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Where Do We Go From Here?

TED Spread

Sorry its been several days since I’ve been on the blog. We are having issues with our network and it doesn’t allow me to access the blog from work so I am limited to writing from home.

I’ve been getting questions from clients about whether we are on the verge of another market crash like we had in 2008 due to the problems in the Middle East. My answer to that based upon the most important indicator I follow is “no.”

Above, the chart of the TED Spread tells me that risk to the global financial system is at normal levels. Those of you that have been following this blog and our newsletters for years know that I’ve referenced and posted this graph several times in the past at times of market turmoil.

My use of this graph goes back to the 1987 stock market crash. I noted at that time that prior to the crash, we had a spike up in the chart in anticipation of the crash. As I researched it and watched it over the years, its is obvious that prior to market crashing events, the ED portion of the spread (which stands for Euro Dollars and represents their yield) relative to the T portion of the spread (which represents the yield on short-term Treasuries) widens.

This represents the sentiment in global fixed income trades where investors are requiring a higher yield on non-safe haven investments. It works in a predictive capacity anytime there are world events that are widely known which could collapse the financial system and investment markets (such as the sub-prime debacle that eventually took down Lehman Brothers) but not on surprise events (like the 911 attack).

We used it in 2007 to get completely out of the financial stocks and in 2008 to raise our overall level of cash in client accounts. And, the indicator worked as it should, giving us a heads up that there were things afoot that would have a severely negative impact on the global financial system.

Today, the indicator is telling us that there is no risk of a crash from the world events that are widely known – ie, the turmoil in the middle east and the oil markets.

It doesn’t tell us, however, if there is a risk of a market correction of the 10% variety that we should watch for.

Breadth Indicator

For the near-term moves in the market, breath tells us whether the broad market averages are ahead or behind the individual companies stock prices. In the chart above, I’ve annotated it to show you what I look for. You can see that I’ve color coded it to show you two separate characteristic market moves.

The green section shows you how the indicator in the upper half gave us a heads up that a pullback was coming followed by the subsequent recovery/move higher. In the top half, you have two different time frames of moving averages for the advance/decline line and the stock market index in the bottom half.

The advance/decline line tells you the number of stocks whose prices are going up compared to the number of stocks whose prices are going down. You want to watch for divergences between the a/d line and the price index to tell you if market is going to change character. When you have a crossover of the shorter term time frame relative to the longer term time frame of the moving average, it tells you that there is a change of character in the movement of stock prices – and if it hasn’t shown up in the index yet, you get either message that you should raise cash in client accounts or put cash to work that you previously raised.

In the green indicators, you can see that the crossover initially gave us an indication that the market was going to pull back, and then the crossover the other way showed us that a recovery was coming. The pink indicators, as you can see, told us just the opposite.

The other important part of this graph is the relationship between the peaks and troughs in the lines compared to their recent past. You can see that I’ve drawn sloping trend lines indicating a series of higher highs (the green trend) and lower highs (the pink trend) that can also provide insight into the whether a trend is strengthening or weakening.

The pink trend line showed us that the internal strength in the market was getting weaker in spite of the fact that the index continued to go up.

What we are watching for now is whether the current crossover back to positive is for real or a head fake. If its for real, we will see a higher high on the blue line that breaks the pink downtrend line.

This breadth indicator is based on prices. I also like to watch breadth based upon volume of trading. Below is that chart.

Vomune Breadth Chart

I had posted this chart a few blog posts ago showing that there was a negative divergence between a significant drop in up volume (ie, the volume of stocks whose prices moved up) compared to total volume relative to the continued upward move in the index (the blue indicators).

You can also see that up volume in the orange indicators moved higher prior to the index moving higher, confirming the breadth price indicator.

The final breadth chart I watch is the one below which I think of as a participation chart (ie, are the individual companies in the market participating in the rally or sell off):

Stocks Trading Above 50-day Moving Average

On the chart above, you can see where I annotated the cross over. At that point, the market continued to move higher in spite of the fact that the number of companies whose stock prices were trading above their 50-day moving average was dropping.

In other words, the stock prices of individual companies were falling below strong technical support (the 50-day moving average) while the index continued to move higher. The trend for that indicator continued to make lower lows while not moving above the crossover point.

Many stock prices have fallen 10% in the current correction in spite of the broad index being down about 3%. That is a breadth issue and and as the charts above show, breadth and the broad market indices are in negative divergence.

So what is all of this telling us and what have we been doing?

1. Based upon all currently available information, a stock market crash like 1987, 1997, and 2008 is not likely to happen as the TED Spread risk indicator is at normal levels.

2. Near-term, breadth has turned positive but has not given an all clear signal that current weakness is over.

3. As the breadth weakend, we used that opportunity to perform a periodic rebalancing of client accounts. The rebalancing allows us to sell off some winners (either all or some of the position) and put that cash into individual companies or themes represented by a few companies which we believe to have prospects for above average earnings growth and p/e expansion.

4. That rebalancing raised some cash – some of which was immediately deployed into companies whose prices had fallen when the index had not, some of which was used to target technical buy levels that we thought we’d hit if the index fell (as the breadth indicators showed was possible).

5. Over the past several days, some of those target buys have hit and some have not. This is to be expected, but if the pink down sloping trend line is broken on the price breadth chart, we will likely go ahead and buy the remaining shares at market prices as the potential to hit the target buy price is diminished.

All of this has resulted in our accounts being in transition – some have small positions that we are adding to as target level buys hit – some have sales that we will be making to generate more cash as the market recovers to use to fund the purchases we are making.

Everything in our investment management operation is a process, and sometimes its hard to understand that process if you are looking at a statement or looking online at your account without benefit of a verbal description like the one above.

Overall, we are still in a secular bear market as you can see on the chart below.

Secular Bear Market

Part of the process of making money in a secular bear market is to be positioned with full equity exposure when the short-term indicators say we should be moving higher and raise cash when the short-term indicators (like breadth) tell you that a correction is coming.

Until the market breaks above the upper band on the trading range and a new bull market starts, you have to be nimble and identify the near-term turning points. In a bear market, you will always see short periods of time where the index returns outpace the returns on a portfolio of stocks due to breadth issues. However, that does not last and sound portfolio management requires a strategy to navigate the market as owning an index fund or a portfolio of stocks that mimic the index is a losing proposition.

The basic economic fundamentals of an easy Federal Reserve monetary policy will continue to act as a floor under stock prices and provide liquidity for economic growth – albeit at a lower than average level and with high unemployment. This should make pullbacks like the current one a buying opportunity for those who missed out on the biggest part of the cyclical bull that started in March 2009 when we hit the bottom of the trading range shown above.

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