Equity Markets Break Down

In our last posting we discussed two possible market scenarios playing out; the latter of the two came to fruition. We saw the SPX test the 1350 level, which was an area of strong resistance, and turn lower from there. So far the SPX has found support at the 1250 level, however if/when that is breached we’re likely to see lower lows. Technically, we’re witnessing a head-and-shoulders pattern emerge on the weekly SPX chart (see below). This pattern denotes market tops, when the neckline is broken we will see losses accelerate in severity and rapidity.

While recent market declines have been damaging to many peoples’ stock portfolios, it’s important to keep the recent losses in perspective. As of this posting (8/4/11 premarket) the SPX has rallied from 1125 a year ago to a current price of 1260, that’s a gain of 10.7% in 52 weeks. So while the recent losses seem drastic it’s important to realize that the equity markets have rallied significantly and are due for a pull back. From my quantitative research and technical analysis it’s my estimation that the equity market declines will be severe and prolonged. It’s indeed a risky time to own equities and as I’ve said before I recommend selling into any strength and closing long positions. Let’s keep an eye on the head-and-shoulders pattern to see how that plays out.

Markets Rally and Meet Resistance

As we forecast the markets fell and reached a short-term closing low of around 1265. Since that low was met on June 15^th the equity markets have rallied 6.5% to a closing high of 1353.22 on July 7^th. The SPX has continuously met resistance around the 1350 level and has only closed above that marker seven times over the last three months (see chart below).  

While this may sound somewhat trivial and obvious there are two scenarios we see potentially unfolding with regards to the SPX in the short to intermediate term: 1) the SPX will rally above 1350 on strong volume, hold that level, and move higher from there possibly testing and surpassing the 52-week intraday high of 1370, and 2) there is a retest the 1350 level and fail putting in a long-term top for the index where we will see all equity markets correct significantly. It is still our long-term forecast that we’re near a long-term top in equities; however it is unclear whether the markets will make one more successful rally before turning tail or if they will move lower from here. Regardless of the market’s short-term trajectory we’re still confident that we’re at or near major top in equities and recommend selling long positions into any strength. A great way to protect long positions is by buying put options against a specific security or the market indices in general. Going forward we will go into more depth about how to use options strategies to hedge positions and we’ll outline some scenarios to show how this works. Stay cool and keep a close eye on the SPX to see how trading unfolds going forward.

Fundamental vs. Technical Analysis

There are essentially two theories or approaches to picking winning stocks and timing the overall market; fundamental analysis and technical analysis. The purpose of this article isn’t to advocate one method over the other, it’s to help the reader better understand the strengths and limitations of each. At the end of this article I will explain how I use each approach in my stock picking and market timing.

Fundamental analysis involves analyzing the financial health, management, competition, market position, earnings, sales, valuation, and other similar factors of a company. Fundamentalists then use this information to make a determination as to whether the stock is undervalued (it’s a buy) or overvalued (it’s a sell). For example, ABC Corporation has EBITDA (earnings before interest, taxes, depreciation, and amortization) of $2 Billion and is trading at 12 times earnings; at the same time XYZ Corporation, which is in the same sector, has EBITDA of $2.3 Billion and it also trading at 12 times earnings. A fundamental analyst might come to the conclusion that XYZ Corporation’s share price should be higher, relative to its earnings, since its EBITDA is greater than that of ABC Corporation. This is just one example of how a fundamentalist may use financial data to make a determination as to whether a stock is overvalued, undervalued, or fairly priced by the market. When looking at the equity market as a whole similar numbers examined such as the overall earnings of the companies in the S&P 500 in comparison to historical valuations. For example, Robert Shiller of Yale University looks at the market’s P/E ratio based on average inflation-adjusted earnings from the prior 10 years (see chart below). He uses this information as part of a hypothesis that over time prices revert to the mean; currently the mean ratio is 16.40 (median=15.78), in December 1999 it was at 44.20 which implied equities were way over valued and this proved to be correct. Currently that ratio stands at 23.33. The problem with a lot of fundamental analyses is that the data used don’t exist in a vacuum, this is to say that even though a company may look undervalued or overvalued based on certain criterion there are other factors (e.g. inclement weather, rising gas prices, etc.) that can affect the future performance of a particular stock, industry group, or the market in general. While prices over time do revert to the mean it’s impossible to tell how long the ratio will remain inflated or deflated. In the mid-1990’s stocks looked way over valued compared to historical levels, but if you took that as a sign to go short you would have gotten clobbered as equity prices continued to rise substantially into early 2000.

