The easy answer is that no one knows for sure. With the mid-term elections just a few days away, traders and investors are eager to see what changes will occur in Washington D.C.  Under the best circumstances, forecasting the financial markets is difficult because the variables that can impact the markets are essentially infinite. When one adds political implications, the task is even more daunting.

By virtually all technical and cyclical measures, U.S. stocks have been in an overbought condition for several weeks. Yet instead of correcting as one would expect, stocks continued to drift upward and those indicators have largely remained positive. Some analysts have attributed the sustained rally to Wall Street anticipating a major shake up in Congress. If that is true and the GOP gains control of the House and possibly the Senate, then perhaps euphoria over the victory will continue to propel stocks after next week’s elections. Additionally, seasonally this is often the strongest period of the year for stocks. So the combination of new faces in Congress with the revenue rich holiday season could keep stocks in an overbought situation for an even more extended period.

Then again, the market could turn around and decline sharply and erase the past few months of gains in a handful of days.

As I reviewed technical indicators and markets this week, I was struck by how similar the market looks now to how it appeared this spring. To see what I mean, look at the chart below of the S&P 500 Index.

I highlighted the period of the current rally with a pink oval.  Then I used the same oval to highlight the advance that began in February and continued through April. Based solely on appearance, these two rallies look remarkable similar. Trust me, this is highly unusual. The earlier rally began when Wall Street and Washington were anticipating GDP and other economic reports showing that the economy was beginning to rebound and the scenario played out as expected. The current rally did not have a similar optimistic economic catalyst. In fact, reports on economic fundamentals over this period have largely been negative.

The gold line on the top portion of the chart is a 50-day simple moving average (MA). In April, the S&P 500 was trading about 6% above its 50-day MA when the market reversed course. Similarly, the S&P 500 is now trading at about 5.5% above its 50-day MA. It is normally a bullish sign when an investment vehicle is trending above its 50-day MA. But this is an indicator that can quickly unravel. In May, the S&P 500 took only three or four sessions to fall below its MA and only about three weeks to erase all of the gains it accumulated in the prior three months.

The middle portion of the chart is a stochastic oscillator. Again I have highlighted the periods of the current and prior rallies—this time with green ovals. During these periods the downward portions of the cycles have been irregular. In a normal cycle, stocks would reverse from an overbought state (about 80 on the stochastic) and fall to an oversold condition (somewhere about 20 on the scale). During these prolonged rallies, the index has remained for extended times at or near overbought levels.

The bottom portion of the chart is a relative strength index (RSI). It is a bullish sign when an investment trends above 50 on its RSI. An investment shows signs of being overbought when the RSI reaches the 70-80 level. So this indicator is showing that the index has strength to continue this advance and is not at an overbought extreme.

The bottom line is that using these technical and cyclical indicators, we get a picture of an equity market that is overbought and extended and we would normally expect to see some sort of a correction from these levels. However, these indicators also remain positive and while a downturn is anticipated, it is not necessarily imminent. It is possible that stocks could continue to climb after the election and even into the New Year.

One thing we can say for certain is that at these levels, market risk is high. The possibility of a significant correction is probably much greater than the chance for a major advance. So our best advice for investors at this time would be to go to the polls on Nov. 2 and vote for the candidates they believe best represent their interests. While they are keeping a close watch on what is happening in Washington D.C., they also need to pay close attention to what is happening on Wall Street. We might not know what is going to occur, but we know that the next few days are likely to be important in determining the economic future for many years.
Flint Stephens

In the past week the world witnessed the miracle of trapped the Chilean miners being brought to safety. It was truly an international victory as the rescue team included experts from several nations and people from across the globe rejoiced when the men were saved.

I suspect the outcome would have been different if the miners had been told to dig their way to safety.

From an economic standpoint, the United States, finding itself in a hole, has tried to solve the problem by digging. As the hole grows deeper and wider, those who have proposed this solution believe great progress is occurring and they struggle to understand why others are critical of their efforts. One piece of evidence they use to show economic progress is that the stock market is advancing. But that is like pointing to the growing pile of dirt outside an ever-deepening hole as proof that the rescue plan is working.

