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The market has sustainable trends, or moves without any trend, but usually is anywhere between them. That's why investors are confused in most sessions because trends are built and are gone constantly. What are major factors to determine the market condition? In theory, any security price such as S&P 500 index ETF (NYSEARCA:SPY) depends upon the inside data given the outside data. The major inside data are interest rates, profit margins and other economic indicators. The outside data are assumed to be given: They include monetary and fiscal policies, political actions, and other quantified natural disasters or geopolitical disorders.

When the effect of inside data dominates, tends are formed. If, on the other hand, the effect of outside data is relatively stronger, the level of market stress is rising so that trends would disappear. In general, time is a crucial element to reveal market trends or disturbances. The longer the time horizon, the more likely trends: The shorter the time domain, the more probably disturbances. In a long run (or in a couple of decades) all market cycles (including trends or swings) tend to regress to the mean. Therefore, the length of time to observe market strains should be a near term (i.e., a couple of weeks) rather than a short term (i.e. a couple of quarters) or a long term (i.e., a couple of years).

The RED (the average of the Rotation - Diffusion Index and the Equity - Diffusion Index) and The RED Spread (or The REDS which is the difference of the two Indexes) monitor the market depth and the market breadth, respectively. They together date market-turning points. Since their inception on April 2012, they yielded two turning points: A peak on April 4, 2012, and a trough on August 28, 2012. Table 1 indicates a significant loss (-7.05%) at an intermediate bottom on 6/25/2012 through a correction after the peak on 4/4/2012, and a good gain (7.71%) from the trough on 8/28/2012 to 2/8/2013.

Table 1: The Market Performance

As most investors witnessed, the market movement from April, 2012 to date has not been straightforward: It went through a correction on May and June, and a doldrums during all summer, and a quite volatile in the fall and winter. The details were on "The RED Spread: A Market-Breadth Barometer - Can It Predict Black Swan?", and subsequent various comments on the same article. The erratic random walks were due mainly to ((NYSE:A)) a historical parallelism based on the previous selloff in May 2011, ((NYSE:B)) worries on the Eurozone and the U.S. debt problems, and ((NYSE:C)) the mounted uncertainty related to elections or leadership transitions in major countries.

The question is how to measure the level of market strains, induced by these outside events and data. The price theory teaches us that there are two price adjustments toward an equilibrium level: One is moving along the schedules given the demand and supply curves. The other one is shifting the demand/supply schedules or both. The former is made by any change in inside data while the latter is affected by any change in outside data and events. Any change by moving along the schedules is relatively smooth while any change by shifting the schedules is abrupt and erratic. The latter changes are the major source of market strains. The demand and supply curves which we are talking about are not for a single security, but they are the aggregate schedules of thousands of individual equities and ETFs. Therefore, they cannot be directly observed.

Fortunately, we have three clearly distinguishable dates of major events on November 6, 2012 (the U.S. election), on December 31, 2012 (the tax deal), and January 23, 2013 (the Debt-Limit Extension bill). It gives us a golden opportunity to develop a Market Stress Index ((NYSE:MSI)). A somewhat discontinued data set of 58 days which contains 45 days - 15 days for each event - to give equal weight to each event, and 8 days at the beginning. Extra 8 days are needed to make a seven-day moving average to smooth out the series. Table 2 shows a part of the selected data - the beginning days and the ending days.

Table 2: THE Relationship Among RED REDS P/T/B ,S&P 500 & 10Y T Yield
*****10Y TNIR
<Dates of 10/29/2012 to 1/22/2013 are hidden>
P = Peak T = Trough B=Breakeven
IR = Inverse Relationship between REDS & 10Y T Yield

On Table 2, two tests are performed: One is the Inverse Relationship Test, and the other one is the Direction Test.

The Inverse Relationship Test

The normal inverse relationship between the RED Spread (REDS) (the Bond Premium in terms of diffusion index) and the 10-year Treasury yield has been usually ON, meaning that the market condition was normal. Some OFF dates indicate an abnormal relationship between them, reflecting market strains or distortions

The Direction Test

The REDS must fall on the current upswing started at August 28, 2012. A wrong direction is found on either an ON date or an OFF date. The wrong direction with ON dates was on 1/23/13 and 1/31/13, and the wrong direction with OFF dates was on 10/18/12 and 1/30/13, as shown in the above Table.

