Why Popular Market Indicators May be Giving False Signals

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Market indicators based on percent of stocks above their 50-day moving average and the number of advancing versus declining stocks are flashing bullish buy signals. While these have supposedly worked well in the past, the underlying conditions that led to their success may not exist in today's market. If so, these indicators could be dangerously misleading.

Ned Davis from Ned Davis Research has recently declared the market is experiencing a 'breadth thrust'. This takes place when more than 90% of stocks are trading over their 50-day moving average. This indicates extreme bullishness in the market. This indicator could be a valuable buy signal to investors if it takes place after a significant market low. The indicator did indeed give a buy signal on May 4, 2009 and again on September 16, 2009. The returns have been considerable from these buys. Another buy signal was given on April 5, 2010. After more than a year of rallying and the Dow Jones Industrial Average up around 70% from low to high, this signal is now more likely to indicate a seriously overbought market with few investors left to buy. This indicator has only flashed 12 buy signals since 1967, three of which took place within the past year. The good returns from the two signals in 2009 have in all likelihood made the overall profit potential of following this indicator look a lot better than it was previously and this should be taken into account when examining claims as to this indicators past performance.

Dan Sullivan from The Chartist is also bullish. He bases his outlook on advances versus declines in the market being greater than two to one. His indicator gave three buy signals in 2009. There have only been 18 such buy signals in the last 60 years. The only other years with multiple buy signals were 1962, 1975 and 1982. The Dow was down 11% in 1962. As for 1975, it followed a major two-year bear market in 1973 and 1974 that almost cut the Dow in half. The Dow rose 32% in 1975 and closed at 852. Six years later in 1981, it ended the year at 875 or an additional 3% higher. In 1982, an 18-year secular bull market began, so this was a good call. However, what made it a good call was the market finally broke out after going sideways and down for 16 years. The most analogous situation to today's rally was 1975. The Dow should have rallied in 2009 from its deeply oversold condition and it has, but that rally can't be infinite.

Investors should not blindly follow market indicators, especially when media reports usually give information that is limited to only what is taking place right now. To accurately decide the value of a current buy or sell signal, it is necessary to know how and why it worked in the past. Close examination may indicate the indicator didn't work as well as claimed or that it works only under certain conditions like the Fed lowering interest rates or immediately after a major sell off. As is always the case, investors who want to make money in the markets need to think for themselves.

Disclosure: Not relevant.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

U.S. Stock Market in the First Quarter of 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Today is quadruple witching, a once every quarter event that takes place on the third Friday of March, June, September and December. On these dates, contracts for stock index options, stock index futures, stock options and single stock futures all expire. While media reports usually focus on volatility during the expiration date, far more important is the trading that takes place in the proceeding weeks. Prices will tend to move to minimize the value of outstanding options due to hedging, if not for other reasons. A negative outlook in February seems to have led to a nice rally in U.S. stocks during March.

Stocks started the year off with a mildly bullish tone and hit a peak in mid-January. The Nasdaq and Dow Transports hit a high on January 11th, the Dow Jones Industrial Average on January 14th and the S&P 500 and Russell 2000 on January 19th. All the indices sold off into February on news of reductions in liquidity from the U.S. Fed and restrictions on bank lending in China. The moves withdrew very little money from the global financial system however. The world's markets are still awash in liquidity. The U.S. dollar was also rallying during this time and since the stock market rally began in March 2009, the dollar and stocks have tended to move in opposite directions.

Stocks then started rallying off their February lows in a stronger dollar environment. This pattern first became evident recently in December 2009 when the trade-weighted dollar rallied strongly and so did stocks during the month. It would perhaps be more accurate to say the euro experienced significant weakness during these periods because of the crisis in Greece (the euro represents over half of the trade-weighted dollar). December represented a shift in trading patterns for the U.S. dollar and stocks for the current the rally.  Investors should note if the strong-dollar strong-stock pattern continues. While it was common in the 1990s, the opposite has been the case for much of the 2000s.

All the major indices hit new current year price highs recently. The Russell 2000 was the first on March 2nd, followed by the Nasdaq on March 5th, and the S&P 500 on March 12th. The Dow Transports hit a new high on March 10th before the Industrials hit a new high on March 17th. New highs are of course generally bullish.  Small caps have been doing best in the rally. This indicates higher risk tolerance on the part of investors and is also something that happens in inflationary environments. Small caps outperformed during the second half of the high-inflation 1970s following the deep recession of 1973 to 1975.

U.S. stocks can continue to do well as long as liquidity is being pumped into the financial system. Liquidity is the driver of prices and not the economy as the mainstream media constantly reports. Liquidity shows up first in the markets and later on in the economy if everything works according to plan. The Japanese in the 1990s and 2000s found that this Keynesian style plan didn't always work however. If things get too bad because too many excesses have built up in the financial system, the liquidity fix is no longer effective. U.S. investors also need to realize that money has flowed out of Europe and into the U.S. and a resolution of the Greek crisis will cause funds to flow out of the U.S. and back into Europe. Moreover, actions the Chinese take can also impact U.S. stock prices. China raising interest rates would be a negative for U.S. markets. Revaluing its currency upward would also shake things up.

Disclosure: None

NEXT: Who Really Benefits From the U.S. Healthcare Bill

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.