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Resistance

sp-resistance
Click on Graph for Larger Image

We have seen a major move higher in the market after the pullback earlier in the month, so I thought it would be interesting to look at the technical picture to see if that gives us any guidance to positively impact our strategy.

The graph above covers a two month time frame – it is a different view than we normally look at here on the blog but I wanted to point out some things that are easier to see at this level of granularity.

Since this is a new view, let me give you an overview of what you are seeing. The top section represents the seven day Relative Strength Index (an important near-term indicator that demonstrates price momentum). The middle section is the S&P 500 Index for the past two months. And the bottom section is the Stochastics (also an important near-term indicator).

In the middle section, you see that I have drawn two horizontal lines that represent two levels of resistance. The red line is placed at the all-time closing high for the S&P 500, and you can see we have bumped up against it several times since year-end, but we have not closed above it. The blue line is another layer of resistance where the market seems to want to trade around. We have bumped up against it and traded through it up to the red line a few times, but there has been no sustainable advance above it which makes it another level of resistance. (Greg Schnell gets the credit for pointing out the double layer of resistance in his blog).

As I look at this graph I see a stock market that is tired and potentially making a near-term top much like it did in late January before the 5%+ drop into early February. A classic sign of a market top is when the index cannot move to new highs after several failed attempts. We always like to keep on top of signs like this as it gives us an opportunity to book profits on positions that have moved higher or to sell something that should be replaced with a company that has more favorable investment characteristics.

But, we can use that sign alone – I like to look at other indicators like the ones I’ve included with this graph.

As I look at the RSI, I see we are right at the upper line that indicates when a market has gotten overvalued. If the index pushes higher up to the red resistance line, the RSI will likely form one of the “hills” above the line that are filled in – that flashes a warning that the index is likely to pull back because momentum has gotten too aggressive and buyers will likely take a breather.

As I look at the Stochastics (which is another representation of the momentum in the market), I see that we are headed toward the upper indicator line on it as well. In this case, once the indicator moves above the upper line, it tells us that buying momentum will soon top out. You can see that after a couple of days above the upper indicator line during February, both times saw the market fall a couple percentage points.

January and February are portfolio rebalancing points for us. From a strategy standpoint, we have used the recent moves to the market top to sell holdings that had gotten overweight in client accounts due to the big moves in the market last year. We have also used it as an opportunity to sell certain holdings whose fundamentals have started to deteriorate (maybe they missed their earnings expectations or some other issue). We then use the drop in early February to reinvest that money in either underweight holdings or new positions that had appealing fundamentals or valuation. We used the move higher in recent days to continue repositioning holdings and we now have a bit of cash on hand to reinvest.

The reinvestment will happen in the next couple of days when the market shows us some clarity. Based upon what it tells us: (1) if we move up to the red resistance line and cannot make a sustained advance above it, then subsequently fall back a few percentage points, we will execute our reinvestment when the indicators tell us the move down has lost selling momentum; or (2) if we are able to break through the red resistance line and sustain that move, that line will then become support and it will be our tell to reinvest for the next leg higher in the market.

This is a simple risk management strategy and it has proven time and again to add positive return over the index. In a market like the current one – unlike last year’s buying and holding of the index being the big winner – it takes proper risk management, stock selection, and timing of purchases and sales to manage portfolios properly.

I have written here many times: invest what you see not what you believe. In the current market, we are investing according to what we see and will implement the reinvestment strategy as detailed above based upon how the market handles its resistance.


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Mark