There are several factors currently bolstering stocks.

• Election expectations—Many traders and investors anticipate significant gains by the Republican Party in this mid-term election. They hope that means a stronger economy in the future. In addition, current office holders can’t afford a major downturn prior to the election. It is to their advantage to use whatever means are available to support stock prices now. We have said several times that there no major correction is likely until after the November elections.
• Ongoing bullish bias—By this I mean that there is a constant flow of money toward stocks, no matter what the market is doing. Each month, workers are contributing to pension plans, IRAs, 401Ks, etc. The majority of those contributions automatically end up in the stock market.
• Seasonality—Although some of the most memorable market slides have occurred in the fall, autumn is traditionally a strong period for stocks. We are just two months away from Christmas and are entering a period known for Santa Claus rallies. For retailers this is usually the best time of the year.
• Corporate profitability—After a couple bad years, many companies have returned to profitability. It isn’t all good news though, because often those profits have come because of layoffs and downsizing. In many cases, companies are back in the black even though overall revenue is sharply lower than in previous years.

Market momentum seems to be self perpetuating. In other words, when stocks are trending up, each piece of positive news seems to promote additional buying, which drives stock prices further upward. There have been numerous examples of this in recent weeks. For example, stocks rose Thursday morning when initial jobless claims for the prior week fell more than expected. Economists expected claims to fall to 455,000 and instead they dropped to 452,000. That’s good, but a 3,000 difference really isn’t meaningful when tens of millions are out of work. In order to get excited about 3,000 fewer unemployment claims, traders had to ignore the fact that the number reported from the prior week’s claims was adjusted upward from 462,000 to 475,000—or 13,000 additional unemployment claims.

Momentum can also work against the market when stocks are in a downturn. Fear and worry can result in panic by traders and investors and gains can rapidly unravel. We saw that occur on May 6, 2010 when the Dow Jones Industrials Average fell 700 points in a matter of minutes. The Securities Exchange Commission report on that event blamed computerized selling by a single large investor that cascaded across the markets. The $4.1 billion sale of e-mini futures contracts sparked a flood of sell orders that potential buyers couldn’t absorb quickly enough.

Thursday CNBC released the results of its latest economic survey showing that pessimism about the economy is growing among Americans. The results showed that just 37% of the public believes the economy will improve in the next year. That is 5% lower than a year ago. Only 20% believe that the value of their home will increase in the next year. These kinds of numbers are evidence that many people are worried and fearful about their economic futures. That type of concern could spill over to the stock market and exacerbate the momentum of any downward move.

For several weeks we have included charts with this blog showing technical indicators telling us that major market indices have reached an overbought status. Just because stocks are overbought does not mean a major downturn is imminent. But when stocks remain at highly overbought levels it is an indication that the potential for a significant downturn is also high.

The U.S. economy is currently struggling with major challenges like high unemployment, a slowing GDP rate, high debt levels, declining real estate values, etc. Until some of these issues are addressed and dealt with, risk in the financial markets will remain high—especially after periods of unusually steep gains like we have seen the past several weeks. Even though there might be small signs of improvement, the U.S. can not dig fast enough to get out of this hole.

Flint Stephens

Today’s issue of the New York Times carried an article by Michael Powell and Motoko Rich with the headline: “Across the U.S., Long Recovery Looks Like Recession.”

The article explained that while economists, analysts, politicians and others are saying that the U.S. economy is no longer in a recession, many areas and people have not experienced a recovery. Here are some of the sobering points included in the article:

·        “At the current rate of job creation, the nation would need nine more years to recapture the jobs lost during the recession. And that doesn’t even account for five million or six million jobs needed in that time to keep pace with an expanding population. Even top Obama officials concede the unemployment rate could climb higher still.

·        “Median house prices have dropped 20 percent since 2005. Given an inflation rate of about 2 percent — a common forecast — it would take 13 years for housing prices to climb back to their peak, according to Allen L. Sinai, chief global economist at the consulting firm Decision Economics.

