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Where Do We Go from Here? What Do I Do Now?

Monday, September 21, 2015

by Sheila Jamison & Rich Jamison

The Dow Jones Industrial Average has seen flood of widely broadcast 300+ point day-to-day and intra-day swings. These can be unsettling. Put a couple of bad days in a row and it can be downright frightening. Get 2 or 3 consecutive up days and it feels like the only way to go is putting every cent into the market. Obviously, either extreme can cause long-term pain. How do we get past the volatility-induced kneejerk reactions to maintain discipline?

Volatility potentially arises from a myriad of sources. Primarily, it’s from the uncertainty that each of these introduces. It’s the “what will happen in the market because X, Y or Z happened in the world?” syndrome. We’ve seen this most recently with the last Fed decision, with China’s slowing economic growth, with China’s devaluation of the Yuan and with Greece’s bailout. But we can also trace it back within a year to Ukraine and Ebola and … (feel free to add all the others you can think of).

We’d like to address both headline questions with a two-prong approach. We will look at these with sources of volatility in mind. The first prong examines some economic realities. The second looks at what the market is doing in response to those realities.

We remind you that we cannot predict what will happen. The market is often completely unpredictable. We watch to see what is happening. Then, we implement our disciplined method to take advantage of what is happening. When “what is happening” takes a turn, that discipline tells us to modify our approach accordingly. Everything within this model is dependent on the market. Nothing looks at the outside events and predicts the market. While some of these predictions are correct, too many of them are simply just plain wrong. As we noted, the market can react with seemingly irrational unpredictability.

With that in mind, let’s begin our first prong with a look at the current situation in China. Undeniably, its manufacturing is slowing. Its economy is slowing … down from “spectacular” to only “better than anywhere else.” Second, it has devalued its currency. The rest of the world has encouraged this for years! Now that it has done so by ~4%, how will that affect our economic results?

We export little to China, about of our GDP. And what we do export is only about 4% more expensive. Will a 4% cost increase stop those Chinese who can afford what we do export to them from buying. Not according to the most recent reports of the new iPhone sales it won’t. US exports and the loss of US manufacturing behind them are unlikely to do much to hurt our growth on either count (China’s manufacturing slowdown or devaluation). That is, because we don’t sell much to China and what we do sell is not much more expensive, we should see a minimal impact here. Yet the US market reacted violently to reports of both China’s slowdown and its devaluation.

Let’s conclude our first prong with a look at the US economy. It is steadily advancing – yes, more slowly than we’d like – but still advancing. We could say it remains steady rather than spectacular. Q2 GDP growth was at a 3.7% annualized rate, a picture of broad strength in the US economy with consumers, businesses and governments all spending and investing more than we anticipated. Additionally, the labor market continues to strengthen and productivity is increasing. In all, the US remains one of the richest countries in the world. More important, it is expected to continue to grow steadily for at least 2015 and 2016, outpacing many other western countries. This is seen in official economist forecasts, the IMF forecast and statistical modeling.

Examining the economic realities is one thing. The reason we don’t predict market behavior to these is readily apparent when you consider the market reaction to China’s recent events. Both caused dips here. And we won’t even touch upon our reaction to China’s stock market troubles. Its connection to our stock market is even tenuous. Take-away: the market often reacts unpredictably.

Second Prong

You can readily tell we don’t believe that our market should have reacted as it did to China’s ‘news’ – but that it did. That brings us to our second prong – how is the market reacting and what do we do to take advantage of that reaction? We don’t have to like the way it reacts. We don’t have to agree with what it’s doing. We just need to acknowledge that the market will do what the market will do. Our methodic discipline doesn’t care why. It adjusts automatically to what is occurring. It doesn’t get bogged down in “this shouldn’t be happening” or “this wasn’t happening yesterday” or “I’ll wait for the market to figure out what I already know.”

Technically Speaking

We know you don’t care about the underlying mechanics of technical analysis. So permit us to cut to the chase and report the standings of two of the ones we follow. A rule of thumb you may find useful is that the faster the indicators respond to the market, the less faith you can have in their indications. They are overly influenced by very short term market swings. While suitable for active trading, they are not usually good indicators for investors. Slower indicators are slower because they collect data for longer periods and are hence more likely to reflect trend changes than market volatility.

