysis of the market relative to the Williams %R indicator
The same anomaly is shown in the next chart which is an analysis of the market relative to the Williams %R indicator.
The Williams %R indicator, like RSI, is a representative of “overbought/oversold” conditions in the market by measuring changes in the momentum of prices over a specific period of time. From the beginning of 2009 to the end of 2012 (highlighted in gold), the index oscillated between levels of -20 or less, “overbought,” to -80 or greater,” oversold.” However, beginning in 2013 the oscillation has remained tightly constrained between ZERO and -30. This is unsustainable longer term and a break below the -30 level on the Williams %R will likely indicate a more severe deterioration in the markets.
Some reasonable assumptions about potential outcomes of a market correction
There is no exact answer to the potential magnitude of a correction in the markets. “This” depends on “that” to occur which is why trying to predict markets more than a couple of days into the future is nothing more than a “wild ass guess” at best.
However, from this analysis, as shown in the table below, we can make some reasonable assumptions about potential outcomes.
Currently, there is a convergence of points between 1650 and 1700 on the index that will present rather important levels of support for the market currently. Not only would a correction to such levels be a “healthy” event in order for the current “bull market” cycle to continue, it would also likely present a fairly decent opportunity to increase equity exposure in portfolios.
As I noted above, a correction of 14-16% is far outside of the expectations of the market currently. Such an event will likely “feel” much worse to individuals that have inadvertently taken on excessive risk in their portfolios by “chasing” markets and “yield.”
However, while I show that the greater levels of a potential correction will likely be coincident with a recession, as they have historically been, it does NOT mean that a recession is required. A sharp rise in interest rates or inflation, a downturn in economic growth, deflationary pressures from the Eurozone, or a credit related issue in the “junk bond” market could all do the trick.
Conclusion
No one will know, until in hindsight, what the catalyst will be that ignites a “panic” in the market. This is why we do analysis to understand the potential risks in the market as compared to expected reward. What is abundantly clear is that the potential “upside” in the market is currently outweighed by the “downside” risk. It is important to remember that our job as investors is to “sell high” and “buy low.” Unfortunately, for most, it is exactly the opposite.
There is one important truth that is indisputable, irrefutable, and absolutely undeniable: “mean reversions” are the only constant in the financial markets over time. The problem is that the next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years. Hopefully, this won’t be you.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://streettalklive.com/index.php/newsletter/current-issue.html?cat=x-factor-report#sell_signal_triggered
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