Mike Picone's  Instablog

            Evidence abounds that the current stock market advance will intensify by the end of the year.  A key element is the incredible strength of the present uptrend in market prices. At the close of an CNBC interview last week, Laszlo Birinyi, who is bullish on stocks at the moment, noted that almost everything was going up, while he instead preferred a stock-picker's market in which quality research and ability are rewarded.  Indeed, the modest daily advances in the most closely watched market indices have masked a more overwhelming move by the broad market recently, and the strength has continued to increase.  In this market almost everyone is a winner, to the chagrin of the pros like Mr. Birinyi and the regret of bearish skeptics who watch from the sidelines.  The availability of considerable cash and the market strength and breadth support a strong move to higher prices.

A New Milestone: Advances/Declines

            By the close on Friday, yet another significant milestone was reached, when my measure of the 10-day advance/decline ratio [A/D] markedly exceeded a value of 2.  This was cited long ago by Martin Zweig [Winning on Wall Street] as a precursor to significant up moves in the market.  For convenience, I derived the following definition of a 10-day A/D value, which uses readily accessible weekly data on the NYSE and the NASDAQ:

A₁₀/D₁₀ = [A₁ + A₂]/[D₁ + D₂],                                                                       (1)

where A₁ is the sum of the number of advancing stocks on the NYSE and that of the NASDAQ after the first week (subscript "1") and the remaining quantities are defined similarly for advancing and declining (subscript "D1") stocks after the first week and after the following week (subscript "2"). This rather naive formula is exact if one estimates |dP_w[i]|, the magnitude of the weekly change in price of each stock (indexed by i), in terms of <dP_w>, the average weekly change in prices of all stocks for the two successive weeks considered:

|dP_w[i]| ~ 2 <dP_w> [A₁+D₁ + A₂ + D₂]/[A₁ – D₁ + A₂ – D₂].             (2)

Equation (2) also assumes the almost trivial condition that the weekly advances and declines of the combined set of stocks traded on the NYSE and NASDAQ are not balanced over the two-week period (denominator nonzero) and ignores the stocks which do not change in price over a given week. With this estimator of the magnitude of the weekly change in the price of each stock, the approximate change in the combined market capitalization over the two-week period is proportional to the total number of weekly advances minus the total number of weekly declines. Equation (1) follows directly.

            A value of A₁₀/D₁₀ > 2 is highly unusual and significant. Using weekly data provided by the Wall Street Journal Market Data Center [online.wsj.com/mdc], I find that A₁₀/D₁₀ > 3 for the most recent two weeks.  According to Martin Zweig's research in Winning on Wall Street, this strong reading bodes well for higher stock prices over the next several months.

Percentage of Stocks Above Their 50- and 200-Day Moving Averages

            The percentages of stocks above their 50- and 200- day moving averages (which I will call P₅₀ and P₂₀₀) are also currently at extremely high readings (well above 80%). This again indicates tremendous strength across the broad market, with the indicators having risen meteorically from values near 10% in early March.  Surprisingly, this aspect of P₅₀ and P₂₀₀ is often ignored. On an episode of Wall Street Week which I remember vividly, Robert Farrell, a famous stock market analyst for several decades until retirement in 1992, publicized P₂₀₀ as his favorite indicator of market extremes. Today, the standard expectation of extreme readings in P₅₀ and P₂₀₀ is that a market reversal is in the offing.  Nevertheless, the current values of P₅₀ and P₂₀₀ show that an unusually strong and broad market move is ongoing.

            The above indicators and similar measures show massive, broad strength in the stock market, and when combined with catalysts provided by economic indicators, interest rates, and the position of the Federal Reserve, portend a strong market advance over the next several months. The upcoming Part 2 of this discussion will detail the catalysts for such a move, including the cash waiting on the sidelines and the frustrated holders of that cash.

