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As we have been forecasting for weeks if not months, in recent days we saw major stock indices decline back to levels not seen since 1997. Unfortunately, in spite of some positive comments from President Obama and from Federal Reserve Chairman Ben Bernanke, there remains a high risk that the stock market might continue its slide.

At this point, major indices have declined about 50% from their highs in 2007 and no market sectors have escaped without damage. Most investors have experienced significant losses and many are quite discouraged about the prospects for future market gains. While the economy currently remains weak and market risk is high, there will be opportunities for investors to make profits and they might not be long in coming.

Below is a chart showing exchange-traded funds (ETFs) reflecting three distinct sectors of the economy and markets. While all of these sectors continue to demonstrate high volatility and risk, each has also shown some signs of life. Gold (black line) has been rising since just before the start of 2009 and recently surpassed its former high. Gold has pulled back since then, but could resume its climb anytime.

The U.S. dollar has also been rising, thanks primarily to weakness in other world currencies. Although the United States faces unprecedented economic problems, many other nations are confronted by even more dire circumstances. As the world’s largest economy, the U.S. might be in the best position to be able to survive this global financial crisis. As a result, the dollar is receiving support from money flowing into the U.S. financial markets. In essence, there are many global investors who are betting on the U.S. economy.

The blue line on the chart is the Nasdaq 100–some of the strongest and largest technology companies in the world. Since bottoming in November 2008, this index shows a slight upward bias. When everything else is falling, just staying even is an evidence of strength. The technology sector has often led other sectors during bull markets. When this bear market finally relents, it would not be surprising to see the technology sector among the leaders.

We are watching a range of technical and fundamental indicators to help us identify when the time is right to start moving money back into the markets. One way we can measure market risk is by volatility. One commonly used volatility measure is the Chicago Board Options Exchange Volatility Index (VIX). In technical terms, VIX is a measure of the implied volatility of S&P 500 index options. A high value corresponds to a more volatile market and therefore more costly options. Options are often used to defray risk from volatility. If investors see high risks of a change in prices, they require a greater premium to insure against such a change by selling options. Sometimes called the fear index, it is a measure of the market’s expectation of volatility over the next 30-day period.

The chart below shows VIX compared to the price movement of the S&P 500 over the past few years. Notice how the expected volatility rose dramatically in the last quarter of 2008. While it has been lower since the beginning of 2009, it remains very high compared to prior years. So while some market sectors might be showing slight gains, the VIX is showing that on the broader market, risk remains very high. One indication of when to start moving back into the market is when VIX drops back into ranges we saw in early 2008 or before.

Other indicators we can watch to know when market health is improving includes things like advancing issues versus declining issues, new highs and new lows, P/E ratios and more. We also keep an eye on fundamental factors like unemployment rates, housing starts, consumer confidence, money supply, etc. Right now all of these indicators show that this is a risky time to jump into the market, even though a handful of sectors might be showing recent gains.

There are currently hundreds of billions of dollars sitting idle in money market funds, and in checking and savings accounts. When investors and traders believe the worst of the economic crisis is over, they will start reinvesting in stocks and mutual funds. The process can occur in just days because all it takes to reinvest the money is a phone call or an Internet order. By comparison, the economic stimulus package approved by Congress will move into the economy at a snail’s pace.

Once investors believe the stock market again offers a reasonable opportunity for reward versus risk, it would not be surprising to see some sectors advance dramatically in a fairly short time. When that occurs, our indicators should reflect the underlying changes in the market and allow us to re-enter at a less risky period.
F.S.

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For several weeks we’ve warned investors that market risk remains high and further caution was warranted. This week we’ve seen declines in major indices and the Dow and S&P 500 reached lows approaching their lowest levels of 2008. So far this year the Dow has dropped about 14% and the S&P 500 is down about 12%. The Nasdaq has fared slightly better, but is still off 6%.

