Over the past three weeks, the equity markets have improved their positions and most technical indicators are positive again. The big question is whether or not this advance will continue or stall.

While there are still lots of negative economic fundamentals, recent days have also provided some positive reports. For example, the Labor Department Thursday reported that initial claims for unemployment insurance fell by 29,000 to a seasonally adjusted 469,000. While it is still a dismal number, at least it moved in the right direction this week. Also, the Commerce Department reported that retail sales rose in February by the largest amount since November 2007. Last week’s blog explained why the role of consumer spending is so important to economic recovery.

The chart below shows the performance of the S&P 500 Index over the past year. The gold line is a 50-day simple moving average (MA) of the index. The most recent correction sent the S&P 500 below the MA in mid-January. Over the past week, the index made a tentative move back above its MA.

One of the most basic indicators of an investment’s strength and momentum is whether it can trend above its 50-day MA. For most of the past year, the S&P 500 was easily able to do that. Right now it is barely above that mark. If it can move decisively above over the next week or two that should be viewed as a positive sign that the index can challenge its December 2009 highs.

The middle portion of the chart is a moving average convergence divergence (MACD). It turned upward a couple of weeks ago and is now right at the zero mark. The recent momentum is clearly upward. The slope of the MACD on this upward move is not nearly as steep as the moves we saw in March 2009 and July 2009. It is more comparable to the move of November 2009. That move produced several weeks of sideways consolidation before the S&P gained ground in December. It would not be surprising to see some consolidation at the current juncture.

The bottom portion of the chart is a stochastic oscillator. It is currently above 80 and rolling over. That is an overbought level and would normally indicate that some consolidation or correction is likely to follow.

The next few weeks are going to be important in helping us understand the near-term nature of major stock indices. If the indices can exceed their 2009 highs, then the bull rally of 2009 is likely to gain strength and continue moving upward. If the rally falters and the old high is not broken, then stocks could begin another bear phase.
F.S.

Early this week the market dipped sharply after The Conference Board said its consumer confidence index fell to 46 in February from 56.5 in January. Economists polled by Thomson Reuters before the release expected a reading of 55.

Investors regularly hear about reports on consumer spending, consumer confidence or consumer sentiment. The reason these numbers are closely watched by Wall Street and by business and government leaders is that consumer spending is the dominant driver of our economy.

A recent USA Today article noted that according to data from the U.S. Bureau of Economic Analysis, consumer spending accounts for 71% of U.S. Gross Domestic Product (GDP).  In simple terms, that means that the best way to keep the economy out of recession is to keep consumers buying goods.

So the latest report that consumer confidence is falling is a pretty big deal. A consumer confidence index reading of 90 or above would show that the economy is on solid ground. A reading of 46 is a significant cause for concern.

The private organization that conducts the survey—The Conference Board—has provided information and analysis about management and the marketplace for more than 90 years. The Consumer Confidence Survey® is based on a representative sample of 5,000 U.S. households.

In a press release accompanying the February 23 announcement, Lynn Franco, director of The Conference Board Consumer Research Center, said: “Consumer confidence, which had been improving over the past few months, declined sharply in February. Concerns about current business conditions and the job market pushed the Present Situation Index down to its lowest level in 27 years (Feb. 1983, 17.5).

“Consumers’ short-term outlook also took a turn for the worse, with fewer consumers anticipating an improvement in business conditions and the job market over the next six months. Consumers also remain extremely pessimistic about their income prospects. This combination of earnings and job anxieties is likely to continue to curb spending.”

There was plenty of additional data reported, but the bottom line is that even though there are statistics and reports showing that the economy is improving, many consumers are still worried about the stability of their jobs and their incomes. In that type of environment, the natural reaction is to try to curtail spending.

In another event Tuesday, former Federal Reserve Chairman Alan Greenspan told attendees at the Credit Union National Association conference that the economic recovery has been extremely unbalanced. According to a Reuters report of the conference, Greenspan called the current crisis “by far the greatest financial crisis, globally, ever” —including the 1930s Great Depression.

The former chairman predicted that unemployment will remain near 9% for a prolonged period. “The reason why the unemployment rate is going to be sticky is that as soon as employment starts picking up, a lot of the people who have not been seeking jobs are going to come back into the labor force, and they will keep the official unemployment rate in the 9 percent area, something like that,” Greenspan said.

I am not providing these gloomy forecasts as a means to frighten investors; rather, I want clients to understand why we continue to believe that market conditions warrant an emphasis on protecting assets from market risk.

For several months we have warned investors that a significant market rally did not make sense, given the weakness of the economic data. Among the areas of the economy that still show unusual weakness, Greenspan cited: small businesses doing badly, small banks in trouble, housing starts and auto sales “dead in the water,” and the aforementioned high unemployment rate.

That certainly doesn’t sound like consumers have much to be cheerful about, so perhaps the drop in consumer confidence should not have come as such a surprise. Until that situation changes, any market rallies must be viewed as tenuous.
F.S.

