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A Market Signal Not To Be Ignored

Daily State of the Markets
Tuesday, September 18, 2012

Good morning. Although the DJIA finished lower Monday for the fourteenth time out of the last fifteen weeks, I found some good news when running through my weekly review of our favorite stock market indicators. But before I get into what could easily be viewed as a bullish argument going forward, let me offer the caveat that stocks have run a long way over the last week, over the last month, and since the dog days of summer. As such, we need to recognize that the market is becoming a little frothy and could easily succumb to a pullback or what I like to call a "sloppy period" in the coming days and/or weeks.

However, based on some of the indicators I follow, a pullback should be welcomed by anyone feeling a little underinvested these days. In other words, if you have been envious of the gains seen recently, a corrective phase might provide an opportunity to "buy the dip." You see - and I'm cutting to the chase here - assuming Europe doesn't implode again or the Middle East doesn't get too messy in the near-term, history suggests that stocks just might head higher over the next several months.

Before the bears out there start sending me hate emails, let me say that my prognosis comes from an objective analysis of time-tested indicators and not my opinion of what could or should happen either here in the U.S. or around the world. As I said yesterday, analyzing the global macro environment and then investing according to what I "see" just isn't my cup of tea.

Now that we've got the appropriate caveats out of the way, let's get to it. One of my favorite buy signals comes from what is called a breadth surge or thrust. The idea is that when the cumulative total of advancing issues swamps declining issues over a long enough period of time, stocks have historically headed higher. More specifically, using a database of operating companies (stocks of companies that actually make stuff and/or provide services - i.e. not bond funds, reits, closed-end funds, ETF's etc.) when the 10-day total of advancing stocks compared to declining stocks is close to 2-to-1, good things tend to happen in the coming weeks and months.

Although the frequency of the breadth surge signal has picked up since the advent of HFT, the good news is that Friday's buy signal was the first one of the year. Therefore, I believe this is probably a signal that is not to be ignored.

Since the middle of 1947, this buy signal has occurred 36 times before Friday. In the prior occurrences, the market has outperformed the average return over the next 5 and 10 days, the next 1, 3, and 6 months, and the ensuing year. For example, one month after the buy signal, the S&P 500 has produced an average gain of +3.2%, which is far superior to the average one-month gain of +0.7%. Three months after the buy signal, the S&P sports a gain of +5.6% vs. an average of +2.0% for all three-month periods. Six months out the S&P is up +11.2% vs. +4.1% and one year after a buy signal, the S&P has been up an average of +16.7%, which is just about double the average gain of +8.4% for the index.

To be sure, these are pretty strong numbers. However, as I noted earlier, the frequency of signals has increased in the HFT era, beginning sometime during 2008. For example, from 1947 through 2004, there were a total of 28 buy signals - or about 1 signal every 2 years. But since the beginning of 2008, there have been nine buy signals or about 2 per year. As such, I decided to take a look at the more recent signals to see if the historical tendencies still held up.

Given that the market has been just a teensy bit volatile since 2008, it isn't surprising to learn that not all periods were as blatantly bullish as they were in the previous 61 years. However, the bottom line is that more often than not, a breadth surge buy signal means stocks tend to head higher over the next two weeks as well as the next 1, 6, and 12 month periods, and that the returns seen after the buy signals were still far stronger than the average market returns for the periods.

It should also be noted that for those looking to "buy the dip" after this type of signal has occurred, the market has provided opportunities recently. History shows that 5 days after the signal, the average return for the S&P was -0.21%. In addition, the market was only higher a week after the signal half the time. 10 days after the signal, stocks were up 5 out of 8 times. One month later, the market was up 7 out of 8 times since 2008. And three months later, the market was up half the time and either higher or lower by a fairly substantial margin.

I could go on (and on), but I'm guessing that (a) half my readers have already clicked delete and the other half get the idea. So in sum, let me say that while there are no guarantees in investing, the breadth surge buy signal does seem to put the odds on the bulls' side - after an opportunity to "buy a dip" that is.

Turning to this morning... It looks like a replay of Monday's early trade as Europe is down on the usual fears, Asia is lower on the usual concerns about China growth and the tiff with Japan. And then here in the states, FedEx guided EPS lower for both the quarter and the full year. As a result, futures are currently pointing to a modest decline at the open.

On the Economic front... We'll get the current account balance this morning.

Thought for the day... Live for today for tomorrow never comes. -English Proverb

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: -0.25%
    • Shanghai: -0.89%
    • Hong Kong: -0.27%
    • Japan: -0.29%
    • France: -0.78%
    • Germany: -0.74%
    • Italy: -1.71%
    • Spain: -1.47%
    • London: -0.57%
  • Crude Oil Futures: -$0.44 to $96.18
  • Gold: -$10.00 to $1760.00
  • Dollar: higher against the yen and euro, lower vs pound
  • 10-Year Bond Yield: Currently trading at 1.857%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -2.34
    • Dow Jones Industrial Average: -25
    • NASDAQ Composite: -6.14

Positions in stocks mentioned: none

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