Technical analysis involves analyzing historical price, volume, momentum, and other market data to make a determination as to the direction of an individual stock or the market in general. Technical analysts, also known as chartists, look for recognizable patterns in charts that they believe are indicative of future price action. As we showed in our last post the S&P had formed an inverted head and shoulders pattern, which is interpreted to be bullish while a regular head and shoulders pattern is bearish. Another popular chart pattern is the cup-with-handle (see chart below) since it looks like a tea cup with a handle, this is interpreted as bullish. Technicians will also look at volume, breakouts, moving averages, Bollinger bands, and hundreds of other indicators to determine whether the underlying security or market is breaking down or poised to go higher.

The Elliott Wave Principle, discovered by Ralph Nelson Elliott, theorizes that underlying social mood affects prices and that this is expressed in specific patterns or fractals which appear in charts. There are multiple wave counts and patterns that exist and each indicates either strength or weakness to come, all based on Fibonacci relationships and retracements. As shown below, the theory suggests that after a wave two low is made the underlying security will rise 61.8% to a wave 3 high. There are other theories and strategies to performing technical analysis; each has its merits as well as its share of setbacks as is the case with fundamental analysis. Just because a stock, commodity, or security sets up a particular pattern or meets certain technical criteria doesn’t ensure it’s a going to perform according to your expectations.

When picking individual stocks as either a short to intermediate term trade or a longer term investment I use both fundamental and technical analysis to guide my decision making. Fundamental analysis tells me what to buy while technical analysis tells me when to buy. Fundamentally, I look for stocks with sound balance sheets, strong earnings growth, strong sales growth, and that are in a leading industry. For example, companies like Apple (AAPL) or Lululemon Athletica (LULU) meet all of those criteria and therefore are companies I would consider buying if the technical aspects are favorable. Once I find a fundamentally sound company, I look at the technical aspects which include a look at chart patterns, wave counts, relative strength, volume (accumulation/distribution), moving averages, and more to determine if it’s a safe time to buy or whether it’s a risker trade. If I was looking to buy LULU and it just dropped below its 50-day moving average in high volume on an earnings report I would likely stay on the sidelines and put it on my watch list.

In regards to my market outlook that hasn’t changed, I still continue to be bearish on the equity markets and foresee a correction intensifying as we move into the summer months. When the market looks favorable again then new stock buy will be presented and we can discuss the fundamental and technical aspects of each. Until our next post take care and have a wonderful Memorial Day Weekend!

Markets Have Witnessed Some Ups and Downs

It has been a while since our last post and I apologize to the readership for such a long gap between updates. In the past month or so the markets have witnessed some ups and downs that are especially noteworthy. As of our last post on Saturday, March 26th the SPX was sitting at 1313.80, then tradedpretty much sideways for a few weeks and then closed out on April 18th at 1305. After that the markethas climbed roughly 4.5% to finish off last week at 1363. Contrary to our bearish outlook of the equitymarkets, we have seen the major averages climb over the past month while especially picking up steam inthe past ten days or so. While our forecast has been contrary to the market’s behavior we do anticipatelower equity prices in the weeks and months ahead. Our outlook has not changed. You may be asking towhat can we attribute the market’s continued assent? From a fundamental standpoint the Federal Reservehas continued with its Quantitative Easing Two measures and plans to keep its dovish stance throughJune. At the same time, the Fed has kept interest rates near zero and has not changed the “for an extendedperiod” language in its meeting minutes. Low rates and the Fed pumping money into the economy hascertainly be interpreted as bullish for stocks. However, at some point the Fed will have to become morehawkish and the true test of the economy’s and equity market’s resilience will be realized. We havealready seen the negative consequences of the Fed’s policy including, but not limited to, a lower dollar,inflation, and higher commodity prices (including gasoline). We will be vigilant as to any policy changesor announcements coming from Chairman Bernanke and the other Federal Reserve policy makers.

As for the technical aspects of the market, which personally interest me more than the fundamentals, wehave seen a bullish pattern emerge in the Dow Jones Industrial Average (.DJI). A “head and shoulders”pattern is seen as a bearish formation when looking at individual stocks, indices, or anything that can becharted. On the other hand, an “inverted” or “reverse” head and shoulders formation is interpreted asbullish and indicative of higher prices. As displayed below, we have seen an inverted head and shoulderspattern emerge in the Dow recently and this has propelled that average to close at 12,810.54 on Fridayafter gaining an additional 47 points that session. We do believe that in the short term the markets willhold up until roughly the middle of next week (second week in May) before we begin to correct. Ifyou’re looking to initiate a new short position or liquidate longs I would use that time period to guideyour trading. That’s all for now, have a great week and enjoy the beautiful weather!