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Mark’s Rule of Three

Rule of Three In Action

For long-time readers of this blog, you know that I talk about the Rule of Three on occasion relative to support and resistance levels.

On the chart above, you can see the blue circle – we have successfully closed above the 200-day moving average on the S&P 500 Index for three successive days. The 200-day moving average has been a big resistance level for several months. As you can see on the chart below, we have been turned back twice in previous months only to see the market fall back to lower levels.

Annotated Rule of Three

These previous attempts did not have investor confidence so they were unsuccessful – you can’t see this on the chart, but if you look at the sectors of the market that were strong during that time, it was the defensive sectors – high dividend paying stocks and consumer staples. You cannot have a sustained market advance with those sectors leading the way – it just doesn’t happen.

Look at what has been leading the way since the beginning of the year:

Risk-On Sectors Lead The Wy

If you look at the performance bars, you can see that the sectors with the highest returns are the least defensive sectors: Materials, Biotech, Industrials. The Consumer Staples sector is actually in a losing position so far, and down for the year.

What is this telling me?

First, since we successfully passed the Rule of Three, the 200-day moving average has changed from resistance to support. It would not be surprising to see the market fall back and test support, but it would have to successfully pass the Rule of Three and close below support for three successive days, which as you can see on breaking through resistance, is not an easy thing.

Second, because the least defensive sectors are leading the market, investors’ appetite for risk is increasing and we could see a pretty nice rally in the near-term — subject to any disasters coming out of Europe, obviously. We are very near the October 2011 high of 1293 which may serve as minor resistance but the real first goal would be to hit the July 2011 high of 1357. That is only six percent away so it seems an achievable goal. The next goal after that would be the May 2011 high of 1370 which is only seven percent away – another achievable goal and it would mean that we had retaken the post crash highs – a technically and psychologically significant event.

Third, as I look at the chart at the top, I see that we have the institutional money coming into the market. If you look at the red horizontal lines I drew on the graph, you can see the trends are up in these indicators. These indicators represent the money flow in the market – and since the institutional traders dominate it, you get a good feel for where the hedge funds and high frequency traders are headed, and that is moving money into the long side of the market.

Fourth, as I look at that same chart, I see that we have moved up very fast and are due for a down day or two. If you look at the two green boxes I drew on the graph, these are short-term indicators and both are at or above their top ranges and need to pull back a bit. That means that either the market needs to stay at current levels for a period of time for the indicators to pull back or it needs to have a couple of down days to pull back.

Don’t fear the down days – in fact, if you are sitting on cash you want to have it pull back a bit so you buy in as close to the support level as possible – but there are never any guarantees that it will in fact revisit support.

What is my strategy?

We have a bit of cash on hand in client accounts that we will be putting to work in a pure beta investment, a SPDR ETF that simply tracks the performance of the S&P 500.

We used rallies in the fall to raise cash going into year end so that
– (1) we would have an opportunity to reinvest if the market gave us a sign it was ready to move higher or
– (2) we would have a cash cushion in case something ugly happened in Europe to send the market back toward the September lows.

We are going to commit some of that cash to purchase shares of the SPDR ETF today given the softness in the market and keep the rest on hand waiting for
– (1) the market to retest the 200-day moving average resistance level or
– (2) to move above the October high resistance level.

So far, the confusion of 2011 in the investment markets looks like we are seeing a clearer path ahead. If for some reason we break support via the Rule of Three and the market appears headed lower, we will again be raising cash to buy back lower. However, right now it looks like investors are putting more value in non-defensive equities and willing to push the market higher.

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