Short Takes

Stock Market Trends: Importance
and How to Monitor Their Health
ATLANTA

Even Warren Buffet Needs Trends

From a fundamental perspective we have two primary drivers in the current market:

• An improving or “less bad” economy.
  
• Inflationary policies that may boost the value of weak U.S. dollar assets.

While the U.S. economy remains weak and fragile, there is no question the economic numbers are improving albeit from very depressed levels. Even if we assume worse than expected economic news, we know what the response will be from policymakers – more government spending, more bailouts, low interest rate policies, and more money printing – all of which are inflationary and supportive of commodities, foreign stocks, foreign bonds, etc.. Additionally, we cannot rule out the possibility of deflation and inflation occurring simultaneously in the economy. Commodity prices may experience inflation. Wages may get hit with deflation. If governments create enough new money, eventually it will make its way into the economy. When it does, it will be looking for a home. One thing that takes a few years to appreciate when working on Wall Street is the impact of monetary and fiscal policies on asset prices.

Is it possible the inflationary policies will fail? Yes, and if they do it will be easy to see in the financial markets. If crude oil makes new lows and emerging market stocks make new lows, it will be a clear signal that deflation is ruling the day. Even if we eventually get high CPI inflation, it will take some time to appear, which means all asset classes could benefit for a time, including U.S. stocks. If inflation starts to get out of hand in a few years, stocks could very well lag commodities by a wide margin. For now, the markets are sending a clear signal that inflation has a chance to take hold. If those signals change, trends in the charts below will begin to fail and the U.S. dollar may strengthen again for a time. If the deflationists are right, crude oil will give us plenty of warning ahead of time. Like oil, the chart of the U.S. dollar is not currently pointing to deflation.

Monitoring Trends

Comments for XSD chart below: It is common for corrections to give back 38.2% to 50.0% of the prior move. A 38.2% retracement of the gains from the March lows would take us back to $30.50. We also have support at $32.07 in the form of the 50-day MA (blue line). A 50% retracement would take us to $29.05, which is complemented by possible support from the 89-day MA at $29.50 (red line) and the 200-day MA at $28.09 (green line). Price support exists at $28.82 (purple line). The bottom end of the trend channel (pink line) also comes up to meet the 200-day MA. If the correction continues, we would expect to see buyers enter the market somewhere inside the green box. We should hold this position as long as support below holds.

As the price of one of our investments drops, it is normal for us to experience fear. The further it drops, the more fearful the typical investor becomes. Rather than focusing on price alone, we need to focus on the trend. We should ask ourselves, is there a compelling reason to exit this trend? Is there evidence that a trend change may be taking place? If the answer is no, in most cases we need to stay with our strategy. Money management comes into play at some point, but we can give smaller positions more rope since the impact on our entire portfolio value is reduced. As stated recently in Short Takes, if your investments fall 12%, but you have 50% of your account in cash, the loss relative to your entire portfolio is 6%. This is why we took some very small positions in recent weeks – some as small as 1% of a portfolio. We can give a 1% holding quite a bit of rope with a limited impact on our principal. A 10% position has to be given 10 times less rope.

A few important points related to entering markets:

• It is not uncommon for market leaders to remain in the top half of their trend channel more than 50% of the time.
  
• Market leaders rarely make new lows or even revisit lows.
  
• Consequently, investors who exclusively enter markets at lows and at the bottom of trend channels often miss market leaders and end up building a portfolio of market laggards – not what we want.
  
• It is important to have several methods to enter and exit markets. Using trend channels is one of many methods we use.

We are experiencing the aftermath of a once in a lifetime credit event. It is never easy transitioning from a bear market to a bull market. Under the circumstances and given the rapid descent during the bear market, followed by a extremely rare and powerful “V” shaped rally off the bear market low, the current environment is especially challenging. We remain confident that hard work and discipline will allow us to make good decisions regardless of whether we have started a new bull market or if the bear returns.

Given the pullbacks in recent days, we thought it might be beneficial to provide you with one of the many ways we monitor our positions. When markets correct, it is important to review your basic strategy in order not to get emotionally involved with day-to-day volatility and normal corrections. Our basic approach to the markets can be summarized as follows:

• Look for fundamental and technical alignment.
  
• Monitor numerous markets and asset classes (something will trend somewhere).
• Identify markets that have a confirmed trend.
  
• Enter these markets.
  
• Stay with a trend as long as possible.
  
• Ignore volatility and corrections that do not disrupt the trend.
  
• Exit the trend when evidence begins to mount that the trend may be ending.

Chris Ciovacco
Ciovacco Capital Management

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