October 1, 2010

Will the Trading Range Break to the Up- or Downside?

After weighing the bullish and bearish arguments, it may be best to follow the odds or stay on the sidelines until more clarity is reached.

 

Thousands of years ago, King Solomon stated: “Expectation postponed is making the heart sick.”

Over the past few months, the stock market’s performance has been making investors sick as expectations from both bulls and bears go unfulfilled. The S&P 500 (SPY) has been stuck within the 1,040 to 1,130 trading range.

On the upside, the S&P has failed twice to stay above the 200-day moving average. On the downside, except for the July 1 low of 1,011, the S&P has found support around 1,040 on six separate occasions. The same general pattern has also emerged with the Dow Industrials and the Nasdaq Composite.

Let’s evaluate the evidence for both the bullish and bearish cases.

The Bullish Case

Reason #1: Stocks will rally due to the election-year cycle.

It is generally believed that the government won’t allow the stock market to fall before the November 2010 elections to the U.S. Senate.

According to the Stock Trader’s Almanac, the sweet spot of the four-year presidential term begins in the fourth quarter of the mid-term year (2010), and carries into the second quarter of the pre-election year (2011), with an average gain of 15% since 1950.

Contrary to the above pattern, the months of October, November and December have seen some of the biggest declines in the past decade. The last serious mid-term election year declines were seen in 2002 (-16.8%), 1974 (-27.6%) and 1930 (-33.8%).

The 1930 decline deserves a second look for a number of reasons. Following the initial 1929 meltdown, the Dow rallied 50% into the highs of April 16, 1930. Following a period of range-bound trading, stocks sold off sharply after September 10, 1930.

The rally into the April highs turned out to be the biggest sucker rally in history. Range-bound trading over the next few months gave investors a few more chances to cut their losses before the hammer dropped.

As a point of reference, stocks topped an April 26, 2010. Following the initial decline, stocks have remained range bound until the present.

Reason # 2: Sentiment is too bearish.

After the worst August since 2001, sentiment was indeed bearish, and investors expected the worst for September as headlines read, “A Cruel Month for Stocks.”

Investors were expecting a cruel September, but as usual, the market did the unexpected.

Nevertheless, the supposed bearishness of investors has created the train of thought highlighted in more recent headlines, like: “For Bad-News Bulls, Adversity is Opportunity.”

The common reasoning that prices will rise because sentiment is bad certainly seems more bearish than bullish.

Another side point, Triple witching occurred on September 19, 2008. Stocks held up from September 19 to November 21, after which the S&P lost 36%.

The Bearish Case

Reason #1: Stocks will decline given these technical sell signals

The August 12 Hindenburg Omen was probably one of the most publicized sell signals of 2010. It’s no surprise that the media’s attention jinxed the effect. But postponed is not eliminated.

A lesser-known sell signal was triggered by the volatility index or VIX on September 3. Similar VIX sell signals occurred on January 11 and April 13. The previous sell signals took a few days to play out but ultimately delivered sizeable declines.

On April 16, the ETF Profit Strategy Newsletter noted an extremely low put/call ratio of 0.32 and noted the following: “A minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling, results in more selling. This negative feedback loop usually results in rapidly falling prices.”

It took several days for this warning sign to play out, but on April 26 stocks topped, and on May 6 (Flash Crash), the results of the extremely low put/call ratio became painfully obvious. On August 23, the put/call ratio dropped to 0.38, the lowest level since April.
Trading volume on the NYSE averaged 880 million shares for the most recent rally leg. The two-year trading volume average is 1.2 billion shares. Conviction in higher prices seems to be weak.

The S&P and other indexes dropped below their respective 200-day moving averages, or MAs, earlier in May, and they have failed to reclaim a spot above that level since then.

Currently, the several key U.S. indexes – the Russell 2000 (IWM), technology sector (XLK), materials sector (XLB), consumer discretionary sector (XLY), consumer staples sector (XLP), industrials (XLI), and utilities (XLU) – and mid-cap stocks are above their 200-day MAs, just as they were in June and August, right before a 10% decline.

Over the past few months, the major indexes have poked above their 200-day MAs no less than three times just to be rejected. The sectors vital to a U.S. economic recovery, financials (XLF) and banks (KBE), trail behind and remain below their 200-day MA. The 50-day MA remains below the 200-day MA.

Reason #2: Stocks will decline given current valuations.

Valuations are the one constant in the investing world. Wall Street has often thought that “this time is different.” Traders and investors believed that old valuations didn’t apply to tech stocks in 2000, real estate in 2005 and financial stocks in 2007.

The market obviously doesn’t care what Wall Street thinks. Sooner or later, stocks always revert back to their mean or fair valuations. At major market bottoms, stocks commonly trade even below fair value.

A look at the readings of various valuation metrics – such as dividend yields and P/E ratios – reached during prior historic market bottoms reveals where fair valuations lie and provides a guideline of how far stocks would have to fall to reach fair value once again (a detailed analysis is available in the November 2009 issue of the ETF Profit Strategy Newsletter).

How to Navigate the Market

After weighing the bullish and bearish arguments, investors would do well to follow the odds or stay on the sidelines until more clarity is reached.

Over the last few months, in fact over the past decade, following the odds has meant doing the opposite of the general consensus, which currently points to higher prices. Even during the recent 1,040–1,130 S&P trading range, forecasts have been bullish at the upper end of the range and bearish at the lower end.

Investors following the trend would have gotten whiplash.

(The ETF Profit Strategy Newsletterand its semi-weekly Technical Forecast provide short-, mid-, and long-term forecasts, along with target and safety levels designed to narrow down the market’s options.)

Expectations postponed may make your heart sick, but expectations proven right eventually are well worth the wait. 

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