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More Downside Ahead?

spx-pmoDouble click on any image for a full sized view

The graph above is one that I follow fairly closely (and have for years) to give me a feel for the direction of the stock market as represented by the S&P 500 Index.  This is a graph that I last showed you this summer when I explained why we had raised cash in client accounts.

This monthly graph of the S&P 500 shows me the prevailing trend in index and its strength.  The indicator in the bottom pane is the Price Momentum Oscillator.  This indicator shows us how much momentum is behind the current trend, and the direction the trend is headed.

You can see that I’ve circled a few different points on the oscillator and on the price graph above it.  These represent longer term trend changes in the index.  You can see that in late 2009, after the crash had bottomed, the indicator turned positive and stayed that way for several years as the market recovered and moved to new highs.

Earlier this year, the indicator turned negative which is one of those flashing red lights for me as a portfolio manager.  The market in turn moved sideways for several months while we raised cash in client accounts.  In August and September, the market corrected >12%, but during October it moved back toward its old highs.

Unfortunately, the indicator continues to point to a weak stock market with potentially lower prices.  I say potentially because no indicator is 100% fool-proof.  This one has proven very reliable over the years and allowed us to take action ahead of major downturns and allowed us to get aggressive ahead of major bull market moves.

I’ve written before, but it seems like a good time to repeat it, that all charts are just representations of investor psychology.  If I look at this chart along with breadth statistics (like less than 1/2 the companies in the index are trading above their 200-day moving average – or in simple terms – less than 1/2 the companies in the index are in a bull market stage), I think this is telling us that investor psychology is weakening.  It may be because most now believe the Federal Reserve will raise interest rates in December or it may be some other less apparent reason – who knows.

As long as this red flag is out there, I plan to be cautious until a clear path to higher prices presents itself.  Just as we did with the August/September correction, we will be opportunistic with any sell offs and add to positions; conversely, as we have been doing over the past week or so, when the market moves back toward old highs, we will lock in the gains and raise cash.

Risk management is a key component to investment management and having the right tools in place to effectively execute your strategy maximizes performance.  Being conservative when risks are high and aggressive when risks are low are key to beating the indices.

Today’s video has no tie in to the blog post other than I was in the third row of the REO  Speedwagon concert last night:


So I thought I’d share one of my favorite songs that was written not too far from where I am sitting writing this post.   Enjoy!