After peaking at the end of February, major indices started March with a minor pullback. But the advance appears to have regained momentum and the longer-term upward trend remains intact.

The chart below shows the S&P 500 over the past six months. The gold line is a 50-day simple moving average (MA). As you can see, the index never threatened to break below its MA.

There will always be some down trading days, even in the midst of the strongest market uptrends. The current advance is one of the strongest experienced in the past couple of years, so investors should take advantage of the opportunity.

The middle portion of the chart is a moving average convergence divergence (MACD). While this indicator remains positive, it did start to roll over when stocks pulled back. But now it appears to be moving upward again. This is normally a sign of a strong market.

The bottom portion of the chart is a stochastic oscillator. It is useful in determining market momentum and turning points. Normally a reading below 20% indicates that an investment has reached an oversold level and a rebound is likely. The last time this indicator was below that mark was in mid-December. On the most recent pullback it did not quite make it as low as 20%. Between those two instances it spent most of its time hovering between 60% and 80% and never completing a full downward cycle. That is something that generally only occurs during powerful market advances.

In spite of rising oil prices, continued high unemployment, potential for conflict with Iran and other threats to the economy, virtually every technical indicator is showing that this advance should continue.

Projecting how long this rally can continue is just a guessing game. After bottoming in early 2009 major indices pushed upward for a year before the next significant retracement. The advance that began in the fall of 2010 persisted for about nine months. The current surge could last another six weeks, six months, or longer.

In the meantime, we’ll keep a close watch on our indicators and trust them to tell us when the long-term trend is losing momentum.

Flint Stephens

This week the financial media has made a big deal about the Dow 30 crossing back above the 13,000 level for the first time since 2008. While that is certainly a significant benchmark, the fact is that the Dow is only slightly above its highest mark from 2011 and is still below its 2007 peak.

The chart below shows the Dow, the S&P 500 and the NASDAQ over the past five years. Of the three, the NASDAQ is the only index that has exceeded its 2007 high. (Of course, the NASDAQ is still well below its all-time high set in 2000.)

In reality, Dow 13,000 is just a number. The more important consideration is that major market indices are in a strong advance that appears to have momentum and strength. The Dow, NASDAQ and the S&P 500 have surpassed their highest marks from 2011 and appear poised to move even higher.

The economy and the markets still face significant threats. European debt, rising gas prices and high unemployment could still derail this advance and the gains could quickly disappear.

But for the present, technical indicators are positive and the best course of action seems to be to remember the old Wall Street adage: don’t fight the trend.

Flint Stephens

There is plenty of media coverage right now about rising gas prices. According to some projections, the national average of the price of a gallon of gas will be over $4 by the start of summer. In fact, it is already above that level in Alaska, Hawaii and California.

Unfortunately, no one seems to have a concrete explanation about why gas prices are spiking.

At a speech at the University of Miami Thursday, President Obama said there are no quick fixes to the problem. He said America needs an energy program that includes oil, [natural] gas, wind and solar power. What he did not mention is that wind and solar generally cost more than oil. And he did not give any specific explanation about why gas prices are going up now.

Some attribute the increase to growing global demand, pointing to increasing auto usage in places like China and India. But that explanation doesn’t really pass muster because there has not been a significant increase in demand over the past month and long-term U.S. demand is declining.

After peaking in 2007, gasoline usage in the U.S. in 2011 was about the same level as in 2004. In other words, domestic demand for gas is falling, not increasing. That means one would expect a softening of prices.

In fact, because of weak demand, the U.S. industry is exporting gasoline, diesel and jet fuel. Here is a quote from an article by Ron Scherer in the Christian Science Monitor:

“Compared to a year ago, exports of gasoline have tripled – at a time when the price of gasoline is 42 cents a gallon more expensive at the pump. On Thursday, for example, the price of crude oil remained elevated at $107 a barrel because of fears over the Iranian nuclear situation, and the price of gasoline rose 3 cents a gallon compared to Wednesday, according to AAA.

