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19-Jan-10
Four Potential Potholes
Most investors spend countless hours searching for investment ideas. With a direct correlation between effort and success, those who are the most diligent increase their likelihood of success. However, markets do not always follow the simple rule of rewarding effort. At times, patience is much more effective than study.
Nearly 10 months ago, the S&P 500 bottomed at 667 when it appeared that our economy and markets were heading into the abyss. Since then, prices have rallied 72% in an impressive fashion. During the few periods where prices pulled back, the largest decline was 7.6%. As the S&P 500 finished 2009 with a gain of 23%, active traders who properly timed the markets did well, but those who sat patiently also gained.
Although 2010 is only eight trading days old, patience is again be rewarded. The S&P 500 has increased 2.7% year-to-date as every dip is quickly bought and prices relentlessly move higher. Impressed by the continued rally, we also must recognize that prices cannot move higher indefinitely and a correction is inevitable. The question is from what level the correction occurs and how far prices will drop.
Currently, the trend is higher. I am bullish and believe we are in the midst of a powerful rally that will not end until the Dow trades above 11,250. For now, the opportunistic should use each dip as an opportunity to buy stocks and generate gains as prices move higher.
A key distinction for investors to remember is that while they should be buying dips, the current phenomenon will not last forever as what goes up will eventually come down. Those who fail to assess where we are in the cycle are bound to buy one too many dips and be left holding the bag when prices eventually move lower.
To assist in determining what factors will indicate that falling prices are the start of a correction instead of dip to be bought, I have identified four key red flags. Markets will always act in unexpected manners, so no list will capture every possibility. However, these are the main triggers items and will serve investors as an early warning system:
•1. Divergence- Great bull markets feed upon themselves and pull all stocks higher. When we see a variety of different stocks marching in the same direction, it shows strength. Currently the picture is positive. Within the past week, 13 of the 14 markets I track have hit recent highs. Rarely will such powerful confirmation signal a market peak. Until select markets push higher while others fall, the trend remains up.
•2. Fibonacci Levels- I am not a believer in the power of Fibonacci sequences to predict the future, but they are useful when determining long-term price points. The Dow closed at a record high of 14,164 in October 2007 and tumbled to a panic low of 6,547 in March 2009. This resulted in a total decline of 7,617 points. Typically, bounces off the low will reclaim anywhere from 50 to 65% of prior losses. As the Dow first consolidated at the 38% retracement (9,460) and then the 50% retracement (10,357), I expect this pattern to continue. The next significant retracement level is 62% (11,255) which serves as my interim price target. Until a decline pushes the Dow below 10,357, the trend remains higher.
•3. Volatility -Volatility is in a freefall. As detailed in the most recent issue of the Sunday newsletter, VIX has recorded an astounding 9 lower lows since mid-June and continues working lower. The most recent spike higher pushed VIX above 30 and until we see a rally above that price, the trend remains lower, markets will remain calm, and stocks will continue rallying.
•4. Earnings Reaction - As we enter earnings' season, many investors are focused on how results compare to current estimates. I am not. Countless examples exist of a company beating its quarterly number and then seeing its price decline. Whether it was a weaker forecast of future periods or a sizable rally prior to the announcement, prices will often move independently of the reported news. Therefore, I am more interested in how investors react to the news than predicting what the news will be. As many companies begin reporting results over the weeks ahead, positive news accompanied by falling stock prices will be our first signal that the rally is losing steam.
Using these four metrics over the weeks ahead will be of great help. Eventually the powerful rally of the past 10 months will mature. However, exiting too quickly will cause us to miss some opportunities and hanging on too long will result in portfolio losses. By looking for signs that the trend is turning, we can remain ahead of the crowd and position our portfolio properly.
Note: Subscribers to my newsletter originally received this report on Wednesday, January 13th.
Posted at 07:57 in Market Report | Permalink | Top
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