The NYSE HiLo

The HiLo indicator (calculated from the number of new annual highs and new annual lows) is a secondary indicator on our scale. It tends to be too short term to base investing decisions on it. The market does things merely days before the HiLo has enough data to reflect that change. However, it’s an early indicator, meaning it shows things before the longer-term indicators. While some say it would be wise to move at the first sign of a change, the HiLo can reverse itself again before a trend can establish itself. That is, investing according to the HiLo might be okay for day-traders but disastrous to investors.

Why then mention it? Because it’s currently giving positive signs for what’s to come. Not positive enough to bet on … it can and does move around … but positive enough to tell us to watch for confirmation.

The NYSE HiLo is now at 17.3% (as of 9/18’s close) but it had fallen to ~8% on August 31st. This is only the 21st time since 1980 (when it began being recorded) it has fallen below 10%. What has happened after those other 20 times? In most cases, it has been a good sign to re-enter the market. It rarely falls to a lower low once it reverses up. However, it can (and has) happened, once in each 2008 and 2009, the last time before that in 1994. However, the last 5 times the HiLo has reversed up, the S&P 500 index was an average of 7.2% higher 90 days after that reversal. We saw this index reverse up on September 16th.

The NYSE Bullish Percent

The Bullish Percent (BPNYSE) is one of our five basic indicators. You’ve heard us mention it only slightly little less frequently than Relative Strength. It shows a number of key levels, on both up and down sides of the equation. Relevant today is the 30% level, a cautionary place on the downside. It had dropped to 24% with the August market pullback and has now reversed itself up to the 30% line. To our delight, this is a longer-term indicator.

Additionally, we have data going back 60 years. Previous to the current drop, this indicator had fallen below that 30% level only 22 times during this period; or roughly, once every 3 years. As we’re still in the period started by the recent plunge below the 30% mark, we can’t know how it turned out. It hasn’t yet. But historically, it has been a common occurrence to see a “re-test” after the initial reversal up. Of the prior 22 occurrences below 30% for the BPNYSE, this indicator has seen a retest twelve times, or roughly 58%. Of those twelve, only four were “failed” retest; that is, it actually produced a new low on the BPNYSE.

Bottom line, it appears likely we can retest the recent lows (the day of the 1,000 point drop). But it also appears likely that we will not fall below it. Historically, the odds are that the bottom is in. Again, historically speaking, odds are in favor of a new market climb.

The “What Do I Do Now?” Part

While we all recognize that history can make no guarantees for future results, here’s what we see.

  1. Cull the herd. Cut out the weakest puppies. At the least, do this during pullbacks. Better yet, get rid of them before they become anchors on the next upward market swing even as markets advance.
  2. Buy solid companies with strong technical attributes now at bargain prices.
  3. Scale into technically strong but more speculative companies. Buy a little and wait for further confirmation of continuing strength. You may pay a little more for the second and/or third bites at the apple (small “a” – an accidental pun), but that’s better than jumping all in if a candidate falters.

The US market still leads the pack. This is probably the best place for now. But Europe and some of the emerging markets are jockeying for a place at the table. A select group of these might slip into step 3 above. Bonds got a reprieve with the last Fed decision … for now. They don’t appear to be where anyone wants to be long term. They risk price declines once interest rates begin to climb.

How’s that! Technical analysis explained in far fewer words and far more simply than you expected, no?

References:

A Historical Look at the NYSE Bullish Percent Below 30%. The Money Managers. Dorseywright.com. September 15, 2015.

NYSEHILO: When the High-Low is Low, Low, Low. Daily Equity & Market Report. Dorseywright.com. September 9, 2015.

US economy: statistics at a glance. Sam Fleming, Emily Cadman, Steven Bernard and Tom Pearson. Ft.com. September 15, 2015.

Historical charts and prices for the NYSE High-Low Index from finance.yahoo.com, retrieved September 19, 2015.