·        “Commercial vacancies are soaring, and it could take a decade to absorb the excess in many of the largest cities. The vacancy rate, as of the end of June, stands at 21.4 percent in Phoenix, 19.7 percent in Las Vegas, 18.3 in Dallas/Fort Worth and 17.3 percent in Atlanta, in each case higher than last year, according to the data firm CoStar Group.

·        “Demand is inert. Consumer confidence has tumbled as many are afraid or unable to spend. Families are still paying off — or walking away from — debt. Mark Zandi, chief economist of Moody’s Analytics, estimates it will be the end of 2011 before the amount of income that households pay in interest recedes to levels seen before the run-up. Credit card delinquencies are rising.”

Most people see similar signs of economic trouble all around. A block from our office is a commercial business strip. Three years ago it housed six or seven small retail shops and offices. It has been empty for about 18 months. Last week I drove through Mesquite, Nevada on Interstate 15. All but a handful of the billboards that line the roadway were blank. I’ve never seen that before.

Yet in the midst of such gloomy reports, major stock indices are rising. The last time the S&P 500 was at this level was in April when it reached its 2010 high. Currently all our technical market indicators are currently positive. They are also all at overbought levels and they have been for weeks. Below is a price chart of the S&P 500. The bottom portion includes three technical indicators: a moving average convergence divergence (MACD), a stochastic oscillator, and a relative strength index. All of them show that the index has reached a level where a significant correction could occur.

Of course these indicators are not infallible. They are much like the tools used by meteorologists to forecast the weather. When a weather forecasters tools show him that a warm front and a cold front are about to collide, those conditions usually result in storms and precipitation. But sometimes they fizzle out and nothing happens. Right now our tools are telling us that stocks are likely to see a substantial price storm.

The S&P 500 is up almost 13% since its most recent bottom in late August. It is tempting for investors to want to jump into the market at this point. But that would be a high risk move that would be like going outside without a raincoat when the skies are dark gray and there is lightning on the horizon. The rain might never arise, but it is not worth the chance.

Flint Stephens

September turned out to be a great month for stocks. In fact, the 8.8% monthly gain was the best September since 1939.  When one considers the weak state of economic fundamentals September’s market rally is mystifying. For example, this week analysts from Goldman Sachs Group Inc. released an assessment stating that over the next six to nine months they expect the economy to be “fairly bad” or “very bad.”  The “fairly bad” Goldman Sachs’ forecast calls for a growth rate of 1.5 % to 2% into 2011 with an increase in the unemployment rate to 10%. The “very bad” forecast would involve the U.S. returning to outright recession.

In another report the International Monetary Fund this week significantly scaled back its estimate of U.S. economic growth for 2010 and 2011.  It predicted annual economic growth of 2.6% this year compared to a previous estimate of 3.3%. And for 2011, it forecasts a rate of 2.3% for the U.S. and a global rate of 4.2%. A 9.6% unemployment rate also remains a big worry.

But even though September was a good month for stocks, the overall outlook for the market remains clouded. Technical and cyclical indicators show that stocks are at overbought levels and market risk is high. The chart below shows the New York Stock Exchange Composite over the past two years. Notice that even with September’s impressive gains, this index is still below its high for the year set back in April. The current level is about the same as it was in mid-January and only slightly higher than where it was a year ago.

This chart includes three indicators that are all positive. But they are also all at levels that normally precede some sort of corrective action. For example, the gold line on the top portion of the chart is a 50-day moving average (MA). The NYSE Composite is currently about 400 points above the MA. That kind of spread does not usually persist for long without a downward move of some sort.

The middle portion of the chart is a moving average convergence divergence (MACD). The MACD is at about the 200 level—an area where downturns often begin. Looking back you can see that for much of 2009 the MACD stayed at or above this level. But in 2009 the economy was beginning to improve after a lengthy period of decline. Right now the economy appears to be contracting rather than expanding. While it is possible that the MACD could remain in this overbought area for an extended period that appears unlikely given the current economic fundamentals.

Finally, the bottom portion of the chart is a stochastic oscillator. It began September at a highly overbought level. During the month it made several attempts to complete a normal downward cycle but each time it was unable to follow through as stocks kept climbing. It is once again at an overbought peak, but this time the MACD is also confirming that overbought status.

