Friday, January 15, 2016

Confirmation Is The Key

Last year's stock market brought up major questions surrounding the sustenance of the broad bull market advance that had begun after the financial crisis. With dropping oil prices threatening the energy market and deflationary pressures leaving the Federal Reserve in tough positions, many investors were stuck between believing in a long-term trend of growth or coming to terms with the inevitability of cyclicality. Don't get me wrong; the last statement should not lead you to believe that I think the market is dropping into a trough because that may or may not be the case. What seems true, though, is that these bulky sell-offs are communicating the popular bearish feeling in most sectors of the market. Perhaps truer than any presumption made by analysts is the 2199.95 point gap between the closing DJIA price today and the high over the past 52 weeks. That's an average of an 11% discount across the major industrial shares that make up the index. Another fun fact, today's closing price is closer to the 52 week than that high. The current trend doesn't appear to be changing anytime soon as well. The largest corporations in the S&P 500 show a similar trend as the index descends past the 1,900 level on a major plunge today.

If we look back to last year, investors created numbers like these in reaction to the Chinese stock crash late in the third quarter of 2015. The same crowd traded shares back up to previous levels making the major sell-off appear unbased and, in some ways, irrational. Looking at the Dow in late August, an abrupt correction sent the DJIA to 15,666 for a brief foray below 16,000. Just seventy-three days later, the same index fell short of 18,000 by only 90 points in early November. Does anyone else think such an ascension was a bit hasty with a bearish trend clearly in effect? Oil prices and that sector, though recovering, were clearly still going to take double-digit losses through to the end of the year. Most Q3 earnings reports showed soft growth if not losses that questioned the fundamentals of a lot of companies. It might be interesting to see what corporate profits in the fourth quarter will look like when considering the rebound of stock prices during that period.

A chart-based analysis of corporate profits compared to the Dow Jones Industrial Average shows an interesting picture of how the stock trend could have developed. In red, the DJIA has been plotted to compare its performance against quarterly corporate profits where the point above 2015-07-01 shows profits recorded for the third quarter. Noticing the significant drop in profits in that quarter, traders sold off into a down trend that appeared to be confirmed by fundamental weakness visible during earnings season. It seems like a logical move with no emotional trickery or voodoo dolls involved. After the correction in August, the latter half of the third quarter and the beginning of the fourth usher in a small period of growth that approached the highs of the first half of the year. Based on this positive trading, a rational estimation of fourth-quarter corporate profits would be somewhere in the range denoted by the green bar, a jump of around $20-30 billion dollars. While we wait for the true numbers to come out later this month, assessment of the viability of this fundamental valuation is possible. Investors are assuming that companies can boost their bottom lines in a deflationary environment where warm weather hurt a winter season that is usually bubbling with retail frenzy. In the Federal Reserve's Beige Book produced today, growth in most districts was described as "modest" at best with little to no growth in consumer spending. Compared to the seasonal trend, retail sales were flat with no signs of a Santa Claus boost. At the same time, the Fed reported, "most manufacturing sectors displayed a weakening in activity." All these symptoms of a slower economy could be attributed to the slowdown in oil and lagging in the consumer price index. After all these facts (most of which were similar to those revealed in August of 2015), the stock market is experiencing a slower but deeper sell-off in equities. Why is that?

In the history of stock market trading, most erratic pricing can be traced to a carnal desire to rid oneself of all pain and fear in order to reach a more pleasurable, peaceful state. While the explanation for a phony price recovery is less zen, the idea contributes to errors the mob may have committed during the early fourth quarter months. Trends are very fickle things; ask any trader who has lost money on the sudden reversal of a stock price. That's why when Charles Dow wrote about the financial markets in the early 20th century. He highlighted the concept of confirmation in order to decrease risks when trading certain stocks and bonds. While most of the stock indices he created were meant to stress diversification in the industry, the ideas around Dow theory sought to support the idea of confirmation through intermarket analysis. An example (which is used on this site often) would be the performance of the Dow Industrials versus the Dow Transport. This relationship can be used as a litmus test for the current trend with behavior that either supports or disagrees with the current trend. This is what made the August correction so tricky. Coming out of the routs in Chinese and U.S. markets, a lot of traders saw weakness compartmentalized to the Chinese economy and the energy sector. Broad-based declines seemed to be a reaction to the fragility in these sectors and were believed to be a temporary kink that was meant to be massaged out. Confirmation of an overall down trend that defined the end of the bull market might have saved investors money on the new long positions they were making at the new lows. We're now seeing those lows as a real possibility on the stock market today. Charles Dows writings also bring up the idea of the various lengths of trends and how they may intermingle to confirm or deny the perceived momentum. He looks at three periods: the tertiary (intra-day trend), secondary (20-90 day trend), and primary trend (1-2 years). While the exact length may vary, each type of trend shows different movement based on how trading occurs in that particular length of time. Intra-day movement tends to be choppier with short-term trading dominating the trends, and primary trends are typically good indicators of business conditions and economic health. 

Looking at a long-term chart like the one above, one can observe a change in momentum that occurs around the beginning of the year. In the chart, the Dow Jones Composite Average, which measures stock prices across industries, shows a general down trend for about a year before the correction in August. Just before the major plunge, we see a major technical signal of the 50-day moving average dropping below the 200-day moving average, a phenonmenon that usually shows a shift in the long-term trend. What I fail to understand is how a continuation like the upward sloping dotted arrow is confirmed by the recent primary and secondary trends?  The new trend line below that seems more realistic especially given the weakness of investment and consumer spending and the failure of industrial production to reach the levels before the correction. The question still does loom at large: have we confirmed a larger bear market? Where will the current secondary and tertiary trends take us in the long term? This time around, most losses infect all sectors and commodity prices are continuing to lose steam that was supposed to be recovered. Recession-like symptoms may be the most likely case as the economy appears to swing down into the trough of the business cycle. Contrarian analysis supports this view when considering the substantial growth of the market in the long-term. Lower oil prices continue to heap pressure on growth and will be an indicator in the future when things are looking up. Investors, it is now more important than ever to look for confirmation in long positions. Some sectors may have a softer fall as well as a higher probability of recovery making them ideal to buy as lows are found. As for broad market trends, do not forget the goals of Dow theory in which intermarket analysis can warn of a gradual (or even sudden) reversal that can be used to improve the integrity of your portfolio. 

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