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Price Momentum Guidance

PMODouble click on any image for a full sized view

After Thursday’s post on the Fair Value of the S&P 500 along with a technical analysis demonstrating investor sentiment, I received a couple of emails from readers who wanted to know a bit more about the technical aspects of what I follow to help determine market direction.

For a big picture intermediate-long term view of where we are headed, I use a 20-year monthly price chart and compare it to the Price Momentum Oscillator (PMO).  I know sounds like Sanskrit for some folks so let me explain.

The price graph (the top panel of the image) above is based upon the monthly movement of the S&P 500 compared to the 10-month moving average of the index.  You can see that the red/black line moves above and below the moving average, indicating bull Vs bear markets.

You can also see a bunch of red circles which I’ll explain in a bit.  For now, though, look at the one on the price graph far to the right.  You can see that the market is moving up and down across the moving average.  To me, this says the market is in a topping process – investors no longer have the conviction to keep pushing it higher but there are still some dip buyers out there that will jump in if it falls to a certain level.

Those red circles are pretty important when you compare them to the PMO.   The PMO is an indicator of the strength of price movement within the market.  Instead of a visual analysis of the index itself, this indicator measure the activity in the market and tells you if investors are acting bullishly or bearishly.

When we look at the PMO on a long-term chart like the one above, you can see in the red circles points in time when the blue line crosses over the red indicator line.  Those crosses are critical as they demonstrate that investors’ are acting in either bullish or bearish manner and that the direction of the market is taking a change.

So for now, we are being cautious and defensive is critical as a strategy but being nimble and putting cash to work on a short term tactical basis when the market gets short-term oversold.  Then when it gets short-term overbought (there are other indicators that I use for short-term market movements that I’ve highlighted here on the blog previously), we are raising cash again to get back to a defensive position.

Our typical practice is to utilize  index exchange traded funds (ETF’s) for this short-term tactical investment activity.  I’m actually pretty grateful that ETF’s have come to such prominence in the past few years given their liquidity and ease of trading, making this a much more efficient and effective process.  As an example, when market was at the February lows, we purchased shares of the Russell 2000 ETF then as the market became short-term over-bought we sold it for a 5% gain after three weeks or so and reinvested the proceeds back into a cash equivalent until the market gets back to short-term over-sold.  Wash, Rinse, Repeat 🙂

As I write this, the market is hovering around break-even with little volume – another sign of the indecision among investors.  When there is indecision, the best thing to do is sit back and watch for signs that a sustainable move will develop in one direction or the other.   Unfortunately, given the reading of the PMO, breaking out to new highs is unlikely so our defensive strategy is the best choice for now.