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Unbelievable Market Action

S&P 500

Last week I wrote to you that we had likely put in the bottom for this correction but that the path higher would also likely be a rough one.

So, with several swings up and down on the broad market average, I thought that a visual look at the market might be a helpful thing for us.

In the chart above, I’ve annotated the graph of the S&P 500 so you can see what is happening. The blue horizontal lines show you the Fibonacci retracement levels for the market from the May high to the August low.

I haven’t shown you graphs with Fibonacci retracement levels for awhile, so to refresh your memory, (and quoted from Investopedia) they are based upon the work of “mathematician Leonardo Fibonacci in the thirteenth century. The Fibonacci sequence of numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Each term in this sequence is simply the sum of the two preceding terms and sequence continues infinitely. One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. This common relationship between every number in the series is the foundation of the common ratios used in retracement studies.

“The key Fibonacci ratio of 61.8% – also referred to as “the golden ratio” or “the golden mean” – is found by dividing one number in the series by the number that follows it. For example: 8/13 = 0.6153, and 55/89 = 0.6179.

“The 38.2% ratio is found by dividing one number in the series by the number that is found two places to the right. For example: 55/144 = 0.3819.

“The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right. For example: 8/34 = 0.2352.

“For reasons that are unclear, these ratios seem to play an important role in the stock market, just as they do in nature, and can be used to determine critical points that cause an asset’s price to reverse. The direction of the prior trend is likely to continue once the price of the asset has retraced to one of the ratios listed above.”

If you look at the chart, as if pre-ordained, the recovery off the August low retraced to the 61.8% level where it ran into resistance before falling back down. The good news is that we are developing an upward sloping trend line (see the green line denoting the uptrend that is in formation).

I’ve also annotated a few other things on the chart that I am watching – if you look at the big red circle on left side, I’ve shown the trading volume for different levels of prices. You can see that within the circle, there is little to no volume that would provide overhead resistance to prices moving higher. In other words, there are very few people who bought during those down days so you don’t have to worry about them wanting to sell their shares to break even once the price hits those levels. It’s really not much of a coincidence that above the 61.8% retracement level you have almost no resistance, but below it, you have people that were buyers but that turn into sellers in an effort to get out of those shares with no loss. Once we are able to break above the 61.8% level, with little overhead resistance, prices should have a much easier time moving higher.

How high? My target is for the market to move somewhere into the green box on the right side of the chart. This green box covers about a 60 point span in the S&P 500 (1225 to 1285) that encompasses the beginning of some more serious overhead resistance, the 38.2% retracement level, and the 200-day moving average.

As the market bottomed out, equities appeared to be undervalued and fixed income appeared to overvalued. This presented us with an opportunity to do a few things: (1) invest cash we had on hand, moving accounts to maximum equity exposure, (2) rebalance accounts so that fixed income and cash were taken to target levels with any excess invested into equities, and (3) rebalance equity and mutual fund holdings so that any that had been hit harder than the rest during the downturn would be added to and any that performed better would be rebalanced back to target levels – this should provide excess returns when the holdings that were beaten down more rebound more as we move toward the green box.

When the market put in a top on the chart above, I think that was likely the high for the year. The direction from here should be to move higher as we approach year-end, but the 61.8% level will probably be tough to break through – however, when all of the people who bough at that level who want to sell have done so, then we should break through that resistance and have little resistance as we move up to the green box.

From a fundamental standpoint, there are several things that support the market moving higher:

(1) at the low when we started to move to a fully invested position, the broader market was trading for a P/E of around 11 compared to a normal range of 22 during economic boom times and 10 during recessionary depths – the P/E of 11 was almost completely discounting a recession 6 to 9 months from now;

(2) current economic reports do not, in my opinion, show that we are heading into a recession – the Chicago Fed National Activity Index showed improvement in its last report, and was consistent with a slow growth economy; rail car loadings were also recently reported and show that we are in an expansionary economy, but a slow growth one; Fed Ex shipments for the recently ended fiscal year continued to grow and have surpassed 2008 for the first time since then; major exporters like Caterpillar and Deere are reporting increased exports and are increasing hiring; car sales are on the rise with GM and Ford both reporting that the industry is recovering.

(3) corporate earnings season gets underway next month and if the trend continues, earnings will be strong – strong earnings growth leads to increasing stock prices.

Our current plan – but obviously subject to change as fundamentals and technicals in the market change (remember my advice: invest what you see, not what you believe you should see) – is to begin to raise cash as we approach the green box. That could be sometime during earnings season, but in any event will not go past 12/31.

We are viewing 2012 as an even more challenging year than the current one – if we are going to see a recession, then it will become apparent in 2012. Why 2012?

(1) I’ve written in the past about the baby boomers retiring and how that will have an impact on their spending. I think we will see a cutback in spending during 2012 as this huge demographic group starts to retire in earnest. That will also put pressure on the top end of the housing market as many will want to downsize – the upper end of the market will have overhead resistance on prices most likely, but the middle part of the market, condos, and rentals – maybe even in very hard hit areas like Florida – will see some demand.

(2) Those retirees will also put pressure on the Social Security and Medicare funds pushing them closer to insolvency – which will push the folks in Washington to do something about it – watch for benefit reductions and tax increases, both of which will have an initial negative impact on the economy – in the long run, it is required but taking one’s medicine is never an enjoyable experience.

(3) We continue to issue significant levels of debt and there is no realistic end in sight, in spite of the discussions on deficit reductions of $4 trillion. At some point, our lenders will require higher interest rates to fund our spending problems. Those higher rates will negatively impact our economy – yes, yes, I know some of you out there will say that we had higher rates under Reagan, Bush 1, Clinton and Bush 2, and that we got along just fine. That is absolutely true – however it is the magnitude of the change that matters to the economy, not the fact that we are returning to a previous level where we were in an economic expansion. Going from a short-term interest rate of 0.25% to 2% is a 700% rate of change, and that is what will have an impact.

(4) 2012 is a Presidential Election year, so anything can happen.

From both the technical and fundamental standpoints, moving higher seems the most likely course for the market. Again, it won’t be a straight move higher as we are in for some volatility and madness. Watch for the upward sloping trendline to converge toward the green box. If events in Europe relative to their banking system hiccup again, we could see another violent downswing, but likely not lower than the August lows, and I’d hope that the forming trend line would provide the market support, if not the 61.8% level once we break above it.

Brace yourselves – the market will continue to be unbelievable for the foreseeable future.

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PS – search your memory and see if you can name the 80’s/early-90’s comedian who starts off the song in this video