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Let's Review Our Key Market Models

Daily State of the Markets
Monday, August 6, 2012

Publishing Note: I have an early commitment Tuesday morning and will not publish a report. Daily State of the Markets reports will return on Wednesday.

Good morning. With the market being driven primarily by headlines, comments, and rumors relating to anything and everything having to do with Europe these days, it is easy to get caught up in the heat of the moment and lose sight of the big picture environment. To be sure, the intraday volatility continues to be eye-popping as the bots grab onto each important word they've been programmed to identify and then race each other to get to the trade first. And while we can't do much about the fact that HFT drives the vast majority of trading on the various exchanges and dark pools, we CAN try to stay in tune with the overall environment. So this morning, I thought we'd spend a few minutes and review the readings of our important market models and see if there is a theme that emerges.

As I've mentioned a time or twenty, I like to use objective models to guide my investment process. Although markets change and the models employed need to be tweaked and/or replaced from time to time, the bottom line is I believe in having a system to lean on - especially when things get tough. And in case you haven't noticed, the markets have been as tough as they get over that past couple of summers. So without further ado, let's get started.

The Environment Model: As the name implies, the Environment Model is designed to give us an overall view of the state of the market from an intermediate-term standpoint. The model is a model-of-models containing scores of indicators covering many areas of market analysis. If I had to look at just one model to determine the health of the overall market it would be the Environment Model. Currently, the model is high-neutral as the overall reading is right on the line between neutral and positive. This tells me that the overall backdrop isn't bad and certainly not as negative as the bear camp would lead us to believe. History shows that when the Environment Model is positive stocks have gained ground at a rate of +28% per year (since 1982). When the model is neutral, the market rises at a rate of 7.7% per year. And finally, when the model negative the market loses ground at a rate of -23% annually. As such, this is clearly a model to keep an eye on. Model Score: Advantage Bulls.

Technical Health Composite: This approach was pioneered by Ned Davis and is designed to provide a look at the technical health of the 100+ industry groups of the market. I've been watching this particular indicator since the early 1990's and while no indicator is perfect, this one does a fine job over the long term in keeping its finger on the pulse of the market. If I could use only one indicator and the Environment Model wasn't available, I'd use this one. Currently the indicator shows that 78% of the industry groups are technically healthy. Advantage Bulls.

Trend Indicators: It is said that the trend is your friend and I am a big believer in this concept. My primary goal as a money manager is to try and stay in tune with the trends of the market. Sounds easy enough, right? The tricky part is to determine which time frame you are looking at (short-, intermediate-, or long-term). I prefer to focus on the short- and intermediate-term time frames (short term is defined as 3-days to 3-weeks, while the intermediate-term is considered to be 3-weeks to 3-months). Currently both the short- and intermediate-term trends of the S&P 500 are rated as positive. Advantage Bulls.

Market Breadth: When looking at the breadth of the market, it is important to recognize that the NYSE A/D statistics are distorted by all the securities traded on the exchange that aren't rally companies. Thus, we prefer to use the A/D stats from an operating company only index. The A/D line is then plotted against an intermediate-term trend smoothing. We then toss in a "confirmation" indictor here and compare the A/D line to the equity index and its smoothing. When both are above their trend smoothings, the stock market has gained ground at an annualized rate of 18.1% per year. However, when both are below their intermediate-term smoothings, stocks lose ground at a rate of -3.1% per year. Currently both the index and the A/D lines are above their smoothings. Advantage Bulls.

Market Cycles: Analyzing the cycles of the market is seen by some as voodoo. However, by plotting the current market action against a composite of the 1-year cycle, the 4-year Presidential cycle, and the 10-year cycle, it is interesting how often the market stays in tune with the general trend of the composite. Currently this is the case and the cycles point to higher prices through mid-September before a modest correction is slated to set in. Advantage Bulls (for now).

In light of the fact that this report is getting a little long in the tooth and we've still got four areas to cover, I'll leave it there for now and pick the review up again later in the week. However, I will provide a bit of a spoiler by letting you know that not all of the 10 major indicators/models I follow on a weekly basis are positive. Stay tuned.

Turning to this morning... Asian markets followed Wall Street's lead from Friday by advancing smartly. And with nothing really new to speak of coming out of Europe this morning, bourses on the continent as well as U.S. futures are modestly higher in the early going.

On the Economic front... There are no economic reports scheduled for release this morning.

Thought for the day... Be sure to match your desires with your expectations...

Pre-Game Indicators

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

  • Major Foreign Markets:
    • Australia: +1.25%
    • Shanghai: +1.04%%
    • Hong Kong: +1.69%
    • Japan: +2.00%
    • France: +0.70%
    • Germany: +0.71%
    • Italy: +0.85%
    • Spain: +0.25%
    • London: +0.29%
  • Crude Oil Futures: -$0.27 to $91.13
  • Gold: +$1.80 to $1611.10
  • Dollar: higher against the yen, euro and pound
  • 10-Year Bond Yield: Currently trading at 1.564%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +5.16
    • Dow Jones Industrial Average: +28
    • NASDAQ Composite: +11.10

Positions in stocks mentioned: none

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