Short Takes

Since the markets are concerned about both deflation and possible money printing exercises by the Fed (inflation), we have been and will continue to move toward a more balanced portfolio. We will keep some of our inflation/cyclical/recovery assets (like silver, copper, Malaysia, Australia, emerging markets) and will continue to mix some deflation/slow economic growth assets (like consumer staples, utilities, fixed income, and various other dividend-payers).

In order to be prepared for possible stabilization/rally in the markets, we ran numerous CCM proprietary asset allocation models and ranking systems last night. The process begins by screening all ETFs which trade with high liquidity. It incorporates returns over various timeframes, as well as both an overall and timeliness ranking of daily, weekly, and monthly charts/data for each sector/ETF. The final composite rankings for the most attractive options are shown below. These results and the results from our Rydex/Schwab ETF research will serve as our shopping list should conditions warrant moving some additional cash off the sidelines.

As we mentioned yesterday, the markets appear ripe for a sustainable bullish turn. However, we remain in a “prove it to me market”. Friday brings the always-important-to-the-the markets monthly employment report. The government is expected to have released Census workers in August, so the headline number will look worse than what is already a weak environment for job creation. Reports this week give us some hope that Friday’s job number can come in slightly above expectations, which call for job losses in August totaling 80,000.

The CCM Bull Market Sustainability Index (BMSI) closed Wednesday at 676, which moves us a little further away from the very unfavorable risk-reward zone when the index falls between -165 and -351.

While the bulls still have some work to do, today’s gains increased the odds that risk assets can rally for some relatively sustainable period (maybe a few weeks). With quite a bit of economic data on tap during the remainder of the week, the bears may have their say before the holiday weekend. For now, conditions remain favorable for a continuation of the current rally.

Wednesday’s gains came on mixed volume (higher on the NASDAQ, lower on the NYSE). Market breadth (advancers vs. decliners) was very strong.

The ISM Manufacturing Index came in above expectations at 56.3, which remains indicative of economic expansion. The ISM number gives some legitimate backing to having Friday’s employment number come in slightly above expectations, which would be better than recent disappointing news on employment.

We invested some relatively tame amounts of cash into consumer staples equities and dividend-paying utilities today. We also have kept a decent amount of cash on the sidelines for now. Today’s investments represent a more conservative way to gain some exposure to risk (relative to more cyclical positions that we already hold). The vehicles we used to gain access to consumer staples and utilities are very flexible and trade commission-free, which will allow us to remain very nimble in a still fragile economic and market environment. Today and last Friday represent steps in the right direction, which is an improvement over what we have seen in recent weeks.

You can find today’s post and detailed research on stocks, bonds, and currencies in Markets Appear Ripe for a Sustainable Bullish Turn.

The only positive from yesterday’s otherwise bearish outcome was volume was light relative to Friday’s volume, which does not fit recent patterns of high volume on down days. Breadth was poor and a selloff at the close is not indicative of institutional confidence.

As shown in the chart below, the 75-week (blue line), 80-week (red line), and 90-week (green line) moving averages (MAs) have acted as both support (green arrows) and resistance (red arrow) in the past. During the 2003-2007 bull market these moving averages, for the most part, held during all corrections. The slopes of all three MAs are currently positive, which leans bullish rather than bearish. The MAs stand at 1,049, 1,030, and 1,011. Breaking them on an intraweek basis is in line with past corrections (2002-2007). A break, especially a clear break, on a weekly closing basis would add to our bearish concerns. These MAs, along with the CCM BMSI, tell us some continued patience is in order the short-to-intermediate term. The CCM BMSI closed yesterday at 377, leaving us with a weak market that historically (1980-2010) has favorable odds in terms of being able to stage a rally over the next four to nine weeks. The markets remain fragile and need to be monitored very closely, understanding how the Fed fits into the picture.

The Fed meets on September 21, 2010. If markets and economic data remain weak over the next three weeks, we believe the Fed will announce more plans for quantitative easing (buying bonds with printed money). We are working on an article covering what we believe is a flawed interpretation of quantitative easing by many market participants. Many believe quantitative easing will have little or no effect on asset prices. If you understand how quantitative easing works in the real world, it is easy to see how it can and most likely will impact asset prices in the coming weeks and months. Going to 100% cash in the next few weeks may prove to be a frustrating experience if the Fed cranks up the printing presses as we expect.

