How Can You Identify Market Turning Points?... Reloaded

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Includes: AGG, DIA, EFA, IWM, QQQ, RSP, SPY, XLB, XLE, XLF, XLI, XLK, XLU, XLV
by: Christopher DeMaria

Summary

Some cautionary notes!

After the market has failed to confirm potential reversals on 1/11/2016 and 1/14/2016, I am watching market activity very closely for any further bottoming attempts.

Market risk is now registering at the lower end of the spectrum with a recent low of -24.2, as measured by my proprietary Market Risk Meter.

Market Leadership and Other Risk Metrics.

There's been quite a stir on Main Street this year as reminiscent echoes from the past appear. Financial pundits say to sell it all, except those treasuries, before the great fall. Is anyone reminded of 2008 or 09? Maybe we won't recuperate this time. Alas, that familiar sound can you hear, a new market bottom must be near.

Cautionary Note

This is one of the more difficult junctures that I've experienced, in the market, since joining the financial services industry over 18 years ago. We are at an inflection point where many of the indicators I follow are dangerously close to turning negative and consequently will warrant becoming more defensive. Likewise, it's important to note that a significant amount of market risk has already been released from the market over the last couple weeks (Please see the Market Risk Meter below).

Stocks are relatively oversold but markets have not been able to follow through on any reversal attempts within the last two weeks. The culmination of multiple long and short term events have been fueling concerns despite the fact that there are also many factors that remain optimistic. Before we look at potential upside scenarios, there are some equally important downside risks which have short and intermediate term implications.

If any of these events occur, I will be forced to revise my positive market outlook and consequently become more defensive with portfolio holdings: If the S&P 500 closes and remains below 1867, this will be regarded as a failure to retest the August and September 2015 lows. Likewise, if the Dow Jones Industrial Average closes below 15,666 it will not only be considered a failure to retest the August and September 2015 lows but, also has implications related to Dow Theory.

The final requirement for a confirmed Dow Theory Sell Signal is a violation of last year's lows. In my interpretation, Dow Theory sell signals are triggered as the result of three developments: First, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJT) must undergo a significant correction from new highs. Then, during the subsequent rally, one or both of the averages must fail to recover above their prior highs. Finally, both averages must fall below their prior correction lows.

Comparison chart of the Dow Jones Industrial Average and the Dow Jones Transportation Average (0825/2015 until 01/14/2016) diagram below.

Dow Theory Click to enlarge

These performance charts have been provided for informational purposes only, and should not be used as the sole basis for making an investment decision. Investment decisions must be made on your own individual needs and risk tolerance. The content you gather from any performance chart is just one of the factors that should be considered before making your investment decision. Past performance is not a guarantee of future performance, and the performance of these diagrams are subject to a number of market factors that may cause the price to fluctuate.

Lower Risk Entry Point Needing Confirmation Before You Purchase.

After the market fails to confirm potential reversals on 1/11/2016 and 1/14/2016, I am watching market activity very closely for any further bottoming attempts. Since 01/11/2016, the Market Risk Meter has declined an additional 6 points and is currently reading at -24.2. As readings move below -20, it is important to create a buy list of favorite mutual funds, equities, ETFs etc. because once that high volume, high volatility, downside trading day coupled with a strong reversal and 1-2 days' follow through is completed, all the conditions for a "Lower Risk Entry Point" will be satisfied.

Market Risk Meter

The Market Risk Meter is a tool designed to measure inherent risk in the overall market. The upper end of the diagram indicates higher risk and conversely, the lower end of the diagram indicates lower risk. When risk drops below -20 and when complimented with a disciplined buy strategy, the Market Risk Meter can be used to identify "Lower Risk Entry Points" for the purchase of equities. When risk exceeds +20 caution is warranted.

Market Risk Meter Click to enlarge

These performance charts have been provided for informational purposes only, and should not be used as the sole basis for making an investment decision. Investment decisions must be made on your own individual needs and risk tolerance. The content you gather from any performance chart is just one of the factors that should be considered before making your investment decision. Past performance is not a guarantee of future performance, and the performance of these diagrams are subject to a number of market factors that may cause the price to fluctuate.

Finding Leadership

When looking at where to allocate in the market, it is important to identify how the market is performing versus a number of different variables. For example, one can compare the S&P 500 index to Cash or Bonds on a relative scale to determine whether one asset class is performing better than another. If Stocks are performing better than cash or bonds, you may want to drill down and further compare the S&P 500 Index to a number of other categories. You can compare whether to own foreign versus US equities or whether there is a particular sector that should be held or not.

In the illustration below, several asset classes have been combined by looking at short, intermediate, and long term relative strength. What this reveals is that The Aggregate Bond Index is and has been performing better than cash. When comparing the S&P 500 to the Aggregate Bond Index it is clear that the S&P has been performing better over the intermediate and long term but the recent correction has made bonds more attractive over the short term. Similarly, The S&P 500 has been performing better than cash in all periods except for the short term but, there is a risk of cash moving into favor if the current trends do not change.

This same methodology is compared across different sectors and market holdings to assist with deciding where to allocate assets. From this diagram, we can easily visualize that the S&P 500 Index is still relatively stronger than cash, bonds, international equities, mid-caps, small-caps, energy, materials, and healthcare. By taking a closer look you may see that cash, bonds, small-caps, energy, and healthcare have been gaining strength. The equally weighted S&P 500 has been performing better than the S&P 500 Index.

On the diagram below, the favored categories have been highlighted in green. A check mark has also been included where the primary index on the left column is in favor. With the exception of AGG in the first row, S&P 500 is generally the index being compared.

Relative Leadership Click to enlarge

These performance charts have been provided for informational purposes only, and should not be used as the sole basis for making an investment decision. Investment decisions must be made on your own individual needs and risk tolerance. The content you gather from any performance chart is just one of the factors that should be considered before making your investment decision. Past performance is not a guarantee of future performance, and the performance of these diagrams are subject to a number of market factors that may cause the price to fluctuate.

Conclusion

Failure for the indices to hold above 1867 in the S&P 500 and 15,666 in the Dow Jones Industrial Average will warrant becoming more defensive. If the market is in a bottoming process and like many past market bottoms, it is acceptable for the lows to be violated briefly.

Per my proprietary Market Risk Meter, the market appears to be very close to a "Lower Risk Entry Point" due to the large amount of risk that has been released from the market. However, all of the criteria have not been met and, with the exception of those that like bottom fishing, confirmation is still needed. Very specifically, what is needed, is a high volume, high volatility, downside trading day coupled with a strong reversal and 1-2 days' follow through before the "Lower Risk Entry Point" is confirmed.

Includes: DIA, IWM, QQQ, SPY, AGG, EFA, RSP, XLE, XLB, XLI, XLV, XLF, XLK, XLU, $RUT, $RMC

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: The information contained in this report or information provided does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation of an offer to buy or sell any security referred herein. Past performance may not be indicative of future result. Christopher DeMaria is registered with and securities offered through Kovack Securities, Inc. Member FINRA/SIPC. 6451 N. Federal Highway, Ste 1201, Fort Lauderdale, FL 33308 (954) 782-4771. Investment Advisory services are offered through Kovack Advisors, Inc. DeMaria Financial Services is not affiliated with Kovack Securities, Inc. or Kovack Advisors, Inc.