Let's Review (Part II)August 8, 2012 @ 8:14 AM EST
Given that the S&P 500 has finished each of the last two days about where it was a minute or two after each day's open, it is fairly clear that the dog days of summer have set in. As such, this is probably as good a time as any to finish up the review of our most important market models and their readings that we began in Monday's report.
If you will recall, on Monday we checked in with our Market Environment Model (which was and still is positive), the Technical Health Model (which shows that the vast majority of industries remain technically healthy at this point), our primary Trend indicators (both the short- and intermediate-term trends are positive), Market Breadth (yep, these models are positive too) and our Market Cycle composite (which will remain positive for another few weeks).
This morning, we will look at one additional "technical" indicator and then move on to the areas of the economy, monetary policy and investor sentiment. Then we will tally up the scores and see what the overall model looks like at this point.
Volume Relationship: This is an individual indicator that looks at the relationship of "demand volume" to "supply volume." As you might suspect, when the demand volume line is above the supply volume line, it is an indication that there is strong buying in the market. And when the opposite situation occurs, it tells us that sellers are in control. At this point in time the message from this indicator is mixed. Although stocks are near their highs for the year, the demand volume line is only modestly above supply volume and the level of the demand volume line is well below where it was in late April, when the indices made their highs for the year. So, while this indicator is officially positive at this point, it is diverging a bit from the price action - which is a warning sign unless/until the divergence can be resolved.
Economic Model: As the name implies, the economic model is designed to give us a reading on the state of the economy. The model consists of more than a dozen individual indicators. And although the stock market is not always driven by the overall health of the economy, the model has been built to provide buy and sell signals. Currently the model is in the high neutral zone, which is consistent with an economy that is growing slowly. However, when the model has been in this zone, the stock market has gained ground at a rate of more than 9.3% a year since the mid-1960's (this compares to the S&P's buy and hold average annual return of 6.0%). So, while the model tells us that the economy is indeed just muddling along, history tells us that stocks have done better than average.
Monetary Model: One of the most famous (and most profitable) Wall Street clichés is "Don't fight the Fed." In essence, this means that when the Fed is making an effort to keep interest rates low, stock prices have historically risen. The reasoning behind the rule is actually pretty simple as corporate America has traditionally been more productive/profitable when interest rates are low. Whether or not that will be the case this time around remains a topic for discussion as rates have been low for some time and there a myriad of other factors working against economic growth at the present time. However, right now, the Monetary Model is rated high neutral. But unlike the Economic Model, the S&P 500 has gained at just about 4% when the Monetary Model is neutral.
Investor Sentiment Model: Finally, we look at another model-of-models designed to give us a read on the mood of the market. This is an important and often misunderstood area of market analysis. Cutting to the chase, when investor sentiment is strong it means that anyone looking to buy has likely already done so and vice versa. Thus, it generally pays to start thinking about going the other way when the crowd (or in this case our model) reaches an extreme reading - in either direction. Currently the model is neutral. Our take here is that while stock prices are near the highs of the year, the overall macro view remains dour - leading to the neutral reading in our model. History shows that stocks have done a smidge better than the buy-and-hold S&P 500 when in the neutral zone.
If you like to dig into such things, you will probably note that of our ten important market models, the majority are "technical" in nature. In short, this means that we tend to lean heavily on what the market actually "is" doing in terms of trend and momentum as well as the internal health of the market. Note that only three of the ten models could be considered "external" in nature (think forest versus trees). And finally, you may find it interesting that we place precisely zero emphasis on corporate earnings and/or market valuation. The bottom line is we've found that "it all comes out in the wash" and that trying to model these areas is a waste of time due to the fact that the market reacts differently to both areas in different types of environments.
Tomorrow will tie everything up in a nice bow and look at the overall model scores as well as what the score means in terms of the appropriate exposure level to market risk.
If you like this type of rules-based market/risk management approach, be sure to check out our Special Report on the system we developed for the new "Adaptive" Daily Decision. The report details our approach to managing risk on a short- and intermediate-term basis, our methodology as well as the results of the system testing.
Turning to this morning... Yields are rising in Spain again this morning and European bourses are down across the board. U.S. futures are following suit and are currently pointing to a pullback at the open. But after a three-day rally of nearly 300 points on the Dow, some backing and filling is to be expected.
Thought for the day... Never forget that the first rule of life, medicine, and money management is to do no harm...
For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)
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