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What Do the Market Models Say? (Part 1)

August 15, 2013 | About:
Okay, let's break it down.

It's August. It's the height of the vacation season. The markets are going sideways. Volume is very light (SPY volume has been below average for 27 straight trading days).

Earnings season has just about ended. There hasn't been an important piece of economic data in a week (although that will change soon). The computers have been in charge on an intraday basis. Sentiment is complacent at best and overly optimistic at worst. Valuations are debatable. And in short, it just "feels" like something bad is about to happen.

Whenever this type of environment occurs, emotions should be put aside and market indicators should be examined. There is just something cathartic about looking at some cold, hard numbers when things are "iffy."

Looking at indicators over different time frames is an important way to diversify analysis. As such, both daily and weekly market environment models are utilized. Today, the intermediate term week-long models will be examined.

The "State" of the Market Environment

Although there are some overlapping areas, the Weekly Environment Model is comprised of 10 individual indicators or models. These 10 can then be broken down into the following categories: tape, trend, sentiment, economic, monetary and the overall risk environment. In terms of weighting, the majority of the model weight is given to tape and trend indicators (60 percent) while the "external" factors account for 40 percent of the model.

This fits with the view that the price/tape action of the market should be the final arbiter of the action. In addition, tape and trend indicators serve as excellent stop-loss signals for those times when the market's moves diverge from the "logic" of things like economics, news or earnings.

To give an incentive to continue reading, let's first review the performance of this particular model. Due to changes in data availability, the overall model was reworked at the end of 2011. However, the live performance hasn't been too bad. In 2012, using the leveraged ProShares Ultra S&P 500 (SSO) when the model is positive, the ProShares Short S&P 500 (SH) on negative signals, and a cash equivalent on neutral signals, the test of the model would have produced a return of 46.2 percent (compared to the S&P 500 cash index return of 16.3 percent).

And then, so far in 2013 (through Aug. 9), the model's return would be 25.4 percent (versus S&P 500: 19.7 percent). As such, the cumulative total return would have been 83.3 percent for the model since 2012 as compared to 34.5 percent for the S&P 500. So, while its history isn't long, this model is watched closely each week.

Since the explanation of the models and indicators that make up the weekly market environment model as well as the analysis of the current readings covers a fair amount of ground, we will break the review up this week. This morning we will take a look at the state of tape and trend indicators.

The Trend Indicators

Let's start with the easy stuff — t he trend indicators. The weekly environment model contains three indicators that are dedicated to the trend of the overall market. For starters, the short-term trend of the S&P 500 is rated. For the purposes of this model, short term is defined as between five and 15 trading days.

Next is the intermediate-term trend of the market. Here the focus is primarily on the market relative to its 10-week weighted moving average (which we move forward two periods). And finally, the cycle composite is examined, which is a combination of the one-year seasonal, four-year presidential and 10-year decennial cycles.

Currently, the short-term trend rating is neutral, for fairly obvious reasons. However, the rating of the intermediate-term trend is clearly positive. A quick peek at the S&P 500 weekly chart versus its 10-week moving average should confirm this rating. And finally, the cycle composite suggests that stocks could struggle a bit next week.

So, the rating for the cycle composite is moderately negative. When assigning a score of +1 for positive readings, 0 for neutral readings and -1 for negative readings, the overall rating for our trend components is dead neutral for the upcoming week.

The Tape Indicators

The weekly environment model incorporates three "tape" indicators. Momentum-oriented indicators are included in this category. These are the indicators that reveal the internal health of the market and help to determine the "oomph" behind a move in either direction.

The tape indicators include a breadth-confirmation system, a review of the supply/demand volume and a model that rates the technical health of more than 100 S&P industry groups.

Currently the tape indicators remain fairly strong. The breadth-confirmation system is positive as both the trend of the market and of the stock-only advance/decline line are above their appropriate smoothings. The supply/demand volume relationship indicator is also quite positive currently as demand volume remains well above supply at this stage.

And finally, the model that rates the technical health of more than 100 industry groups is moderately positive at this time. So, while these indicators are all intermediate-term or longer in nature, the group as a whole is positive.

Spoiler Alert: While there are still a handful of model components left to review, the overall rating for the weekly environment model is currently moderately positive. This suggests to give the bulls the benefit of the doubt should things get sloppy in the near term.

To clarify, this model does not attempt to "predict" what is going to happen in the market. No, the goal is to first identify and then stay on the right side of what "is" happening in the current environment.

Current Market Drivers

Success comes from understanding the driving forces behind the market action on a daily basis. The thinking is that if one can both identify and understand why stocks are doing what they are doing on a short-term basis, it is unlikely one will be surprised/blind-sided by a big move. listed below are some of the driving forces of the current market (listed in order of importance).

1. The State of Fed/Global Central Bank Policies

2. The Outlook for the U.S./Global Economy

3. The State of the Budget (starting to come up on traders' radar screens)

The State of the Trend

It is important to analyze the market using multiple time-frames. Short-term is three days to three weeks, intermediate-term is three weeks to three months and long-term is three months or more. Below are current ratings of the three primary trends:

Short-Term Trend: Neutral

(Chart below is S&P 500 daily over past one month)

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Intermediate-Term Trend: Positive

(Chart below is S&P 500 daily over past six months)

%5Egspc

Long-Term Trend: Positive

(Chart below is S&P 500 daily over past 12 months)

%5Egspc

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the important levels to watch today:

  • Near-Term Support Zone(s) for S&P 500: 1680
  • Near-Term Resistance Zone(s): 1710
The State of the Tape

Momentum indicators are designed to determine the technical health of a trend, i.e. if there is any "oomph" behind the move. Below are a handful of indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator: Moderately Positive
  • Price Thrust Indicator: Positive
  • Volume Thrust Indicator: Neutral
  • Breadth Thrust Indicator: Neutral
  • Bull/Bear Volume Relationship: Positive
  • Technical Health of 100 Industry Groups: Moderately Positive
The Early Warning Indicators

Markets travel in cycles. Thus one must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • Overbought/Oversold Condition: The S&P 500 is neutral from a short-term perspective and is low neutral from an intermediate-term point of view.
  • Market Sentiment: The primary sentiment model is low neutral .


The State of the Market Environment

One of the keys to long-term success in the stock market is to stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help identify the current environment, we look to the longer-term State of the Markets Model. This model is designed to determine when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model reveals whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: Positive. This suggests it continues to favor the bulls.

Thought for the Day

“If your actions inspire others to dream more, learn more, do more and become more, you are a leader.” - John Quincy Adams

Mr. David Moenning is a full-time professional money manager and is the president and chief investment strategist at Heritage Capital Management. He focuses on stock market risk management, stock analysis, stock trading, market news and research, and actionable subscription portfolio services.

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