The Stress Score: Zero to a pass for both tests, 50 to a pass for one test, and 100 to a fail for both tests. The Table 3 displays a part of The Market Stress Index.

Table 3: The Market Stress Index
< Dates of 10/29/12 to 1/22/13 are hidden>
REDS = The RED Spread
MSS = Market Stress Score
MSI = Market Stress Index

(Click here for the complete data.)

On January 31, 2013 the Senate passed the House bill extending U.S. borrowing authority until May 18, by 64:34: 52 Democrats and 12 Republicans voted for it while 33 Republicans and one Democrat voted against it. The bill is now on the desk of the president. The erratic market movements still will be likely as budget battles are looming. There are four key dates: Mach 1, March 27, April 15 and May 19. In three months or so we will see progress or a standoff between the GOP and Democrats on spending cuts. A comprehensive resolution of the deficits and debt reductions will take much longer time.

On March 1, the sequester is set, followed by a March 27 deadline for all stopgap measures for the rest of the current fiscal year, encountering an odd situation for members of Congress to see their pay withheld unless they have budget outlines on both sides of the aisle on April 15, and finally reaching a critical point at which the debt-limit authorization expires on May 18.

The actual course of proceeding of budget battles is highly uncertain, meaning that we don't know on what dates major forced spending cuts (and with or without another round of tax hikes) will happen. The Wall Street Journal's editorial helps us to set some milestones as the editorial perorated:

Washington is a fit of collective terror over the "sequester,"…White House…blamed Republicans for 'talk about letting the sequester kick in as though that were an acceptable thing.'…left out that President Obama proposed the sequester in 2011…Then on Tuesday Mr. Obama warned about 'the threat of massive automatic cuts that have already started to affect business decisions.' He proposed tax increases and 'smaller' spending cuts to replace the sequester until Congress and he can agree to another not-so-grand-bargain…The sequester that nobody seems to love would cut an estimated $85 billion from the budget this fiscal year starting in March. Half of the savings would come from defense and half from domestic discretionary programs…The White House strategy was to create a fiscal hatchet that would disproportionately carve up the defense budget to force the GOP to raise taxes…Republicans have rightly concluded after two years of being sucker-punched that the sequester is the main negotiating leverage they have and may be the only way to restrain spending. So now Democrats and a gaggle of interest groups are denouncing Mr. Obama's fiscal brainchild because the programs they cherish…are about to get chopped too…The most disingenuous White House claim is that the sequester will hurt the economy. Reality check: The cuts amount to about 0.5% of GDP…The sequester will help the economy by leaving more capital for private investment…The bad news for Congressional Democrats and their spending interests is that the noose only tightens after this year. Mr. Obama's sequester mandates roughly $1.2 trillion of discretionary cuts over the next decade. But if Democrats really want to avoid a sequester, they should stop insisting on higher taxes and start getting serious about modernizing the entitlements…that compromise the other 60% of government. If they won't then sequester away. (The Wall Street Journal's Editorial, "The Unscary Sequester," February 7, 2013)

The quote seems to be somewhat lengthy, but it is worth reading to see how White House and Congressional Republicans stand far away with their completely opposite plans on the deficits and debt resolution. The president plan is "tax increases and 'smaller' spending cuts. The GOP plan is spending cuts without revenue increase. The president and Democrats will continue to insist tax increase. Congressional Republicans would foot on a 'principled prudence' ground to avoid ugly fights with Democrats, as they did last year." ("Adding Some Prudence to Republican Principle" By David Wessel. The Wall Street Journal, January 24, 2013)

The most probable case under this circumstance is to be ending up on May 18 when the three-month suspension of the debt-limit authorization will be expired. And then what? The most likely scenario would be another temporary extension bill would be enacted, as Keith Hennesssey predicted:

"Step three is the crucial lever for applying public pressure to Democrats to cut spending…It's hard to overstate how much members of Congress …hate to vote for a debt-limit increase…for more borrowing without spending cuts, over and over again…Democrats should bear the political weight of voting to raise the debt limit every three months until voters make their choice in the next election." ("How to Wage the Debt-Ceiling Fight," The Wall Street Journal, January 17, 2013).