“The oil industry maintains the exports are necessary because domestic demand is weak. The industry says if refiners could not send American-made gasoline to China, India, Europe, and South America, the refineries would have to close as several have already done on the East Coast. Yet, other energy observers say exporting gasoline at a time of rising prices is sort of like throwing flammable liquid on a fire.”

Based on a historical perspective of oil prices, there is no reason for gas prices to be approaching record levels. The chart below shows the price of USO, a domestic exchange traded security designed to track the movements of light, sweet crude oil, over the past five years. While the oil price has risen recently, it is still below its highest levels of 2011 and well below the highest levels of 2007 and 2008.

The next chart shows a comparison of the price of USO and the U.S. dollar over the past three months. The value of the dollar has been falling since mid-January. That is at least partially responsible for the rise in oil prices.

Oil is a global commodity priced in U.S. dollars. That means the price of oil automatically rises any time the dollar loses value. However, the increased oil price is disproportionately large when compared to the drop in the dollar.

The best explanation for the current price spike is likely speculation in the oil futures markets. An article about this possibility by Dan Burrows on CBS Money Watch, references research by Ed Yardeni, president of Yardeni Research.

“Oil futures traded on the New York Mercantile Exchange have leaped above $106 a barrel. The current national average for a gallon of regular gas stands at $3.61, up from $3.19 a year ago, according to AAA’s fuel gauge report. That’s the highest price at the pump ever for this time of year.

“But speculators in the gas futures markets are largely to blame, according to Yardeni, not demand. ‘Large speculators and small traders were net long a record 101,926 [gas futures] contracts on February 14,’ Yardeni writes in a note to clients.

“Since each contract is for 42,000 gallons, or 1,000 barrels, of gas, and gasoline inventories in the U.S. stood at 232 million barrels, ‘speculators and traders, in effect, held a record 43.8 percent of U.S. inventories,’ Yardeni says.”

What all that really means is that because speculators control almost half of the U.S. supply of oil, a speculative bet that the price of oil is going to rise becomes a self-fulfilling prophecy.

Unrest in the Middle East is the likely cause for speculators betting on higher oil prices. If war breaks out and disrupts the supply of Middle Eastern oil, then crude prices are likely to skyrocket and the speculators who have already locked in supplies of crude at higher prices will see a substantial increase in the value of their contracts.

All of this is bad news for the U.S. economy and likely for investors. Rising gas prices act like a brake on economic activity. Higher fuel costs impact virtually every aspect of the economy and get passed on to consumers rather quickly. That will lead to a decrease in consumer spending, which makes up about 70% of U.S. economic activity.

Right now the U.S. stock market is in the midst of its longest and strongest advance in many months. If the price of gas keeps rising watch for this rally to come to an abrupt end fairly soon.

Flint Stephens

Most people are familiar with the concept of bell curves, standard deviations, distributions, means, etc. According to Wikipedia, “In probability theory, the normal (or Gaussian) distribution is a continuous probability distribution that has a bell-shaped probability density function, known as the Gaussian function or informally the bell curve.”

The accompanying illustration depicts a typical bell curve like most of us learn about in high school.

Probability theory has been applied to investing with the assumption that returns and volatility will fall within a normal distribution. In reality, that is rarely the case.

Investments with low volatility like short-term bonds have smaller expected returns and a tall, skinny-looking bell curve. Stocks have a higher expected return and a flatter curve. That is because they more often produce results that are much better or worse than average.

This is important in order to understand that investment risk does not adhere to a typical distribution pattern. Whether the curve is tall or flat, there are usually far more outliers than one would expect from a bell-shaped distribution.