One impressive day in stocks is a possible starting point for positive outcomes over the next few weeks, but we need to see some follow through this week before we can read too much into the gains made late last week. Friday’s rally in stocks was impressive in terms of breadth and volume. Volume associated with advancing issues made up 92% of the total volume traded on the NYSE. The advance-decline ratio on the NYSE was 8.4 to 1.3, which is very good. S&P futures were up over 8 points on Sunday night. At 5:45 am ET on Monday, S&P futures were up a modest 2.3 points. During the trading day on Monday, we will be looking for some type of follow through relative to Friday’s gains. If we can get another positive day in terms of breadth and volume, the odds of a sustainable intermediate-term rally in risk assets will have increased.

In order to be prepared should markets be able to continue to rally this week, over the weekend we ranked flexible and no/low commission investment options. With markets focusing on both deflationary and inflationary forces, it is important that we remain flexible and nimble in the current environment. The table below shows our final notes relative to this weekend’s research; colors are based on short-term attractiveness; rankings on longer-term attractiveness.

If the markets remain weak, we may do nothing with the research conducted this weekend. However, we are prepared should Friday’s rally attempt be able to see some follow through gains sometime this week. The CCM BMSI came in at 235 on Friday, which is indicative of a weak market, but one where conditions are favorable for a rally. As we discussed on Friday morning, this remains a “prove it to me” market.

Federal Reserve Chairman Ben Bernanke speaks at 10:00 am ET this morning from the Kansas City Fed’s Jackson Hole Summit. Participants in fragile asset markets are looking for a clear message concerning the Fed’s strategy to address recent economic weakness. A generic delivery by Bernanke could light the fuse for another leg down in asset prices. A speech hinting toward or clearly outlining additional quantitative easing could spark a rally in risk assets.

We put the current market environment into the “prove it to me” category. Markets remain weak, but they have reached a point where the odds of a short-term reversal are becoming more favorable. Tornado watches and tornado warnings serve as a good analogy for the state of the markets. A tornado watch is issued when weather conditions are favorable for the development of tornadoes in and close to the watch area. A tornado warning is an alert issued by government weather services to warn an area that a tornado may be imminent. A warning can be issued after either a tornado or funnel cloud has already been spotted, or if there are radar indications that a tornado may be possible.

Currently, the markets are in “rally watch” mode, meaning conditions are favorable for a rally to develop, but not much in the way of bullish activity has occurred to date. We remain open to bullish outcomes, but prudently skeptical until we have some evidence to support a possible intermediate-term bottom in asset prices. The CCM BMSI closed Thursday at 312, which aligns well with a weak market that has a better than average chance to rally in the coming days and weeks. For now, the bears remain in control until the bulls can muster enough strength to cross the “prove it to me” threshold.

In the last few weeks, Wall Street has been spooked by a technical occurrence know as the Hindenburg Omen. The basis for the concern is we have recently seen both relatively high numbers of new 52-week highs and new 52-week lows. Wikipedia has a good summary of the Hindenburg Omen calculations.

The recent triggering of the omen is concerning and aligns well with our models in that it is indicative of a weak stock market. However, comments and data about the omen seem to do a good job covering the “bad” outcomes after the omen was triggered, but give little performance data for stocks when “good” outcomes occurred following a Hindenburg sighting.

In a very well researched article on the Hindenburg Omen by Robert McHugh, he states the following:

There is a 30 percent probability that a stock market crash — the big one — will occur after we get a confirmed (more than one in a cluster) Hindenburg Omen. There is a 40.8 percent probability that at least a panic sell-off will occur. There is a 55.6 percent probability that a sharp decline greater than 8.0% will occur, and there is a 77.8 percent probability that a stock market decline of at least 5 percent will occur.

McHugh does a good job covering the “bad” above. Here is the same data presented from the “good” perspective:

There is a 70 percent probability that a stock market crash — the big one — will NOT occur after we get a confirmed (more than one in a cluster) Hindenburg Omen. There is a 59.2 percent probability that at least a panic sell-off will NOT occur. There is a 44.4 percent probability that a sharp decline greater than 8.0% will NOT occur, and there is a 22.2 percent probability that a stock market decline of at least 5 percent will NOT occur.

The first Hindenburg trigger came on August 12, 2010 when the S&P 500 closed at 1,083,61. Since then stocks have already dropped 4.04% using yesterday’s intraday low of 1,039,83. Therefore, some pressure on the markets has already been relieved from a basic technical perspective.