In early June, my newly completed mid-term trading model indicated a continued, sustained, upward move in the market. At the time that I reported this in Seeking Alpha, the market of course immediately entered a corrective phase but then indeed moved upward significantly.  Obviously I should have quit while I was ahead; however, in fairness, I have decided to provide the present reading.  The medium-term (several-month) trend of the domestic stock market is strongly upward. Interest rates have remained at a very low level. The consumer has been reluctant to borrow money, instead reducing debt and increasing the potential to support future economic growth. The future impact of the Fed in the next several months is enigmatic, in that its interest rates are as low as they can go, rendering reductions in short-term rates unlikely. In spite of the absence of further stimulative interest rate changes by the Fed, one must consider its position to be very supportive.

The bottom line is that the model continues bullish on a time scale of several months. This is very uncomfortable, given the historically negative bias of the market during the September-October time frame. Further, a conventional interpretation of the market price action is that we have reached an overbought extreme. On the other hand, the negative seasonal tendency has achieved the level of “mantra,” and thus is mitigated by my investing Rule Number 2: “Market ‘wisdom’ is either a lie or an error.” The short-term overbought condition could result in a correction. Nevertheless, the model supports higher market prices several months from now and implicitly augers against another disaster like that of last fall and winter.

One thing worthy of note is that copper, a useful indicator of inflation, has been rising noticeably. A concurrence of several precursors of inflation could force us to revisit Rule Number 2 as applied to the influence of inflation on market prices. Presently, inflation remains mild and deflation appears to be under control.

     The stock market plunge and economic crisis of the past year have helped to solidify my views of the actual value of stocks today versus other periods dating back to around 1919.  Prior to the crisis, I had been suspicious that stocks were indeed just pieces of paper, albeit virtual ones in our electronic age.  After all, in a bankruptcy, equities will lose all value with very high probability.  In the early 1920s, the stock holders of large corporations were at least paid a significantly higher yield than were bond holders, thereby recognizing the greater risk of holding stocks.  Even at today’s depressed prices, the average yield differential is too small to make stocks a true value investment. Credit Wall Street’s marketing machine and public ignorance for this sad state of affairs!

     In this case, the only strategy that makes sense is to mitigate risk by trading stocks on a medium-term time scale (one month or longer) and then only if one can discern a definite trend appropriate to that time scale. This low frequency trading objective prevents overtrading and permits the investor time to capture the greater portion of any sustained upward move. Meanwhile the investor avoids most of the losses of a similar downward move like that suffered by the market over the last year. A key psychological objective is to avoid the pain of catching a downpour of “falling knives,” as value investors did from June, 2008, to March, 2009.

      I have developed such a strategy based on trend, interest rate environment, and monetary policy. On the surface, this is not much different from that of many analysts. As asserted above, the key difficulty to any of these methods is to have a faithful trend indicator.  My studies of market and economic indicators over the last 12 years have produced a reliable method to capture and confirm the medium-term trend based on moving averages of market prices.  

     Another element is to use a diversified portfolio of credible stocks, hence the emphasis on index ETFs. To invest in a very small number of individual companies puts one at great risk in the current unstable environment.

     As with any trading strategy, one can be whipsawed by volatility in the market. This is the price of capital preservation when the market is flat (on average) over several months while being highly volatile on shorter time scales. To summarize: The idea behind this medium-term approach is to do the following: 

(1) to mitigate market risk by trading,

(2) to catch and ride any sustained moves upward, and

(3) to mitigate company-related risk through a diversified holding of stocks issued by established companies. 

     This is the first of my reports on my results regarding the this trading strategy. On Friday, my trend indicator for time scales of 5 months or longer showed a sustained up trend for the first time since June 15, 2007, nearly two years!  Of course, the policies of the Federal Reserve have been accommodative, to say the least.  The yield curve is qualitatively normal, although near the high end of the range for the difference between long rates and short rates. 

     The reflation strategy of the Treasury and Fed is working, perhaps too well, in that copper and oil are much higher since January.  Gold, a speculative favorite, has remained relatively stable at the high end.  No one can call the future of inflation with any certainty.

     In this environment, one can buy confidently into a diversified stock portfolio and let it ride until the trend falls back or until the interest rate/monetary environment turns negative. In future articles, I will report on changes in my medium-term indicators.

Disclosure: Through a retirement account, the author holds stock index securities equivalent to SPY and VXF