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S&P 500 Index Annotated

We’ve had a lot of news and movement in the markets since my last entry. Sorry for the length of time its been but work gets really busy this time of year and we focus on actually managing money for clients instead of talking, or in this case, writing about it.

In the last post, I mentioned that I thought the move above the 200-day moving average would not hold and that we would pull back and make a try to move through it again. That did happen as you can see on the graph above – the candlesticks the week of Nov 7 barely nudged above the 200-day again but could not complete my Rule of 3 (to be a successful breaking of resistance, you have to close above the resistance point for three days or by 3%).

By not closing above the 200-day moving average for three days, the market was not strong enough to sustain the bad news that the Super Committee could not reach an agreement to cut $1.2 trillion from the budget deficit, plus the news that finances in Italy were worse than people had imagined sent the market down appreciably, not to the August or October lows, but enough so that it was painful to watch.

Fortunately, we didn’t just sit back and watch – coincident with the market being unable to sustain a break of the 200-day moving average resistance, we added a new mutual fund to client portfolios that provides some hedge against market downturns. This fund was up 2% in the period of time that the market was down 10%. We allocated roughly 5% of each account to the fund – maybe it should have been more but I still think we will make an assault on the 200-day moving average again in early 2012 and I don’t want to be betting against myself.

So where are we now? As you can tell from the title of this post, we are in oversold territory, particularly after last week’s low volume sell-off. This morning as you can see on the graph, the S&P 500 is up a bit over 3% as I write this while small caps and emerging markets are up 4.5%. This is a big rally off the oversold lows – but the question is can we rally back to the 200-day moving average or will the rally fade.

Looking at the graph, you will see that I’ve circled the oversold readings on several of the indicators I follow – they all confirm each other showing that we were severely oversold and due for a nice bounce. We are getting that bounce today and we should see some follow through in coming days as the oversold readings work themselves out.

There are a couple of other things I want to point you to that also show how oversold we had gotten: (1) at the top, you will see the two small teal colored boxes drawn around the bars on the indicator for stocks trading above their 50 and 200 day moving averages – you will note that we are back to the same levels we were at in October when we rallied 15%; and (2) its no coincidence that the market stopped falling last week when you look at the volume by price bars on the left side of the graph – I’ve drawn a pink box around the important ones where you will see the buying volume at those levels far outweighs the selling volume – you have a lot of interest by buyers in protecting those levels since a lot of money was committed there so you should be able to anticipate that buyers will step in to buy the dip at those prices.

So, where should we anticipate the market will go? I’d look at the 50-day moving average as the first stop. Last time we were trying to move higher off the October lows, we sailed right through the 50 and never looked back, easily completing our Rule of 3 for that resistance level. This time, we may have to make an assault on it and work our way though it depending upon the news coming out of Europe. This will probably be tougher than last time because we have the failed triangle pattern to deal with.

Calvin & Hobbs

In coming up with a price target for the market based upon the failed triangle pattern, you have to add half the difference between the price at the point of the triangle and the established support level to that support level, or (1250 – 1158)/2 + 1158 = 1204. Coincidentally, 1204 is roughly equal to the 1205 on the 50 day moving average, so that is why I think the 50 day moving average will be tougher resistance this time.

If we successfully break the resistance levels of the 50 day moving average line and the first price target from the broken triangle pattern, then the point of the triangle, or 1250 is the next target – but that is getting way ahead of ourselves since we next have to break through resistance around 1220 (the high in Sept and the low in Oct). The fundamentals of what has been driving this market, namely the news reports of the problems in Europe and their potential solutions combined with our government’s ineptitude at solving our deficit problem will weigh in strongly on the potential direction of the market between now and year-end.

All of the asset classes are connected and even the diversifying low correlation assets are all moving up and down with news, albeit with bigger swings than the S&P 500 Index. At some point, we will return to a more traditional relationship between the asset classes where the low correlated classes provide the type of diversification and return enhancement that they normally provide, but we just have to wait out the current situation and manage the process to the best of our abilities (like adding the mutual fund mentioned earlier to hedge against news-driven sell offs).

Our plan is to continue to hold our current positions during this rally, then raise cash as we hit the targets noted above. We might add to our new mutual fund or just hold the cash – we haven’t decided that yet – but my goal is to have a 10% cushion in client portfolios that we build up in order to prepare for 2012.

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