Anyone who follows the financial markets closely understands that the daily price of a specific investment instrument or of an index varies from minute to minute and day to day. The challenge for investors is knowing when a price is high or low in order to determine the best time to buy or to sell.

All of us like to get a good deal and no one likes to pay more for something than is necessary. Unfortunately, for many items we have little choice about when we make a purchase. For example, if someone is driving in a remote area and is low on gas, he will pay a high price for gas because he has no other good option. The price of the gas is going to be impacted by everything from how much the vendor paid to the distance from other vendors selling gas. When we have the choice, most of us would prefer to do some research, shop around and get the best possible price for anything we purchase.

One significant factor in determining the price of an investment is demand. When demand for an investment rises, so does the price. When no one wants to buy, the price falls. When excessive demand drives the price of an investment to an extended high level, traders refer to the situation as being “overbought.” Conversely, when lack of interest drops the price of an investment to a low level, the condition is called “oversold.”

As a general rule, investors hope to buy a specific investment when it reaches an oversold low and to sell it when it becomes extremely overbought. Unfortunately perfectly timed buys and sells are uncommon.

There are several technical tools traders use to help decide when an investment reaches an overbought or oversold condition. I’m going to describe two and explain their strengths and weaknesses.

Below is a chart of the S&P 500 over the past year. The middle portion of the chart is a stochastic oscillator. This tool is used to try to measure the location of a current price in relation to its price range over a period of time. The objective is to attempt to predict price turning points by comparing the closing price of a security to its price range. Some traders use this tool to try to identify exact buy and sell points for a given security. In my experience, this tool does not do a good job of pinpointing exact tops and bottoms; however, it is fairly accurate at predicting when an investment approaches a bottom or a top.

I highlighted the top portion of the oscillator with a green band. Normally when the oscillator reaches this level (above 80%) it indicates that the underlying investment has become overbought and is likely to correct soon. Similarly, I highlighted the bottom portion of the chart in pink. When the oscillator falls into this range (below 20%) it is oversold and a positive move could shortly occur.

Right now this oscillator is signaling that the S&P 500 is overbought and should soon correct. But this is not a perfect science. If you look at the oscillator in March 2010, it had also reached a similar overbought status. Instead of turning down, the S&P 500 continued to advance and the oscillator remained in an overbought situation for several weeks. During that time the oscillator rolled over a couple of times but it never retreated to the oversold area. Instead it reversed after only completing a half cycle and returned to overbought levels.

The bottom portion of the chart is a moving average convergence divergence (MACD). Like the stochastic oscillator, the MACD also measures an investment’s momentum. The MACD is a computation of the difference between two exponential moving averages (EMAs) of closing prices. This difference is charted over time, alongside a moving average of the difference. The divergence between the two is shown as the black histogram portion of the chart.

The MACD is currently positive and has not yet reached a level that would reflect a highly overbought situation. But it does appear to be getting ready to roll over.

The MACD is most effective in a trending market. According to Wikipedia, “Since the MACD measures the divergence between averages it can only give meaningful feedback as trends change. Thus, the MACD is less useful if the market is not trending—trading sideways or trading erratically—making sudden, dramatic, and/or countervailing moves. In a sideways market, the divergence between averages will not have a trend to illuminate. In an erratic market, the changes will happen too quickly to be picked up by moving averages or will cancel each other out, diminishing the MACDs usefulness.

Right now both of these imperfect indicators appear to signal that stocks have reached an overbought level. That does not mean a correction is imminent. But it does provide an indication that the risk of a correction is increasing. For an investor thinking about buying an S&P 500 Index fund, these indicators are showing that waiting might provide a better opportunity. Of course the real challenge for most investors is that unlike purchasing consumer goods, when it comes to investments, buying when the price is falling can feel frightening.
F.S.

Wednesday the Federal Reserve released its latest Beige Book report on the economy. In summary, the report stated pretty much what everyone already knows: economic activity is slowing across most of the country. Job growth and the housing sector remain weak.

The Beige Book is published eight times each year. Each Federal Reserve Bank gathers anecdotal information on current economic conditions in its district through reports from bank and branch directors and interviews with key business contacts, economists, market experts, and other sources. The information is summarized by district and an overall summary of the 12 district reports is prepared by a designated Federal Reserve Bank on a rotating basis.

In this week’s report, five of the 12 districts reported decreasing economic activity. By comparison, the previous report in July showed declining activity in only two districts.

During economic turning points, the stock market is often a leading indicator. Traders on Wall Street are successful if they stay ahead of the curve. So the market will often rise or fall ahead of advances or declines in the economy. Last year was a good example. Stocks began to rise in the spring of 2009, even though economic reports showed no real gains in the economy until several months later.

Right now the economy appears to be losing ground and the stock market has been mostly sideways for the past year. Perhaps what that is telling us is that just like the rest of us, Wall Street really doesn’t know what to expect in the coming months from the economy.

Last week I wrote that I believe major stock indices will remain in a fairly tight trading range over the next several weeks. While I can’t make any promises about what might occur, the action of the past week has done nothing to dispel that possibility. The chart below shows the S&P 500 over the past six months. It is easy to identify the tight trading channel that has persisted for the past three months. And while this and other major indices rose in the past week, technical indicators are currently showing a loss of positive momentum.

