Why U.S. Stocks Can Move Higher in 2007 - Part II

How should one react when expecting a big move, but the market moves against you?

Having laid out our basic thesis, the potential for major gains in U.S. equities, we are immediately faced by selling that is described as "ugly" by most traders. What this really means depends upon one's time frame.

A Good Example
Today CNBC featured an interview with a technical analyst who does good work. Let us recap his comments, with the S&P 500 daily chart in front of us.

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The analyst was asked whether it was a good time to "buy the dip." The market was down about 1% at the time. His response was as follows:

• It was good to take money off of the table from the run-up. (It was not clear whether that was to be done at the moment of the statement, a week earlier, gradually, or on yesterday's close.)
• There would be continued selling.
• The basic trend was upward, so one should be getting long in the 1450-1475 range.

Let us suppose that an active fund manager or trader had followed this advice. Since there was no specific guidance and days or amounts, we shall assume that he sold 20% of his position at about 1500 give or take a few points. (This was a popular technical point, 1503 in the SPU's and a bit less in the cash.)

Let us further suppose that the fund manager sold another 20% with the market down 1% today.

What is the plan? Is he to buy some at 1475 and the rest at 1450, assuming that point is reached? Even if everything is executed to perfection, the trader makes about 0.4% on one leg (20% times 2%) and 0.8% on the other leg (20% times 4%).

Most traders are neither so agile nor so accurate. Meanwhile, what if the full dip does not occur? Most traders have trouble "chasing" when the predicted dip does not happen. The risk is that they are under-invested during a major run.

It is tricky to time the market for a small gain.

Longer Time Frames
Investors should look at the longer time frame, better represented by a weekly chart. On this basis the selling seems like a minor setback.

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Our modeling guru is Vince Castelli, a consultant who completed a distinguished career as a Navy scientist. He has a method for trend-following situations. It may lose something at turning points, but catches all of the big moves. The time frame is relatively short, measured in days. Vince's models remain bullish on all market indices. He uses indicators similar to others, but measured in ways we regard as superior.

Our Take: We remain long even in our short-term trading accounts. Please note that the trading position is model driven. The charts are just for illustration.

For another technical view and better charts, we always read Trader Mike, who today sees a bit of technical damage. Worden also went to a downtrend on the shortest of their four time frames.

Psychology
Today's psychology illustrated exactly what we had predicted. There are many active traders and hedge fund managers who want to be the first to anticipate a poor economy. The highly negative sentiment has many poised to jump at any sign of economic weakness.

Fundamentals
Fundamental analysis should be the watchword for long-term investors. That means looking at forward earnings projections compared to risk-adjusted returns from other asset classes. As long as stocks are so cheap compared to bonds, the buy signal is in place.

Those who believe they are wiser than economic forecasters seize upon any piece of evidence to support that viewpoint. At "A Dash" we are consumers of forecasts, including the following:

• The ECRI, repeatedly stating that leading indicators show strength in the economy.
• David Malpass, who continues to see economic strength, with risk coming from eventual inflation.
• Consensus economic forecasts, showing solid growth in the rest of the year.

At "A Dash" our emphasis is on education -- picking the best sources, choosing the right indicators, and interpreting data. We do not offer trading advice. So many who blog about trading do that better. We do wish to help long-term investors get on the right side of major moves.

We remain quite happy with what our friend at Abnormal Returns calls a contrarian position. This is good.