All of these measures confirm that risk for a market downturn is high. That does not necessarily mean a significant correction will occur. But it does indicate that investors holding long positions in stocks need to be cautious.

As mentioned in last week’s blog, in mid-May 2010 Strategis began taking bond positions in many of its managed strategies. That proved to be fortuitous because in the ensuing months, long-term government bonds have outperformed major market indices like the S&P 500 as the chart below illustrates. The chart also shows that for several months blue chip stocks and long-term government bonds have maintained an inverse relationship (I used a six-month chart for this illustration because it does a great job of showing the inverse movement). But when stocks staged a strong advance in September, long-term bond funds and ETFs like TLT did not experience an equally steep decline. In fact, during the last couple of weeks of the month bonds also advanced.

While some analysts believe that bonds may have peaked, a decline in stocks would likely propel long-term government bonds to even higher levels. Bonds would also benefit if the Federal Reserve takes additional steps to shore up the economy, as many economists believe will occur in the coming weeks.

The bottom line is that investors who happened to be holding stocks during September’s strong advance should feel fortunate. But technical indicators and fundamental factors paint a picture of rising market risk. This would likely not be a good time for investors to increase their exposure to stocks.

Flint Stephens

Investors have long been counseled to diversify their portfolios as a protection against risk. While that strategy is still valid, traditional asset class diversification models developed in the 1950 and 1960s and still in use by many advisers have repeatedly failed to protect investors from major market downturns.

Typical asset class diversification is a passive approach to risk management. The idea is that by dividing assets among different classes (large cap, international, small cap, growth, value, etc.) some might show greater strength during market downturns. A major flaw in traditional asset allocation models is that in recent years during major market corrections most asset classes have shown a high level of correlation. In other words, when large cap stocks declined small cap stocks, international stocks, value stocks, and virtually every other equity classification also declined.

At Strategis Financial Group, we take a more active approach to investment risk management. Instead of diversifying assets among different asset classes, we try to diversify among different types of investments and among different investment strategies. We also try to mitigate risk by moving investment assets away from sectors that show weakness and toward those that show greater strength.

A good example is the Focus Growth Strategy created and managed by Rod Jackson. For this strategy, Rod chose five sectors that tend to have low correlation. These include U.S. stocks, international stocks, real estate, long-term bonds, and a money market position. He is constantly comparing and contrasting these sectors, trying to determine which is showing the most strength and which might be losing strength.

The chart below illustrates the strategy. The lines represent four ETFs from the sectors mentioned above.  In May, assets were moved from the money market fund into TLT. As you can see, over the ensuing period, TLT has significantly outperformed the other sectors. Of course, it does not always work out so well. In 2009 assets in the Focus Growth Strategy were kept in the money market fund even as U.S. equities staged a strong rally. The reasoning was that in spite of rising stock prices, considerable market risk remained because of a recessionary economy. The choice was to protect investors from what was believed to be a high risk level even if it meant giving up a potential profit opportunity.

Thursday morning the financial media were reporting that the Dow was likely going to end the month as the best September in seven decades with a gain of more than 8%. You can see the advance in U.S. equities reflected in the performance of the S&P 500 (SPX) on the chart. While the month-long rally is impressive, major equity indices are barely above the level where they began 2010. The international position (EFA) was even stronger for the month than SPX.

In contrast, during September TLT saw a two-week decline and is just recovering from mid-month lows. If the disparity in performance between TLT and EFA persists, the strategy will shift from the bond position to international. But a similar situation occurred in June when the other three positions outpaced TLT for about four weeks, then fell back again.

The traditional asset allocation approach would be to maintain a portion of the assets in each position. While that captures all the gains in strong months like September, it also captures all of the losses in weaker months like August. September’s strong showing seemed out of character given the continued weak economic environment. One analyst attributed the gains to an expectation by Wall Street that the Republican Party has a reasonable change to regain a majority in one or both houses of Congress in the upcoming November election.

Whatever the reason for the September gains, it seems unlikely that stocks will be able to continue to advance at this pace. For the time being we will maintain our bond position and wait for a signal that it is time to change to a different sector.

F.S.