Indicators reflect a market where risk remains high
There are currently many investors, traders, politicians, economists, and ordinary citizens who hope the major stock market indices have bottomed. Some are convinced that a major rebound is right around the corner and they warn others not to pull their money out of the market at this point. I learned long ago that just because we want something to happen does not mean it will. It is going to take more than hope and desire to bolster the economy and turn the markets upward again.
Keep in mind, many of the people telling investors to hold on and keep their money invested have a conflict of interest. They do not make money if investor assets remain on the sidelines. For example, on my desk is a year-end report from an asset allocation mutual fund. The fund lost -30.92% in 2008. In its outlook for 2009, the report states: “We believe a new cyclical bull market may emerge this year that could push the S&P 500 up more than 30%.”
Unfortunately, the report fails to offer substantive explanations about why the S&P 500 is going to stage such a strong advance in 2009.
Wednesday President Obama said that if Congress does not quickly pass his economic stimulus package the current recession will turn into an economic “catastrophe.” As a former journalist who covered a few presidential press conferences, I can assure you that no president would use such a word lightly. I suspect it will be difficult for the stock markets to stage a powerful advance under economic conditions that could create a catastrophe.
For the past two months, major indices have traded in a mostly sideways pattern. The previous eight week sideways trading period occurred in July and August 2008 and it followed a steep slide in June. I distinctly remember that in early August a potential client told us he decided not to invest with us at that time because his existing broker assured him the worst was over and he did not want to miss the ensuing market rebound. His account was down about 17% at that point. Since then the S&P 500 has lost an additional 30%–about 425 points.
Below is a chart showing the S&P 500 price movement over the past year. I added the two red lines. The top one shows that the long-term downtrend continues. The bottom red line shows a support level slightly above 800. Since the beginning of December 2008, this support level has held while the sideways trading channel has narrowed. It is likely that stocks will soon break out of this channel. While we would all like to see the market rally and the recession end, there is a high degree of risk that the next major market move could be downward.
The gold line on the top portion of the chart is a 50-day moving average (MA) of the S&P 500. While the index broke briefly above this MA back in January, it was unable to remain above that level. If the index had continued to rise for a few more days, our indicators would have signaled us to begin re-entering the market, but that did not occur. During any sustained advance, an index will trend above its 50-day MA.
The middle portion of the chart is a moving average convergence divergence (MACD). During a sustained advance, the MACD should be able to trend well above the zero level. The S&P 500 spent about six weeks above that mark in late spring 2008, but it failed quickly on every attempt since then.
The bottom portion of the chart is a relative strength index (RSI). If the index has enough strength to maintain an advance, its RSI should be able to trend at the 60 to 70 level. The fact that the index has struggled to reach 50 and has not been able to remain above that level is a sign of continued long-term weakness.
I could go through several more technical indicators and all of them would provide essentially the same assessment: weakness is dominant over strength right now. That means market risk is high.
While I have used the S&P 500 as an illustration, charts for the Dow Jones Industrial Average and for the Nasdaq look remarkably similar.
One advantage of an active risk management strategy is that we are watching our indicators closely on a daily basis. Perhaps the markets will rally for several months after an economic stimulus package is approved. In that case, we are ready to re-enter the market when it makes sense to do so. In the meantime, we are content to wait patiently on the sidelines as long as our indicators show that risk remains high.
F.S.
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