The bottom portion of the chart is a stochastic oscillator. It is currently at a highly overbought level (80 or more) which normally signals that a downturn will shortly occur.  The middle portion of the chart is a moving average convergence divergence (MACD). This indicator is still positive, but in a narrow trading range, it often does not reach highly overbought or oversold levels before changing direction.

September and October are frequently associated with some of the stock market’s biggest declines. In spite of the recent weak economic reports it would probably take a fairly dramatic, unforeseen event to push the market into a substantial decline between now and the November elections. Regardless of party affiliation, incumbents in Washington have a great deal at stake this year. Making the wrong move now could end up costing them their seats. So expect members of Congress to do very little between now and then. That increases the likelihood that stocks will maintain their status quo.

Members of the Federal Reserve, traders on Wall Street, and ordinary people like us all have a pretty good idea where the economy stands right now. What happens in November could provide a clue about what to expect in 2011.
F.S.

Over the past couple of weeks Federal Reserve Chairman Ben Bernanke appears to be on a campaign to say the right things to boost the economy and the markets. It worked on Friday, Aug. 27, and again on Wednesday and major indices posted nice single-day gains each time. But words without action cannot sustain a rally for long. In his Friday comments at a Federal Reserve symposium in Jackson Hole, Wyoming, Bernanke pledged that the Federal Reserve is ready to take steps to strengthen the U.S. economic system if such action is required. While that was comforting to Wall Street, some economists and analysts question whether the Fed really has much leverage left.

In a MarketWatch column on Yahoo! Finance, Brett Arends wrote: “This is the man who four years ago predicted ‘a leveling out or a modest softening’ in home prices. (He also said households were in ‘reasonably good’ financial shape, because their booming house prices were offsetting their rising debts).

“Just over three years ago he said the sub-prime crisis ‘seems likely to be contained,’ adding that he saw ‘some tentative signs of stabilization’ in house prices.

“As late as April, 2008, with the great implosion just months away, he forecast ‘a return to growth in the second half of this year and next year.’ You remember that return to growth we had in the fall of 2008, don’t you?

“Last Friday he admitted the Fed had been as surprised as everyone else by the sharp downturn in the U.S. trade balance in the second quarter.”

And apparently the chairman himself has concerns about the Fed’s ability to stave off additional economic complications. At Jackson Hole he said “In sum, the pace of recovery in output and employment has slowed somewhat in recent months, in part because of slower-than-expected growth in consumer spending, as well as continued weakness in residential and nonresidential construction. Despite this recent slowing, however, it is reasonable to expect some pickup in growth in 2011 and in subsequent years.”

That comment is far from a solid pledge that the economy will see significant gains anytime in the near future. In fact, Henry Blodget wrote this in Friday’s Business Insider: “If you can’t spare the time to read Ben Bernanke’s whole speech this morning, we’ll boil it down to 11 words for you: ‘Yes, the economy’s weak, but there’s not much more I can do.’”

Or consider this commentary from Joe Weisenthal in the same publication: “The most interesting part of Bernanke’s speech to the Fed Symposium is where he discusses the FOMC’s policy options, in the event that weakening conditions warrant more easing. And if you read it, the basic message is: Yeah, we have some options, and none of them is likely to work very well. [He highlighted] three key possibilities, and in each case he makes a very good point why they might not work.”

My personal belief is that no one can accurately predict—let alone control—what the markets or the economy is going to do because there are just too many variables. If officials at the Federal Reserve had known that a financial meltdown was about to occur in 2008, they would have done more to prevent it. The fact is they did not know and they might not have been able to do much anyway. So now Bernanke is trying to put a positive spin on the current situation. But he cannot promise that things won’t get worse, just like the Federal Emergency Management Agency can’t promise that Hurricane Earl won’t slam into the East Coast. All they can do is promise that if the storm hits they will try to mitigate the impact of the damages.

Below is a chart of the New York Stock Exchange (NYSE) Composite over the past year. Wednesday’s big upward move was enough to turn a number of technical indicators positive. For example, the gold line on the top portion of the chart is a 50-day simple moving average (MA). The NYSE is currently above its MA. The bottom portion of the chart is a relative strength index (RSI). The NYSE is above 50 on its RSI. The middle portion of the chart is a moving average convergence divergence (MACD). While this indicator is still below zero, it has turned upward and is signaling positive momentum.

So while the economic fundamentals aren’t good, for now stocks have positive momentum.

I added and green line and a red line to the top portion of the chart. For most of the past year, the NYSE composite has traded within the range encompassed by these two lines. And now it is right in the middle of that range. While I claim no ability to predict what the markets will do, it is my personal belief that for the next two months, stocks will probably continue to trade within this range.

The upcoming November election is critical for Congress and the presidential administration. They simply cannot afford any major meltdown of the economy or the markets between now and then. So I think they will use whatever means possible to provide a boost or to at least preserve the status quo for that period. One of the tools at their disposal is the Federal Reserve.

For the next two months, it is likely that Bernanke will be just one of many government representatives telling us that the economy is really better off than we might believe. For example, Rep. Barney Frank, D-Mass., and chairman of the House Financial Services Committee, appeared this week on the David Letterman show and he indicated that the economic situation is improving. These kinds of public appearances can’t sustain the markets indefinitely under a barrage of negative economic data. But it might be enough to help hold things together for a few more weeks. Then all bets are off.
F.S.