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As I do most mornings, I read through various news papers and financial websites to see what is happening in the world, the markets, and our economy. This morning, I was listening to the business news on CNBC and a guest was talking about our booming economy at the same time as I was examining the chart above that appeared under this caption: “Industrial Production has never declined on a 24-month basis without the US economy being in recession.“
How can two sources reach such diametrically opposed conclusions?
If you look at the stock market, you would think that CNBC is reaching the correct conclusion. Check out the 5-year graph below of the S&P 500 Index:
Looking solely at the price graph in the middle, you see a fairly consistent upward trend with only a couple of corrections and the index near an all-time high. That sort of price action can be intoxicating and draw in investors who have been on the sideline waiting for another of those corrections in order to invest.
However, if you look at a couple of the indicators on the graph, I read those as troublesome for the market.
First, you see the two pink dashed lines that bracket the price graph in the middle. Those two dashed lines represent a level of 10% above and below the 200-day moving average. In previous posts here on the blog, I’ve written that these two levels are strategically important as the index historically has oscillated between levels that are either 10% above the index’s 200-day moving average or 10% below the 200-day moving average.
What this means is that from a historical perspective (and obviously there is no guarantee that the market will act in the same fashion as it has in the past), a safe time to buy stocks is when the market hits the line that is 10% below the 200-day moving average and important time to sell is when the market hits the line that is 10% above the 200-day moving average.
If you look closely, the market touched the 10% above line a few days ago and has been weak ever sense. If you look back to the two corrections in August 2015 and January 2016, both of those drove the price down to that lower line, but the market soon recovered to higher prices.
Below is a 20-year view of the index with a weekly instead of daily price graph:This 20-year view gives you some longer-term perspective. Even when the market falls apart like it did in 2001-03 with the NASDAQ crash and 2008-09 with the Subprime Debt crash, with the price graph dropping below the lower line, it is still a good indicator that you should consider putting some money into the market and NOT selling at the bottom.
The other indicator that is bothering me is the PMO (price momentum oscillator) at the bottom of the 5-year graph above. On the far right, you can see that the black indicator line has has fallen below its red signal line. This is telling us that even though the index has not yet materially fallen, the momentum behind the move that has pushed prices higher has weakened significantly.
Check out the longer term graph below and you can see from a historical perspective the relationship between the two:
This chart is a monthly view of the index instead of a daily. You can see that I’ve circled that spots where the PMO changes direction and the market follows suit. This has been a fairly reliable indicator of when the market is going to change direction.
So which is right? Are the economic indicators that are flashing warning signs of recession correct or is the stock market that has continued to power higher based upon the hope for tax cuts and simplified regulation correct?
For what its worth, I don’t have the answer – only time will tell which right. However, what I do know is that the stock market is over-valued by 10% or so and that we are due for it to correct back to the 200-day moving average or maybe more (see the prior blog post for a discussion of my fair value model for the S&P 500 Index to understand the 10% or so over-valued statement).
Prudent investment management dictates that we maintain a conservative posture with regard to our investment activities. Because of this, we will maintain above average cash and fixed income reserves in order to have liquidity to buy our favored companies when the inevitable pullback occurs.