A balanced view of both the “bad” and “good” outcomes was presented by Mark Hulbert in How Bearish is the Hindenburg Omen? Below are some excerpts:

That’s the urgent warning coming from devotees of an esoteric market timing gauge known as the Hindenburg Omen. They say that it is a reliable indicator of an imminent stock market crash. But I’m not so sure. In fact, my review of the data suggests that those using the Omen to predict a crash are good candidates to win the Chicken Little award…Upon closer scrutiny, the Omen’s triggering earlier this month turns out to be not very scary at all.

At CCM, our models flashed some warning signals on August 11, 2010 as described in the post Odds of a Multi-Week Correction Have Increased. Like the followers of the Hindenburg Omen, we have been and continue to be concerned about the current market environment. We believe the markets need to be monitored very closely in the coming days and weeks.

Taking into account the S&P 500’s recent slide from 1,129, from a historical standpoint (1980-2010), the markets risk-reward profile is indicating some patience is now in order. We respect the risk-reward profile could deteriorate from current levels, but at present it favors bullish outcomes over bearish outcomes. The markets have been and remain fragile, so our bullish bias here is tentative and subject to change if the CCM BMSI drops below -165 (see table below). The August 25th BMSI level was 278 leaving us with a positive bias for the time being.

According to the Wall Street Journal, significant stock market declines have followed Hindenburg Omens only 25% of the time. Said another way, 75% of the time significant stock market declines did NOT follow a triggering of the Hindenburg Omen. There are plenty of technical and fundamental reasons to be concerned in the current environment, but the Hindenburg Omen seems to be getting a little too much hype relative to the statistical realities associated with it.

Today, we have reports on durable goods at 8:30 am and new home sales at 10:00 am. GDP is released at 8:30 am on Friday. Tuesday’s existing home sales came in below expectations and below even the lowest estimate.

The CCM Bull Market Sustainability Index (BMSI) closed yesterday at 398. We may be getting closer to some type of bounce or intermediate-term bottom, but the chart of the S&P 500 still looks weak. We do not have positive divergences that you would like to see as markets approach recent lows, which means further weakness in the short-term would not be surprising.

An updated version of the chart we posted before Tuesday’s open is shown below. It is still reasonable to assume the S&P 500 may attract some buyers between 1,010 and 1,040, but we would like to see some better set-ups on the charts (something we do not have yet).

In terms of strategy, we will see how markets behave between 1,010 and 1,040 and adjust as needed. We are comfortable with our ratio of risk-to-conservative investments. We remain open to becoming more defensive if needed. Weak economic data could still impact markets in a negative manner.

As we have been doing for the last two weeks, we raised some additional cash in the majority of client accounts today. Tomorrow, we will continue with the plans outlined in this morning’s post.

The markets have entered a mixed position in terms of risk-reward. On the bearish side of the equation, markets remain weak and susceptible to further declines. On the bullish side of the equation, we have some improving risk-reward ratios and possible areas of support relatively close to current levels on the S&P 500. The CCM BMSI closed yesterday at 427, a level which has historically produced a favorable risk-reward ratio over the following year (see green portions of table below).

We have also entered an area where the BMSI is unlikely to fall rapidly in the next few days. In the very short-term, it is unlikely we will see BMSI levels drop into the very unfavorable -165 to -351 range (see red portions of table above). Historically, more often than not, markets have been able to rally from similar technical profiles. That is the good news. The bad news is the S&P 500 could fall further before making any attempt at a rally. As shown below, logical areas for a possible intermediate-term bottom fall between 1,010 and 1,040 on the S&P 500.

We began reducing risk (raising some cash) on August 11, 2010. Our decision was based on deteriorating short-to-intermediate-term risk-reward ratios. Roughly two weeks later, the risk-reward ratios have improved, but the market remains fragile. Our current stance is to possibly make some additional relatively small risk-reduction changes (raise more cash) as long as the market’s profile does not deteriorate significantly. However, we stand ready to take significant and swift defensive action in the event the market’s risk-reward profile reaches unfavorable levels. We remain very concerned about the markets, but some restraint and patience is prudent as long as the S&P 500 remains above (a) 1,040, and (b) 1,010. Similarly, as long as the CCM BMSI remains above -165, wholesale defensive actions are not yet needed. We are reviewing client accounts today and will make some adjustments as needed.