As any regular reader of this blog knows, when it comes to trying to forecast what stocks might do, I use charts and technical analysis to help. But in spite of the fact that I rely on technical analysis, I know it has many shortcomings.

As defined by Wikipedia: “Technical analysis is the study of past financial market data, primarily through the use of charts, to forecast price trends and make investment decisions. In its purest form, technical analysis considers only the actual price behavior of the market or instrument, based on the premise that price reflects all relevant factors before an investor becomes aware of them through other channels.”

Technical analysts use a wide range of tools and philosophies. These include everything from moving averages to candlestick charting. Some proponents rely on a single tool or methodology while others combine a number of tools to make investment decisions.

One area of technical analysis in which I have no faith is the attempt to forecast the movements of investment vehicles based on chart patterns. There are many books devoted to the study of chart patterns. Most investors have heard phrases like “double bottom” or “head and shoulders.” These refer to specific types of chart patterns. In my opinion, forecasting market action based on chart patterns is not reliable. Certainly one can find recurring patterns. One can also find recurring cloud formations. But seeing the same fluffy bunny formation three days in a row is not necessarily predictive of anything.

When it comes to charts, I do believe there is some value in identifying areas of support and resistance. Because so many investors and traders watch these levels, I think they often become self-fulfilling.

The main value of charts and the main value of technical analysis, in my opinion, are to identify trends. Isaac Newton’s first law of motion states that “An object in motion will stay in motion and an object at rest will stay at rest unless acted upon by an external force.”

While an investment is not generally considered an object, the price of an investment moves from day to day and that movement can be illustrated on a chart. This law of motion appears to hold true for investments just as it does for physical objects. A trending investment will continue to trend until some circumstance or event changes the direction of that price trend.

In my opinion, long-term trends might be the best indicator available for forecasting market movement. While many traders focus on short-term trends, I like trends that have been in place for at least six months to a year. Longer is better.

Most of the technical tools I rely on–moving averages, MACDs, RSIs, momentum, stochastics, etc.–are all helping me to try to answer a single question: Is the trend intact? As long as a long-term trend has not been violated, I can hold through some corrective action without much worry. When a long-term trend breaks down, it is can be a signal that the underlying instrument is going to be in serious trouble for some time.

In addition to technical tools, I also consider cyclical tools and fundamental analysis when making investment decisions. Once again, these elements primarily help me determine whether or not a trend is likely to remain in place.

Unfortunately at present, these tools are not providing a definitive picture of the market trend. As an example, look at the chart below of the New York Stock Exchange composite (NYSE) over the past three years.

I have added two moving averages (MA) to this chart. The blue line is a 200-day MA and the gold line is a 100-day MA. I use the 200-day MA quite a bit. It seems to be fairly reliable at identifying major market trend changes. Because it is using a shorter term, the 100-day MA is more subject to whipsaws when used as a trading tool.

As the chart shows, the NYSE crossed above its 200-day MA in June 2009. Normally that would be an indication that it might be time to begin investing back into the market. But given the serious nature of the prior downturn and the possibility that the move was a bear market rally, continued caution seemed warranted. Combined with negative economic fundamentals, that was enough to keep us out of the market at that time.

We started easing back into the market in the fall of 2009, but since then stocks have generally traded sideways until the past few weeks when a downward move gained momentum.

Today the NYSE remains above its 200-day moving average, but below the 100-day MA. In addition, the economy continues to give mixed fundamental signals. In this situation, all we can really do is remain patient and wait for more technical confirmation about which direction the market will go next.

Because although I understand that technical analysis is far from perfect, two decades of market experience has taught me that I am not smarter that the tools I rely on.  So even though it is frustrating to remain on the sidelines for now it is still the safest to keep the bulk of your assets in a money market fund.
F.S.

Over the past three weeks, we have seen a significant correction in the U.S. equity markets. At this point most investors and traders are wondering whether the downturn will continue or whether stocks will rebound from these levels and begin advancing again.

If only we knew for certain!

We are closely watching our indicators and analyzing what they mean. Unfortunately nothing is definitive so the best we can do is to try to make some educated guesses and err on the side of caution. We sold our small position in Fidelity Select Software and Computers (FSCSX) as a defensive measure because the technology sector has been hit hard in this correction.

The chart below shows the New York Stock Exchange over the past year. The blue line is a support line I added. At its most recent low, the NYSE retreated back to the same level as it was at the end of November 2009 and October 2009. If it should break below support at this level (6800), there is support at 6500. Below that the next technical support level would be slightly above 5500—a level last seen in July 2009. That is about 19% below the current mark and it would certainly result in renewed pain for investors.

The gold line on the chart is a 200-day simple moving average (MA). The 200-day MA is usually an area of strong technical support for longer-term cycles. So far, this level has not been broken. The chart also has two areas I highlighted with pink ovals: the current downturn and the downturn of June and July 2009. Right now, these two corrective periods look similar.

