Technical Outlook for the Stock Market

The majority of investors view stocks and bonds as a means of making their money grow–the faster the better. Though I am just as concerned about the well-being of my financial assets as the next person, what really keeps my interest in markets is the fascinating interaction of raw human emotions which are responsible for much of the market’s unpredictable volatility. Greed, fear, brilliance, stupidity, plain dumb luck, generosity, deceit corruption, outright crime etc. are all on display here.

 This potent combination of crowd sentiment is the reason why no reliable mathematical model has ever been developed to accurately forecast the market’s short or long term turning points. This is not from any lack of effort on the part of countless analysts, Nobel Prize winners in economics, high powered Wall Street strategists or independent editors of technically focused newsletters.

 The market action in recent months has provided more than enough reason for market participants to contemplate the possibility of one of those major market reversals. After more than three years of rising prices this primary bull market is among the longest on record. Since March 2003, its steady advance, as measured by blue chip indices, experienced no correction larger than 9%. Even the latest correction, from the May 2006 highs, is still short of 10%.

 This unusual resiliency created an aura of complacency that has many financial commentators referring to the May-June weakness as “volatility.” At what point this “volatility” would qualify as a sell-off or be called, in the financial lexicon, a bear market is hard to tell. I imagine 20% down from the May 2006 highs would do it.

 The moderate decline in blue chip indices such as the DJI and the S&P 500 does not illustrate the extent of pain investors already feel. The decline in indices comprised of secondary and speculative stocks that led the bull market charge, has gone beyond volatility. The NASDAQ Composite, the S&P 600 Small Cap, and the TSX Composite already lost, at one point, more then 13%, with a large number of stocks down more than 20%, the rule of thumb definition of a bear market.

 Whether the unpleasant business of the last two months is called volatility or a correction, or deserves the label of a bear market in the making, it has left the market deeply oversold by most technical measures. This is fully reflected in the continuing bearish standing of our trend-following group of technical indicators.

 The group’s bearish reading of -46% signals that, at least in the short-term, the market decline went down far enough and fast enough to have attracted bargain buying and profit-taking by short sellers. From recent trading history, the technical indicators are at over-sold conditions comparable to levels at the intermediate bottoms of April 2005 and October 2005. One negative difference is that the minor rebound in price indices from their mid-June 2006 lows has yet to be confirmed by comparable rebounds in the Advance/Decline Line and the Upside/Downside Line.

 A stronger argument for a more sizeable rally is provided by the Sentiment group of indicators that extended its recent rebound all the way to a bullish +36%. In contrast to the trend-following indicators the majority of sentiment indicators get stronger as the market weakens and vice-versa. The best signals come when their readings hit extreme levels of either bullish or bearish expectations displayed by identifiable groups of investors.

 As I had already noted, secondary and speculative stocks that investors had loaded up on during the bull market, took extra large beatings. The pain inflicted was sufficient to spook investors to the point where the Sentiment group is at its best level since the March 2003 bottom. Within the sentiment group, only the NYSE&AMEX Insider Sales/Buys ratio remains bearish. Among the indicators that turned bullish are the AAII Sentiment, the Investors Intelligence Advisory Sentiment, the CBOE Equity Puts/Calls, the CBOE Option Volatility indices (VXO and VXN) and the ISE Puts/Calls ratio.

 In contrast to the two credible arguments for a short-term rally, namely, the technically oversold conditions and the high levels of bearishness, the long-term outlook as projected by the Fundamental/Monetary group of indicators remains bearish at – 41%. The improvement from -50%, of a month ago, has been primarily due moderate improvement in stock valuations following the recent decline in prices. However, rising yields across the entire maturity range, and the likelihood of further increases in the U.S. federal fund rate, make investment in stocks increasingly less competitive compared to fixed interest paying securities.

 One measurement of the relative investment appeal of equity vs. bond investments is the so-called Risk Index. It compares the annual total returns from equities with that for 10-year treasuries. Based on monthly data it is not a fine market timing tool. Nevertheless, its signals provided advanced warnings for the three major bear markets of the last 25 years.

 In short, the market is ripe for a rally that will fail to take it above the 2006 highs.