The chart below shows price action of the Dow over the past year. The severity of this bear market is readily apparent from the plunging price. Notice that this week the Dow fell to approximately the same level as its prior low in November 2008. Many investors and analysts believed that the November lows would be the lowest point of this correction. Now we can see that such beliefs were premature.

The gold line is a 50-day simple moving average (SMA). The Dow is currently trending below its SMA and has done so for most of the past year. The green line is a trend line that I added. This marks the top of the trading channel. As long as the bear market remains in place, short-term advances should find strong resistance at this level.

 
The middle portion of this chart is a moving average convergence divergence (MACD). While this indicator remains negative, it is currently headed in a mostly sideways direction. While it could turn up from here, it has not reached a level where one would anticipate an imminent reversal.

The bottom indicator is a slow stochastic. A stochastic is an oscillator that is useful in determining waxing or waning momentum. In other words, it helps pinpoint short-term reversals. In this case, the stochastic has reached a level where it is showing that the S&P 500 is oversold. That indicates that we could easily see stocks rebound in the next few sessions. This would only be a short-term reversal dominated by the longer-term bear trend. That means that it should end somewhere near the green trend line on the top portion of the chart.

It is important to note that while we closely watch technical indicators like these for clues about what the markets might do, these are lagging indicators so their predictive value is limited. Nevertheless, right now all of our indicators portray a market where risk remains high, justifying our decision to remain on the sidelines.
F.S.

I originally planned on writing about some of President Obama’s comments from his press conference this week. But based on comments I’ve heard in the media and from some acquaintances, there is something more urgent that needs to be addressed. Whatever economic stimulus package Congress approves, we might see some significant market volatility in response to those actions. But we won’t be able to assess the real impact of any plan for several months if not years.

I worry that many investors’ response to this economic crisis is likely to further damage their investment portfolios. Many people have a powerful emotional attachment to money. I used to organize seminars on options trading. In the first class session, the instructor would borrow a $100 bill from someone in the class. Then he would tear it into tiny pieces while everyone watched. Usually the person who provided the bill showed some discomfort. The most interesting part of the lesson was to watch the reactions of others in the class. There was almost always a loud gasp or two. Usually several class members showed signs of uneasiness, even though it was not their money that was destroyed.

The instructor then discussed the reactions with the class. He explained that losses were inherent in any options trading system and that those who felt their stomachs tighten when the $100 bill was destroyed might want to reconsider their desire to trade options.

Today many investors are feeling nervousness about their portfolios. For some who have experienced dramatic declines, that concern can verge on desperation. As a result, they might knowingly choose risky investments in an attempt to quickly make up for those losses. That is exactly the wrong approach to take.

The main objective of active risk management is to try to avoid investment losses that come from major bear markets like the world financial markets are currently experiencing. Many investors do not really understand the economics of losses and they incorrectly believe that when cycles turn up, losses can quickly be erased. Even after the significant losses incurred by major market indices over the past year, many investors we speak with are more concerned about missing potential gains than they are about avoiding additional losses.

To help explain how a major loss can impact a portfolio, let’s consider a specific example. From its peak in October 2007 until its low in December 2008, the Dow Jones Industrial Average lost about 46%. So an investor who started with $100 was left with $54.

This is where it gets interesting. If the Dow regains 46% in 2009, the investor will not be back to even in his account, because now we are talking about 46% of $54 instead of 46% of $100.

So after a 46% gain in 2009, that investor who started with $100 will have $78.84. To recoup his original 46% loss to make his $100 whole, the investor actually needs an 85% gain.

Here is another example to put these recent losses in perspective. Wednesday the Dow closed at 7,939. Ten years previously in February 1999 the Dow was at 9,298. In other words, the Dow today is 14% lower than 10 years ago. If that rate of return continues indefinitely, no one reading this will live long enough to regain the loss.

Be assured the markets are not likely to continue losing money indefinitely. There are going to be future opportunities to earn profits. But with the uncertainty that currently dominates the economic situation and with continuing market volatility, investor focus should remain on protecting existing capital and preventing additional losses.