In that earlier correction, stocks rebounded after about six weeks of decline and quickly erased losses from that correction. At the time, we were warning investors that fundamental economic factors did not support the rally that was occurring. The irony of the current correction is that it has occurred when the fundamental reports have been surprisingly good. The fourth-quarter GDP number was much better than anticipated as was the most recent unemployment report.

The middle portion of the chart is a moving average convergence divergence (MACD). This tool is negative, but had not reached an oversold extreme. That would indicate a possibility for additional declines; however, a rebound from this level would not be unusual. In July 2009 the market rebounded when the MACD reached the zero level.

Finally, the bottom portion of the chart is a stochastic oscillator. It reached an oversold level in late January and the NYSE responded with a couple of days of positive action. But the oscillator only completed a half cycle before turning negative again. Normally that is a sign of market weakness. This oscillator turned positive again this week.

The combination of these indicators and improving economic fundamentals lead me to believe that stocks could hold at this support level and stage a new short-term advance. But there is certainly no guarantee that will occur. And if something happens to drive stocks sharply below this support level, the market could get quite ugly with a downturn similar to the one we saw in the early months of 2009.

Much of the eastern U.S. is currently hunkered down and waiting for the recent storms to pass. That seems to be a good strategy in response to the recent market storm as well.
F.S.

U.S. Treasury bonds are generally considered low risk investments. They are usually lumped into this category because the chance that the U.S. government will default on its obligation is slight. What many investors fail to consider is that there are many ways in which one can invest in Treasury bonds and they all have varying risk levels.

The risk level is low if an investor is actually purchasing the Treasury bonds themselves and holding them until maturity. For example, consider an investor who purchases a $100,000 10-year Treasury bond paying a 2% yield. If he holds the bond until maturity (10 years) he will receive his original $100,000 back at the end of the period. Along the way he will have received $2,000 per year in yield payments.

But many investors do not want to tie up their investment capital for the periods required by long-term Treasury investments. So instead of buying the actual bonds, they opt for investment vehicles such as mutual funds or exchange-traded funds (ETFs) that invest in long-term Treasury bonds. Sometimes they falsely believe that these other investment vehicles offer the same low risk level as the actual bonds.

In reality, bond mutual funds or ETFs can be quite volatile and offer no real protection against downside risk.

To understand this, take a look at the chart below. The black line reflects the daily price movements of TLT, an ETF that invests in long-term U.S. Treasury bonds. The gold line is the S&P 500, included for comparative purposes.

Over the two years covered by the chart, it is easy to see that the price of TLT has fluctuated dramatically. An investor who purchased at the peak in December 2008 would have seen the value of his investment decline by more than 30% just six months later. That hardly qualifies as a low risk investment.

The blue arrows on the chart point to price gaps. That means the fund opened higher or lower than the prior day’s close. Gaps are usually indicative of an investment that is volatile.

Investors also mistakenly believe that bonds always move inversely to stocks and as a result can be used to hedge against market declines. The red arrows on the chart reflect periods where both TLT and the S&P 500 were falling at the same time.

The volatility of bonds results when investors elect to sell them before maturity. At that point, the price of the bond is determined by what someone is willing to pay. Consider another example. Let’s imagine that an investor pays $100,000 for a 20-year Treasury bond yielding 3%. After five years, the investor chooses to sell his bond. The person buying the bond might not be willing to pay the full $100,000. So he might try to buy it at a discount.

If the bondholder sells his bond for $90,000, it appears as though he lost $10,000. But remember that he received a yield of 3% ($3,000) for each of the five years he held the bond. So he actually gained $5,000 on his five-year investment.

On the other hand, the person who purchased the bond for $90,000 is now going to be receiving the $3,000 per year yield payment. But since he only paid $90,000 he is receiving a 3.3% annual return. In addition, if he holds the bond until maturity, he will receive $100,000. So his original $90,000 investment will return $3,000 a year for 15 years ($45,000) plus an additional $10,000 (the difference between the $90,000 he paid and the $100,000 he received at maturity). That means his overall return will be nearly 4.1% on an annualized basis instead of the original 3% yield.

Obviously this is a simplified example that does not take into consideration tax implications or capital gains or losses.

When hundreds or thousands of such transactions are bundled together inside a mutual fund or some other investment, it becomes easier to see why investing in bonds is not as simple as it seems. Include the fact that many bond traders are speculating on the price based on what they guess interest rates might be 10 or 15 years in the future. Then one can begin to understand why secondary bond instruments can become quite volatile.

Keep in mind that this discussion focused only on long-term U.S. Treasury bonds. There are many other types of bonds such as high quality corporate bonds, zero coupon bonds, high yield bonds, international bonds, and many more. And virtually all of these bonds have derivatives and secondary markets.

So don’t make the mistake of thinking that just because you have invested some of your assets in a bond position the risk of loss is low or a positive return is assured.

F.S.