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Let's Review (Part III)

Daily State of the Markets
Thursday, August 9, 2012

Publishing Note: I am traveling Friday thru Tuesday (family wedding) and won't publish an early morning report. Thus "Daily State" will return the middle of next week.

Good morning. Stocks appear to be treading water at current levels while waiting for the next batch of news/data/reports/rumors that would cause traders to adjust their views on the potential for additional stimulus from the ECB and/or the U.S. Federal Reserve. And make no mistake about it; it is expectations for additional central bank help - first in Europe and second in the U.S. - that is driving the action in the stock market. So, since things are fairly quiet right now, this appears to be a good time to wrap up our review of my major market models that was presented on Monday and Wednesday.

In the first two parts of the report, we introduced each model, detailed the objective and/or the makeup of the model, and then looked at the bottom-line reading for each of the 10 models (I know, there were only nine models listed but the "Trend Indicator" counts as two since we rate both the short- and intermediate-term trends of the market in our model). In today's report, I will summarize the message from the models and talk about how one might utilize the information.

The first thing we do each week is to assign a score to each model and add 'em up. If a model is positive it receives a +1. If a model is neutral, it gets assigned a 0. And if negative, the model score is -1. So let's take a look at the current model readings and see where the score lands.

Model Reading Score
Environment Model Positive +1
Industry Health Composite Positive +1
Short-Term Trend Positive +1
Intermediate-Term Trend Positive +1
Market Breadth Positive +1
Market Cycles Positive +1
Volume Relationship Positive +1
Economic Model Positive +1
Monetary Model Neutral 0
Investor Sentiment Model Neutral 0

Doing some quick math, it looks like we've got 8 positive readings, 2 neutral readings, and 0 negative readings, which gives us a total of +8 for an overall model score. Given that the maximum score is +10, we must recognize that this is a pretty solid reading. As such, if one were going to gauge their exposure to market risk on the "weight of the evidence" from our models, they would be fairly fully invested at this point in time. And given that the DJIA and S&P are just shy of their high-water marks for the current bull market, it seems that the model score is in tune with the level of the indices.

Another approach to take would use the model score to provide an overall exposure level to the stock and bond markets. This graduated approach would require weekly adjustments to the allocations to both stocks and bonds. For example, with a model score of +8, stock market exposure would be 80% while bond market exposure would be 20%. Thus, if the model score were to decline in response to a correction in the stock market, one's exposure to stocks would decline while your exposure to bonds would increase. While this approach can produce a fair amount of movement and is by no means a great timing indicator, it would have been very helpful during the major declines seen in 2008/09, 2010, and 2011.

Speaking of timing indicators, the overall model score can also be used as an intermediate- to longer-term timing indicator. We've found that scores of +3 and above are pretty good indications that the odds favor the bulls while a score of -3 or below suggests that the bears should be given the benefit of any doubt. Thus, one would want to be long at +3 or above, short at -3 or below, and in cash when the model score is +2 to -2.

While no model is perfect in the type of whippy, news-driven environment we've seen during the last three summers, the model will tend to keep you on the right side of the major trends that occur a couple times a year. For example, looking back at recent history, the model would have given a buy signal in December of 2011, allowing you to catch the nice rally into early April. The model would have gone neutral on April 16 and then waffled back and forth between buy and neutral on 4/23 and 5/7. However, the model flashed its most recent buy signal on 6/25 at 1313.72 on the S&P 500. And while the mood swings in the market this year have been rather extreme, following this type of weekly model would have produced a gain of +16.51% through yesterday's close for calendar 2012.

Is this approach perfect? Uh, no. Again, no model or system for timing the stock market is. However, this type of "weight of the evidence" approach WILL keep you on the right side of the big moves, which is really the goal over time. And for now, while Europe is still the focus of the market and stocks are indeed overbought, our indicators suggest that the bulls deserve the benefit of the doubt at this point in time.

However, for those that might be nervous about the potential for the Eurozone crisis to make yet another comeback in the near term, one could always hedge their bullish stance a bit whenever the market becomes extended - just in case the bears are able to produce another scary 3-5 day downdraft. But from our model's objective standpoint, the bulls continue to retain possession of the ball for now.

Turning to this morning... Overnight markets were mixed with Chinese stocks higher on the back of data showing that inflation has cooled (meaning that the government now has room to ease monetary policy further) while European markets are seeing red in the early going. U.S. futures are currently following Europe and point to a slightly lower open at the present time.

On the Economic front... We'll get the report on Weekly Jobless Claims, Trade Deficit, and Wholesale Inventories this morning.

Thought for the day... Are you feeling inspired today? Shouldn't you be?

Pre-Game Indicators

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

  • Major Foreign Markets:
    • Australia: -0.23%
    • Shanghai: +0.61%
    • Hong Kong: +1.02%
    • Japan: +1.10%
    • France: -0.40%
    • Germany: -0.95%
    • Italy: -1.17%
    • Spain: -1.33%
    • London: -0.26%
  • Crude Oil Futures: +$0.17 to $93.52
  • Gold: -$3.30 to $1612.50
  • Dollar: higher against the yen, euro and pound
  • 10-Year Bond Yield: Currently trading at 1.683%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -3.33
    • Dow Jones Industrial Average: -22
    • NASDAQ Composite: -2.37

Positions in stocks mentioned: none

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