Investors are more uncertain about the stock market’s future today than at any other time during the past six years. Thirty-eight percent of investors polled by the American Association for Individual Investors are in the “neutral” camp — a six-year high. Unfortunately, uncertainty is no investment strategy. It takes fact-based conviction to succeed in investing. So what are the facts?
Volatility: Bad For Stocks
Volatility in the past six months has been off the charts. Volatility is more than just the performance of the Volatility Index or VIX. Volatility includes the volume and conviction associated with the recent roller coaster.
During the past six months, the Dow Jones has seen 38 (almost every third trading day) 90% days. A 90% up day means 90% or more of trading volume and point moves were to the upside, thus a 90% down day is exactly the opposite. Of those 38 90% days, 16 happened to be to the upside, 22 to the downside. That is highly unusual. I’ve read interpretations stating that high-volume, 90% up days (also called breadth explosions) are bullish for stocks.
Before drawing conclusions, let’s try to decipher the emotions that cause 90% days. Fear, panic and certain news events cause severe down days. Most up days seem to be caused by positive news rather than a fundamental change.
In summary, we have erratic news-based buying and panic-inspired selling with 58% of the 90% days being down days (Dec. 19 was the latest). This doesn’t look like the beginning of a new bull market to me.
Fundamentals: No Change
The U.S. financial system got into trouble because of falling real estate prices. The European financial system got hammered by sovereign debt defaults.
Now, U.S. real estate prices continue to fall, and entire European countries continue to struggle with pure survival. Neither the U.S. nor the European debt! crisis has been dealt with properly.
QE2 was all the rage at the beginning of 2011, but its effect was limited and short-lived. The European Central Bank’s charter prohibits outright QE where newly printed money is given to banks.
However, the ECB has expanded its repurchase operation to three years. European banks can borrow money from the ECB for 1%. With the borrowed money, banks can now do what the ECB isn’t allowed to — buy more toxic bonds from Greece, Italy, Spain, etc.
At first glance, this looks like a profitable symbiosis. Banks pay 1% and get paid 3%, 4% or more via their bonds. Unfortunately, banks forget that they should be concerned about the return of the money more than about the return on their money.
Banks buying more unstable sovereign debt is a short-term Band-Aid but a long-term recipe for disaster. The expiration date of the “long-term disaster” label might well run out early and bite banks and investors in the butt sooner than expected.
Keep It Simple
The past two years have made one thing painfully clear: I can’t predict the news and how the market reacts to news. Often there’s no rhyme and reason; that’s why I don’t even try.
What I can do is extrapolate the market’s signals via technical analysis. The chart below shows some of the trend lines and Fibonacci levels I follow. The S&P 500 shows remarkably consistent respect for trend lines, Fibonacci levels and other support/resistance points.
Earlier in 2011, the S&P got close to a multi-decade trend line that ran through 1,378 in May. Slightly lower was important Fibonacci resistance at 1,369. Additional Fibonacci resistance was found at 1,382.
Based on this resistance cluster,! the Apr il 3 ETF Profit Strategy update stated that “In terms of resistance levels, the 1,369-1,382 range is a strong candidate for a reversal of potentially historic proportions.”
The May top at 1,369-1,382 made sense because sentiment was very bullish and seasonality was turning bearish (sell in May, go away).
In October, once again seasonality, sentiment and technicals were lining up for a major buying opportunity. The Sept. 23 ETF Profit Strategy Newsletter predicted that “From its May high at 1,370 to its eventual low, the S&P will likely have lost about 300 points (22%). This kind of move validates a counter-trend rally. The plan is to square short positions and buy long positions around 1,088. The rally, once under way, will probably re-inspire a certain degree of confidence into the market before it runs out of steam. The most likely target for this rally is S&P 1,266-1,282.”
2012 Outlook
The outlook for 2012 doesn’t look good. Only some version of QE3 and more aggressive ECB intervention can mask up the technical damage visible on all major charts.
The rally from the October lows still is within the confines of a counter-trend rally and has yet to move above common Fibonacci resistance and two major trend lines.
Short-Term Outlook
The Dow Jones and S&P 500 have managed to exceed their early December highs while the Russell 2000 and particularly the Nasdaq are lagging behind.
The euro — the driving force behind the early 2011 stock and gold (NYSE:GLD) and silver (NYSE:SLV) rally — is remarkably weak and has not confirmed the S&P’s recent strength.
It seems like the generals (S&P and Dow) are marching ahead while the troops (Nasdaq and euro) are following behind. An army in disunity can’t conquer, and a fragmented market is a weak market.
Seasonality might push stocks a bit higher, but the seasonal tailwind will calm significantly in ea! rly 2012 . Sentiment once again is turning bullish (a contrarian indicator), and technicals are looking weak. It seems like another high-probability setup (like in May and October) is in the making.
The ETF Profit Strategy Newsletter provides a short-, mid- and long-term forecast along with the target level for this rally and the support that, once broken, will usher in the next leg of the bear market.
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