Tuesday, December 29, 2009

Stock market technicals

In this post I will take a look at the recent internal behavior of the U.S. stock market and explain why I follow these indicators, using the "army" metaphor to describe the market. The comparison is simple: you want to "buy" an army that is winning the war, and "sell" an army that is losing. I know of four kinds of indicators useful to assess the sustainability of the performance of the stock market (i.e. is the army progressing or receding):
  • First, are the different sectors of the economy all performing well? You would be wary of an infantry progressing while the Air Force is taking a beating, would you? The same holds true for the stock market. This is why is watch the Industrials, Transports, Utilities, Financials, Techs, etc. Important divergences in the behavior of these indexes signal trouble ahead. This does not seem to be the case right now.
  • If the generals go on an offensive without support from the troops, what's going to happen to them? You want to see that the troops are following the generals, that is, you want to see as many stocks advancing as possible. This is referred to as breadth. Breadth recently has been quite good, although not as strong as it was this summer.
  • Next, imagine that your army is making progress on the front, but at the same time the daily number of your soldiers getting killed increases. Furthermore, the enemy is suffering lower casualties every day. What is then the quality of your army's recent advance? Most likely, it is not sustainable. That is why you want to monitor the number of kills (stocks breaking to new highs) and deaths (new lows). These are referred to as the stock market internals, and there's no complains to be made about them at present.
  • Finally, you want to monitor the exhaustion versus restfulness of your soldiers. If, after an advance, your soldiers still have energy left, it is more likely that this advance can be sustained. You monitor this by looking at the number of stocks above their moving average level: stocks above their moving average tend to revert back. At present the market seems to be very overbought on that basis, although there has been some progress in the past couple months, and this is constructive because it happened while the market worked its way higher.
Alright, there are other kinds of indicators, such as volume. I haven't been able to fit it into my metaphor, but it is quite important, and it hasn't been really good, which brings support to the view that the advance since the March low was just a bear market rally. Overall the technical picture is quite positive at the moment, but the overbought condition suggests to me that we are seeing the last stages (the most speculative) of this advance. As such, caution is warranted, while small exposures to put options for hedging purposes are still, for now, more appropriate than outright shorts.

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