Gary Elsner, Ph.D., the editor of an investment newsletter Achieve Profits wrote this about standard deviation:

“The standard deviation is a good measure of volatility, since it measures the amount of variation around the average and is probably the most widely used measure of financial risk. But the standard deviation has two weaknesses for financial instruments. First, it measures the variation from the average in both the up (good) direction as well as the down (bad) direction. Second, the standard deviation does not distinguish between short or long sequences of losses.. Investors are only concerned about downside risk (or the potential for losses), whereas upside changes or rapid increases in value create profits.”

Standard deviation is a measure of volatility regardless of whether it is above or below the mean. But when it comes to investing, investors have no problems with volatility when investments are moving up rapidly. Only the negative moves that cause concern.

Because of that investor bias, Peter G. Martin recognized the folly of using traditional volatility or standard deviation measures to measure risk aversion. In 1987 he created a tool called the ulcer index (UI) that focused exclusively on the negative side of volatility.

According to Martin, his index “measures the depth and duration of percentage drawdowns in price from earlier highs. The greater a drawdown in value, and the longer it takes to recover to earlier highs, the higher the UI. Technically, it is the square root of the mean of the squared percentage drawdowns in value. The squaring effect penalizes large drawdowns proportionately more than small drawdowns (the SD calculation also uses squaring). In effect, UI measures the severity of drawdowns.”

In other words, the UI considers the depth and duration of drawdowns. An investment that offers the same return as another investment that has more negative volatility will be more palatable to investors.

This concept is illustrated in the accompanying chart. Fund A and Fund B start and end at the same return over the same period of time. An investor who experienced the performance of Fund B, however, is likely to endure more stress because the drawdown is more severe and endures for a much longer period.

In addition to feeling more emotional stress and pain, an investor holding Fund B is more likely to succumb to investment anxiety and sell his position at the bottom. That would lock in his losses and possibly prevent him from recouping those losses when the fund turned upward again.

Martin and Byron B. McCann first described UI in their 1989 book, The Investor’s Guide To Fidelity Funds. In the ensuing years, it has gained wide acceptance as a superior means to measure investment risk.

For anyone who would like to learn more about UI–including the formula—a web search will turn up numerous sources of information.

Flint Stephens

So far in 2012 stocks have been advancing on a steep upward slope with no significant pauses or corrections. The situation in Europe threatens to disrupt the smooth ride, but the bumps have not yet been enough to derail the strong rally.

I have always acknowledged that I don’t have any predictive ability when it comes to knowing what the stock market will do and I don’t believe anyone else does either.

But I do believe that there are many technical indicators developed by extremely smart people that can help assess the strength and momentum of the markets. Today those indicators are about as strongly positive as they ever become.

The chart below of the S&P 500 (SPX) illustrates the current situation. The gold line on the top portion of the chart is a 50-day simple moving average (MA). I added it because it is a good indicator to help determine when a rally is losing steam. When the price movement drops to the 50-day MA, then one should be nervous about whether or not the advance will falter. Right now SPX is still trending well above its 50-day MA.

The next section of the chart is a moving average convergence divergence (MACD). Although this indicator has flattened out, it remains strongly positive and has not yet reached such an overbought extreme that a major correction appears likely. I like to compare this indicator to measuring the tension in a rubber band. Right now it is stretched tight, but it has not reached a breaking point.

The next chart section is a stochastic oscillator. It measures random market cycles and can be used to help pinpoint market turning points. It turned downward a couple days ago, but you can see that the past three times it turned down it was not able to complete a full cycle. That normally occurs when the market is in a strong advance.

Finally, the bottom portion of the chart is a relative strength index (RSI). Anytime the RSI is trending above 50, it means the market has the momentum and strength to sustain a longer-term rally. The RSI recently approached 80. Usually at that high level some sort of consolidation will take place. But there is currently nothing to indicate that the RSI will break below 50 anytime soon.

The advance since late December has been the strongest in more than a year. Like a tea kettle that has reached a full boil, it now needs to vent some steam to release pent-up pressure.

It would not be surprising to see a couple weeks of market consolidation or correction from this level. But so far there is nothing to indicate that a serious correction is on the immediate horizon.

Flint Stephens