"The next election" is the Massachusetts special Senate race, scheduled in June 25. Curiously enough, the same State, twice in a row, lets "voters make their choice," this year and in 2010 for the seats Democrats John Kerry and Edward Kennedy held, respectively. ("How to Wage the Debt-Ceiling Fight," The Wall Street Journal, January 17, 2013)

If the president and Democrats would take "stop three," we are going to have a lackluster market because the current slow but resilient recovery would be a bit dented, but not be derailed. The likelihood of an alternative is slim, but cannot be totally ruled out. For instance, the president and Democrats would back down from insisting tax raises, by making compromises on spending cuts. This case is almost impossible because not only the odds of a smooth deal on spending cuts are bad, but also "targeted spending cuts have been historically been both rare and small…there is virtually no prospect for meaningful targeted spending cuts." ("The Case for Across-the-Board Spending Cuts" By Jeff Bergner, The Wall Street Journal, January 28, 2013). But If a spending cut resolution happens, the currently suppressed market would surge with a bang.

A prudent investment strategy in three months or so is to play a defensive game given your investment timeframe, holding liquid, well-diversified, low-cost, and tax-efficient Index ETFs or some blue chips, such as: Power Shares Dividend Achievers ETF (NYSEARCA:PFM), Vanguard Utilities ETF (NYSEARCA:VPU), Power Shares Financial Preferred Port ETF (NYSEARCA:PGF), Power Shares Insured Muni Bond ETF (NYSEARCA:PZA), Power Shares High Yield Corporate Bond ETF (NYSEARCA:PHB), SPDR Barclays Capital Intl Treasury Bond ETF (NYSEARCA:BWX), Home Depot (NYSE:HD), Coca Cola (NYSE:KO), and Kansas City Southern (NYSE:KSU).

The Market Stress Index starts posting each day along with two sisters - the Daily Market Condition (DMC) and the Daily TANER Momentum (DTM). The distinctions of these three posts are in order: Both DMC and MSI are the macro monitors - the market condition and the level of market strains, respectively - while the DTM is a micro security-momentum selector. The time frames of these three also differ: The DMC in an intermediate term (a couple of quarters, The DTM in a short term (a couple of months), and The MSI in a near term (a couple of weeks). These three together guide you to make your investment decisions properly given your investment goals and time frame.

Table 4: The Relationship between The MSI & the S&P 500 Index.
TAX DEAL53.1>34.71,425.24<1,456.36
DEBT LIMIT59.2>37.81,478.39<1,500.10
: Figures are seven-day averages. < = higher. > = lower.

Table 4 summarizes the negative relationship between the MSI and the S&P 500 index: The higher the MSI, the lower the S&P 500 index, and vice versa, for all three events. Table 4, however, offers a possibility for us to foresee the probable near-term market outlook by checking daily changes in the SMI further.

Table 5: The Market Stress Index [MSI
REDS = The RED Spread
MSS = Market Stress Score
MSI = Market Stress Index

Table 5 is an update of the MSI for after February 1, 2013 when the benchmark (28.6) was established. (The index is computed by a 7-day moving average of the stress scores of the 7 previous days. The last Index on 2/12 was the 7-day average including the score of 2/11. This Index on 2/12 can be used as the expected index of the following day from 2/11.) Note since the MSI is based on closing prices of securities, the actual level of market stress would be higher than the MSI indicates if intraday swings are wide. For example, Thursday (February 7) was the fourth day out of five in February in which the Dow Industrials had triple-digit swings intraday.

Thursday and Friday (February 8) the SMI lifted off. Why was the market showing more volatility and higher level of stress all of a sudden? Perhaps it was because on Tuesday (February 5) the president's initiative on the sequester issue caused quite a stir as Congressional Republicans responded immediately because they are ready to go with their plan which is far away from the president's plan. The market perceived spending-cut deals (or budget battles) as a starting point for a significant pullback in the months ahead. The task of the MSI is to measure market strains through four key milestones - March 1, March 27, April 15 and May 18. The MSI is just set up at the right time when the market is extremely stressful.

Disclosure: I am long PFM, PZA, PHB, BWX, KO, KSU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The Relationship Between A New Market Stress Index (MSI) And The Market