Short Takes

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.

CCM’s BMSI closed Friday at 804. These comments from last week still apply as we head into trading on Monday:

In the chart below, green is best, yellow is neutral to a little concerning, orange is concerning, and red represents an unfavorable risk-reward environment from a historical perspective. The bottom line is we need to remain patient and nimble in the current environment. While the markets remain above the BMSI bull/bear demarcation line, the market’s profile on monthly, weekly, and daily charts is decidedly weak and fragile. As we plan our short-to-intermediate term strategy, some very favorable conditions existed when BMSI scores fell between -165 and 703. Below -165 is where the risk-reward ratio makes a significant shift in terms of favoring bearish outcomes over bullish outcomes.

The CCM Bull Market Sustainability Index (BMSI) closed Thursday at 1,196, which continues to give a mixed outlook for the next three months. Similar historical BMSI scores (1980-2010) have favorable risk-reward profiles looking out six months to a year. That all sounds good, but real world situations are fluid when markets congregate near the bull/bear demarcation line. BMSI scores can change rapidly in markets like the one we face presently.

Our decision to raise some cash in the last two weeks is based on the knowledge the market’s profile could turn decidedly bearish in a relatively short period of time. We have spent countless hours studying markets, which is really part quantitative and part behavioral science. While the markets remain above the BMSI bull/bear demarcation line, the market’s profile on monthly, weekly, and daily charts is decidedly weak and fragile. When we refer to “markets” and “charts”, we are really referring to the aggregate buying interest of all market participants, or lack thereof.

Two examples from history where a very weak market recovered are 1994 and 1998. BMSI and 80-20 scores were very low in both cases, as they are today. The problem from a money management perspective is we cannot just review the “good” cases. We must examine all cases; the good, the bad, and the ugly, which we do with risk-reward ratios.

1994 and 1998 do provide some basis for optimism, but if the markets deteriorate to a point where the risk-reward ratios turn decidedly negative, we will continue to reduce risk.

To illustrate the fine line we must walk in the next 90 days, one of the best risk-reward profiles for stocks occurred when BMSI scores fell between 1,366 and 1,551, a level we could reach in a matter of days. On the other end of the spectrum, one of the worst risk-reward profiles for stocks occurred when BMSI scores fell between 879 and 1,100 (returns going out one to three months). We could fall into the 879 to 1,100 range on Friday or sometime next week. As we plan our short-to-intermediate term strategy, some very favorable conditions existed when BMSI scores fell between -165 and 703. Below -165 is where the risk-reward ratio makes a significant shift in terms of favoring bearish outcomes over bullish outcomes.

While it may seem highly unlikely given the news and mood of the day, 1994 and 1998 are two examples where weak markets and pessimistic investors were surprised by strong rallies that rewarded those who remained patient. As the BMSI scores indicate, there are still prudent reasons to remain patient with some of our allocation, but the window of patience is rapidly narrowing. We enter the day with a defensive bias.

In the event the S&P 500 trades between 945 and 1,010, the probability of the Fed standing on the sidelines is almost zero. The Fed’s next regularly scheduled statement is September 21, 2010, now only four weeks away. Below are some excerpts from an August 19th article from the Irish Independent on recent Fed moves and policy:

THE US central bank has bought $2.5bn (€1.94bn) of US government bonds (treasuries) to prevent money being drained from the financial system…It is the first outright purchase of US government debt by the Federal Reserve since October, but the newest member of the Fed’s policy-setting Open Market Committee (FOMC) said interpretations of the Fed’s actions have been too pessimistic…Mr Kocherlakota, who heads the Minneapolis Federal Reserve, said a “modest” recovery appeared to be under way. …The Fed statement last week announcing the bond purchases may have led investors to inaccurately believe the US economy is in worse shape than had been presumed, Narayana Kocherlakota said…JPMorgan Chase analysts estimate the Fed will buy about $284bn in treasuries during the next year — more than the combined purchases of Japan and China during the year ended May.