Research & Advice

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A Technical Correction

Monday, March 1, 2010

 

    • The correction is not over (though most of the damage has already been done), but it is not the resumption of the bear market.

However, the stock market remains vulnerable.

  • It is (somewhat) likely that the stock market will drop back toward its recent lows and probably test its 200-day moving average, which would be about 1,025-points on the S&P 500 – within two-percentage points of the February 5th low – before it begins a sustained advance.
  • While the broader market will define direction, Materials and Commodities will offer leadership by going down more as the market goes down (possible short term) and going up more as the market goes up (the primary trend).

Fundamentals are one story. Technicals are another.

First, the fundamentals. On June 30, 2009 we declared that the recession would be over by the end of the Summer, since then we’ve had two back-to-back quarters of economic growth, as measured by Gross Domestic Product (GDP), with gains of 2.2% and 5.9%. As was explained in our December 30, 2009 “Economic Outlook for 2009”, we are currently ruling out a double-dip recession in 2010, or even 2011.

We have covered the fundamentals, and the situation has only improved over the last two months. As such, it is rational to expect a continuation of the stock market’s advance. But as John Maynard Keynes said, “the market can stay irrational longer than you can stay solvent.” So while we wouldn’t ever ignore the fundamentals as they help us forecast what should happen, we also have to pay attention to the technicals because they tell us what is happening.

It is important to keep in mind that with the S&P 500 having already corrected 9.21% (peak-to-trough) the issue is not whether or not the stock market is in a correction – it is. The issue is whether this short-term correction is nearly over, or if it will roll over into a new bear market.

Every bull market (whether cyclical or secular in nature) has at least one pullback that fools investors into thinking that a new bear market has begun. To create this deception, these pullbacks need to be severe enough to raise expectations that a new bear-trend is underway – such as might occur with a correction of about ten percent. But, to be deceptive, such declines should also be relatively rare occurrences. Corrections of ten percent happen only about once per year (relatively rare, or at least rare enough that investors forget that they’re not altogether infrequent). Since they are rare, it is possible to see how they can be interpreted as the initial phase of a major market decline – they are scary.

While it is likely that the stock market will drop back toward its recent lows (and probably testing it’s 200-day moving average, which would be about 1,025-points on the S&P 500 – within two-percentage points of the February 5th low), there is a growing body of evidence to suggest that the current correction is just that – a correction, and not the beginning of a new bear market. To review that body of evidence, let’s first reexamine some of the technical tools that we use due to their relative consistency and reliability.

We have often written about 90% Upside Days and 90% Downside Days. 90% Downside Day are defined by volume and points. Such a day has 1) downside volume that equals 90% or more of the total upside plus downside volume, and 2) points lost that equals 90% or more of the total points gains plus points lost. A 90% Upside Day is just the converse.

These metrics are used to measure what is called Buying Power (Demand, or buying interest, for stocks) and Selling Pressure (Supply, or selling interest, for stocks).

90% Days, Buying Power, Selling Pressure are simply tools used to measure what investors are doing –buying, selling, and just how aggressively for each instance. That is the easy part. The trick, of course, is to extrapolate and to interpret so as to determine what investors are going to do.

• Typically short-term corrections end (at least in terms of magnitude, if not duration) with a small selling climax at or near the market’s eventual low for that cycle. Such a selling climax occurred on February 4th with a 90% Downside Day. Such days are characteristic of panic selling and likely exhaustion of Supply (or selling interest).

• By itself, a lack of Supply is not enough to generate a sustained rally. A sustained rally requires strong, enthusiastic buying – such as indicated by a 90% Upside Day, one of which occurred on February 16th. This recent combination of 90% Days, therefore, represents the contraction in Supply and expansion in Demand frequently found at (or around) important market lows.

• The rally coming off of the February 5th low has been led by small- and mid-cap stocks. This change in focus away from big-cap stocks suggests expanding Demand and an increased willingness to adopt greater risk on the part of buyers.

• Forewarnings of major market tops and subsequent declines have traditionally been signaled by sustained patterns of expanding Supply and contracting Demand. At present, though, there are numerous indications of exactly the opposite process – that is one of expanding Demand and contracting Supply.

In summary, the weight of the evidence indicates that the primary uptrend remains intact.

There have been numerous indications of expanding Demand and contracting Supply associated with the stock market over the last few weeks. This is the antithesis of the heavy selling and lack of buying that typically signals a major market top.

None of this suggests that the stock market’s move is only up from here – the S&P 500 will likely approach 1,025 points before it advances to 1,200 points. But it does suggest that, give or take a few percentage points the lows for this correction have been defined as any pullback should be limited in scope and duration.

We are not being pollyannas with rose-colored glasses. We are certainly aware of the risk and, as Berkshire Money Management clients know, we are not afraid to raise cash if we feel that a bear market is coming (we did in 2001-2002 as well as in 2007-2008, and we’ll do it again if we feel it is the right thing to do). We will remain flexible. We will be looking for evidence that contradicts our expectations. We will be looking for signs of weakness, either suggesting that our premise is absolutely wrong, or that the rally we expect to come will be more vulnerable than currently believed.

The recent bout of stock market weakness has left investor pessimism at levels that are likely conducive to another stock market rally (investor pessimism is just a means of clearing out Supply by allowing those that want to sell stocks, to sell – the remaining participants are buyers and that allows Demand to overwhelm Supply, thus sending prices higher). It will be important, however, to monitor this expected rally as we continue to believe that the stock market is vulnerable to a larger correction in the second half of 2010. To gauge the quality of the rally, we will look for deterioration among our breadth, sentiment, and monetary indicators. If the quality of the rally is weak, we will look for opportunities to reduce equity positions (or at least reduce “beta”). For now, although likely to be weak during a re-test of the recent stock market lows, Commodities and Materials appear poised to stage another run at leadership.

We expect the primary trend of the stock market’s advance to continue until:

1) monetary conditions begin to worsen, with rising interest rate pressure in the U.S. and globally, and/or

2) stock market optimism becomes excessive again. That would leave equities vulnerable to economic disappointment should the expansion lose momentum.

We do not intend to hold investments for the sake of populating your portfolio. Cash is always an option should we expect something larger than a correction, such as a resumption of the bear market. We fear and try to avoid bear markets, not necessarily corrections within bull markets. A continuation of the rally may not be imminent, but once it does begin (likely over the coming weeks) we will be watching for signs of divergence (where breadth weakens and the price levels of broad stock market indices become supported by a shrinking number of stocks), potentially warning of a topping process and the start of a deeper and more drawn out setback than we’ve seen since the bull market started almost a year ago. With enough indicator deterioration, we would be compelled to cut back on our equity exposure.

Bottom Line: Probabilities are not certainties, and allowances for exceptions to the probabilities are always necessary. But there is little or no evidence at this point, based on longer term measurements of Supply and Demand that the market is rolling over into a new bear market. The weight of the evidence indicates that the primary uptrend remains intact. Investors should avoid being caught up in these short-term declines as they are not terminal events. Rather, these pullbacks should be used to cull weak positions from portfolios and to redeploy cash into stronger positions.