As I write this Thursday morning, the Dow is off nearly 200 points. As you can see from the chart above, the current level is very near the lows established in November 2008. If the Dow breaks below this technical support area it could easily fall to 7,000 or even lower over the next few weeks. Other major indices are in similar circumstances.

Investors who are positioned in the safety of government insured money market funds should not be hurt by the continued deterioration of investment markets. Those who are still invested because they do not want to miss out on an eventual market upturn may well suffer continued losses that might take a lifetime to recoup.

Of course there is always a chance that today’s action could mark the bottom and the stock market could rebound strongly from this point. But that would be contrary to what our technical indicators are showing at this time. And betting against those indicators now does not seem worth the risk.
F.S.

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There are currently many investors, traders, politicians, economists, and ordinary citizens who hope the major stock market indices have bottomed. Some are convinced that a major rebound is right around the corner and they warn others not to pull their money out of the market at this point. I learned long ago that just because we want something to happen does not mean it will. It is going to take more than hope and desire to bolster the economy and turn the markets upward again.

Keep in mind, many of the people telling investors to hold on and keep their money invested have a conflict of interest. They do not make money if investor assets remain on the sidelines. For example, on my desk is a year-end report from an asset allocation mutual fund. The fund lost -30.92% in 2008. In its outlook for 2009, the report states: “We believe a new cyclical bull market may emerge this year that could push the S&P 500 up more than 30%.”

Unfortunately, the report fails to offer substantive explanations about why the S&P 500 is going to stage such a strong advance in 2009.

Wednesday President Obama said that if Congress does not quickly pass his economic stimulus package the current recession will turn into an economic “catastrophe.” As a former journalist who covered a few presidential press conferences, I can assure you that no president would use such a word lightly. I suspect it will be difficult for the stock markets to stage a powerful advance under economic conditions that could create a catastrophe.

For the past two months, major indices have traded in a mostly sideways pattern. The previous eight week sideways trading period occurred in July and August 2008 and it followed a steep slide in June. I distinctly remember that in early August a potential client told us he decided not to invest with us at that time because his existing broker assured him the worst was over and he did not want to miss the ensuing market rebound. His account was down about 17% at that point. Since then the S&P 500 has lost an additional 30%–about 425 points.

Below is a chart showing the S&P 500 price movement over the past year. I added the two red lines. The top one shows that the long-term downtrend continues. The bottom red line shows a support level slightly above 800. Since the beginning of December 2008, this support level has held while the sideways trading channel has narrowed. It is likely that stocks will soon break out of this channel. While we would all like to see the market rally and the recession end, there is a high degree of risk that the next major market move could be downward.

The gold line on the top portion of the chart is a 50-day moving average (MA) of the S&P 500. While the index broke briefly above this MA back in January, it was unable to remain above that level. If the index had continued to rise for a few more days, our indicators would have signaled us to begin re-entering the market, but that did not occur. During any sustained advance, an index will trend above its 50-day MA.

The middle portion of the chart is a moving average convergence divergence (MACD). During a sustained advance, the MACD should be able to trend well above the zero level. The S&P 500 spent about six weeks above that mark in late spring 2008, but it failed quickly on every attempt since then.

The bottom portion of the chart is a relative strength index (RSI). If the index has enough strength to maintain an advance, its RSI should be able to trend at the 60 to 70 level. The fact that the index has struggled to reach 50 and has not been able to remain above that level is a sign of continued long-term weakness.

I could go through several more technical indicators and all of them would provide essentially the same assessment: weakness is dominant over strength right now. That means market risk is high.

While I have used the S&P 500 as an illustration, charts for the Dow Jones Industrial Average and for the Nasdaq look remarkably similar.

One advantage of an active risk management strategy is that we are watching our indicators closely on a daily basis. Perhaps the markets will rally for several months after an economic stimulus package is approved. In that case, we are ready to re-enter the market when it makes sense to do so. In the meantime, we are content to wait patiently on the sidelines as long as our indicators show that risk remains high.
F.S.

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