Short Takes

This morning’s bullish payroll report aligns with the “another push higher” and probable strength into next week scenarios. The area near 1,343 remains important on S&P 500, especially on a closing basis. We are open to making bullish or bearish adjustments, but we are still leaning toward the correction camp.

DeMark indicators look for price exhaustion, which speaks to a market that runs out of interested buyers. Based on the way the signals are generated, a market must exhibit some respectable price strength to establish “exhaustion”. The fact that DeMark counts have been slow to develop over the past six weeks is indicative of a weak and tentative advance in stocks.

Once again, we failed to hold the levels needed on Tuesday to generate an exhaustion signal on the daily chart of the S&P 500 Index. For the signal to occur today, we need (1) an intraday high greater than 1,303, and (2) a close greater than 1,295.50. Once we get the signal, there are some things to look for in the following days which increase the odds of a reversal.

Numerous markets and time frames still point to lower lows in stocks later in 2012. We believe the S&P 500 could push above 1,285 toward the 1,300 - 1,343 range. However, that move may be retraced fairly quickly, based on DeMark counts, increasing bullish sentiment, and still-elevated Italian bond yields. The negative implications of a 10-year Italian bond yielding 7% were outlined at the 00:29 and 13:00 marks of a December 18 video.

UBS created an interesting chart using the Juglar cycle, Kitchin cycle, and Dow Jones Industrial Average. According to Wikipedia:

The Kitchin cycle is a short business cycle of about 40 months discovered in the 1920s by Joseph Kitchin. The Juglar cycle is a fixed investment cycle of 7 to 11 years identified in 1862 by Clement Juglar.

Investors tend to get overly bullish near market tops and overly pessimistic near market bottoms. The latest AAII sentiment survey aligns with the idea of a probable peak occurring between 1,285 and 1,340 on the S&P 500. Bearish sentiment fell to the lowest level in roughly a year. Bullish sentiment rose to the highest level since early February 11, 2011; the S&P 500 peaked a week later (see below).

Extreme volatility and panic buying are typically associated with bear markets. In the examples below, all the gains were retraced. We posted these charts in the past, but they are worth another look.

If you are reading this analysis when the S&P 500 is experiencing a monster rally, keep the three historical rallies below in the back of your mind:

The three rallies above occurred in the context of a bear market. If the current market can rally and the S&P 500’s 200-day moving average can turn back up, then we would be more willing to push our bear market concerns aside. But a rally that occurs with a downward sloping 200-day moving average, even a big rally, should be viewed with a dose of skepticism.

The charts of the three rallies above illustrate two important points about bear markets:

1. Volatility picks up
2. Sharp rallies are common

While most people understand the current global debt crisis is a serious matter, many investors may still be thinking along these lines:

1. Companies are healthy right now.
2. Earnings are fine.
3. Dividend stocks do well in a bear market.
4. My investments are not directly impacted by government debt.

While there is some truth to the statements above, it is vitally important for investors to (a) remember the domino effects that occurred in the economy and financial markets during the mortgage and housing crisis, and (b) to have a specific risk management or “stop loss” strategy in place for all their investments.

The video below draws parallels between investor psychology, the economy, and financial markets during the previous financial crisis and the current debt crisis. Like all Americans, we hope the global debt crisis can be contained by central bankers and policymakers, allowing the bull market to regain its balance. However, we must be aware of and plan for possible negative investment outcomes.

We updated our similar markets study last night. The results are similar to the first pass. As mentioned in the July 18 video (see below), the slope of the S&P 500’s 200-day moving average remains a key differentiator between markets that should have been sold and markets that warranted a more balanced approach to risk management.

The current slope of the S&P 500’s 200-day is basically flat, telling us to reduce risk, but not to throw in the towel yet. If the slope of the 200-day turns down especially for more than a few days, we will reduce risk further.

The green arrows in the charts below show the midpoint of the similar historical periods as identified by the CCM Bull Market Sustainability Index (BMSI) and CCM 80-20 Correction Index (80-20 CI). Notice in 1998 the slope of the 200-day flattened out, but did not turn over in an obvious manner. Stocks recovered in 1998 and went on to make new highs.

In 1999, we had a similar situation; the slope of the 200-day flattened out, but did not turn over in an obvious manner. Stocks recovered in 1999 and went on to make new highs.

In 2000, the bear market began in earnest after the slope of the 200-day rolled over in a convincing manner.

The 2007-2009 bear market also ramped up its bearish bias when the slope of the 200-day turned negative.

As we mentioned in the video above, we do not feel 1984 is all that good a proxy for the current technical backdrop. However, when the slope of the 200-day turned up, it was a bullish signal.

Given the recent deterioration in the market’s risk-reward profile, we have reduced our mix of risk assets and more conservative assets to roughly 50%-50% depending on the needs and risk tolerance of the client. If the market can find its footing soon, we will maintain that mix for a time. If we see further deterioration, we will raise more cash. The risk portion of our portfolio is mainly comprised of the S&P 500 Index (SPY) and mid-caps (IJK). Our conservative portion is primarily made up of cash, bonds, gold (GLD), and silver (SLV). Our gold and silver represent a hedge against the possible further debasement of paper currencies. The Fed meets next Tuesday; we believe the odds are decent they will make some precious-metal-friendly comments.

Update as of 2:50 p.m. - We reviewed all client portfolios today. We have orders saved to raise some additional cash in the majority of accounts. The chart below, first posted on July 12, still contains some meaningful values (1,267, 1,258, 1,249).

The 200-day currently sits at 1,285. As we described in this July video and post, a break below the 200-day has occurred in the past under similar circumstances and was eventually followed by higher highs.

CCM Clients: The market is concerned about recent weak economic data. Depending on how the remainder of the day goes, we may take some additional defensive steps before the close. The Fed meets on August 9; until then the bias may remain negative.

Our levels were exceeded near the close on Germany (EWG), foreign (SCHF), Simon Property Group (SPG), materials (XLB), and emerging markets (EEM, SCHE). We sold portions or all of these positions today. We will enter next week with a continued defensive bias. If needed, we will continue to raise cash until the markets find their footing.

Weekly jobless claims came in today at 474,000, well above the consensus of 410,000. While the first three trading days of the week brought significant weakness in numerous markets, many trends and relative-strength trends remained intact through the close on Wednesday. On Thursday, many of these trends were broken in a bearish manner, which prompted us to begin raising cash.

We reduced our positions in energy, commodities, emerging markets, and precious metals today. The selloff this week is significant and needs to be respected and monitored closely. While many markets are still within reach of a logical recovery, another day of heavy selling on Friday would have us even more concerned about the short-to-intermediate-term outlook. The incremental approach we use calls for raising cash at a rate that corresponds to the rate of deterioration in the markets. We will raise cash at a more rapid rate if the markets cannot find their footing soon.

Near today’s close, we had checked off 58% of things we would expect to see on a daily chart prior to a relatively significant market pullback. On a weekly chart, we have seen 37% of what we would expect to see. These figures can ramp up relatively quickly should we experience a few more days of weakness.

Based on numerous factors (see post), we cut back on positions ranging from energy to utilities today. If the markets can find their footing soon, we are happy to hold our remaining positions and profit. If the markets and our models continue to point toward the need to raise more cash, we are ready to do so using the incremental approach.