“All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident” — Arthur Schopenhauer, German Philosopher
Trying to find the rhyme and reason in the markets these days can cause a lot of investors to feel anxious. We continually face negative catalysts in the market — European Sovereign Debt Crisis, Fukushima, Flash Crash, Arab Spring, etc. — yet the market marches higher. You can say, "Yes, but that’s because the Fed is printing money." So you’re saying you know why the market is going up but you will not invest in it? The key to investing is having a discipline that avoids emotional influences. This is the difference between a retail investor and an investment professional.
Stocks have been going up for a while now and the dips have been minor and short-lived. Maybe it’s time investors begin to believe in the bull market as I do and begin to assume the trend is higher — not that a correction is looming behind every corner. Such thinking will paralyze an investor. A good investment discipline will never paralyze your actions because it forces you to be objective.
There are many ways to guesstimate the trajectory of the market using economics, company earnings, or technical analysis. Each school attempts to extrapolate forward guidance from existing data. Nobody has a crystal ball to scry the exact future, but a series of disciplines or guidelines from which to work from. What is your discipline? What are the guidelines you use to invest your money?
While I have spent seventeen years studying all three schools, my favorite is technical analysis — the study of the markets and investor psychology. Within this discipline there are many mathematical means of extrapolating forward guidance. So let’s take a look at what the technical "crystal ball" is saying.
Basic Technical Analysis
Over the last few weeks, I’ve been double checking the trend, pattern formation, sector rotation, and rhythm of the stock market. But the most important thing for any investor to identify is the trend. John Murphy gives ten important rules of technical trading — but I believe they can all be summed up in just one: Spot the Trend and Go With It. Looking below, tell me if you can't spot the clear trend in this market:
Viewing the chart above, we can see that this is clearly a bullish trend; however, note how close we are getting to the upper channel resistance level. This is a key observation that may signal the likelihood of selling pressure despite the S&P 500 hitting new all-time highs in the months to come. The same could be said from the 2011-2013 trend (near channel resistance); however, there’s a clue that a new accelerated trend is developing — all because the May-October consolidation never reached the bottom of the channel as shown below.
Combining the two charts above, we get a clear view of two trend channels (the Cycle and the Primary trend) that show resistance at the same spot. In technical analysis, when you have more than one area of support or resistance near the same level, its importance increases.
So here, in all three charts, we have some very basic forms of technical analysis that show we’re nearing an important area of resistance for the market, somewhere in the mid-1800s. We can’t rest there in our scrying. Technical analysis is about using all of our tools to see if more evidence supports our outlook.
As I’ve been mentioning on the Financial Sense Newshour, the stock market has undergone a consolidation from May to October — despite the higher highs and higher lows — and that is now over. Consolidations have many forms — triangles, rectangles (sideways), head & shoulders (yes not always just tops and bottoms), and wedges. Once a consolidation is completed by a breakout, we can calculate a target price objective based on the base of the pattern. The 2013 consolidation pattern points towards a price target of 1862 based on the base of the wedge and the breakout point.
Sector Rotation and Breadth
You’ve heard it on the radio show from me and Jim Puplava: we’re beginning to see rotation out of high beta and back into large-cap and non-cyclicals. Why? Maybe hedgies and fund managers see value there because they corrected all summer long. Maybe they see this run from 2011 to 2013 looks long in the tooth. Maybe, they’re following the sector rotation model and believe a correction will be coming at the onset of a Fed taper. Whatever the reason is, it’s not as important as the event itself.
The two best sectors over the last month and a half have been industrials and consumer staples. It makes sense with oil falling that industrials should be doing well, especially the transportation industry within the industrial sector. Who else benefits from falling oil prices? Consumers — both discretionary and non-discretionary consumption — are helped when consumers receive some discretionary spending relief from lower energy prices.
Another reason for the move back into consumer staples and even healthcare is a defensive portfolio allocation weighting. That might be occurring because we have already seen some substantial gains off of the 2011 corrective low at 1099. One sign that might be tipping investors is the deterioration in the market as fewer names are participating in the rally, evidenced by how many stocks in the S&P 500 are over their 200-day moving average. That number has dropped from the peak in May near 94%. Currently, it is 84% and we are 120 points higher.
Mean Regression
Once the market hits a supply zone, possibly along the upper bands of the two trend channels I showed above, then we might see some mean regression in the markets. The ebb and flow of the markets is based on market psychology. Usually, in a bullish trend, we find significant support along the major moving averages. Two of the most well-known are: the 200-day moving average and the intermediate 50-day moving average. These are well below the current price on the S&P 500, but they’re rising. It’s very unlikely that any correction will pierce through these moving averages when they are rising so quickly. Keep in mind, tops are a process.
The last tool we can use to determine support during corrections are Fibonacci retracements. Once the market finishes where I think we’re heading, I’ll begin looking at some retracement levels that make sense from a technical and Elliott Wave perspective.
Advanced Technical Analysis: Elliott Wave
(If you’re not a fan of technical analysis and consider it nothing but voodoo, then please skip this section!)
In the chart above, you may be asking yourself what those numbers and letters mean. These are the notations and nomenclature of Elliott Wave analysis. Without writing a book on the technical tool, Elliott Wave is the concept of a market that progresses in waves. Waves themselves are patterns of directional movements based on the social nature of investor psychology. Buy, buy, buy followed by sell, sell, sell (repeat). You have waves that push the market in the general trend and counter waves that serve to regress the trend.
The basic tenet of Elliott Wave is that the market progresses in the form of 5 waves — three of which progress the market in the general direction of trend while two help to regress back to the mean. Because these forms repeat themselves, they can provide guidelines by which the discipline can make predictions.
While technical analysis is an art, not everybody will interpret the same results. Think of it as one would expect when interpreting the meaning of a piece by Leonardo da Vinci or Vincent van Gogh. Despite the frivolous connotations that Elliott Wave receives, it is a discipline derived from science and the study of mathematics. In fact, Elliott Wave is based on thirteen century mathematics utilizing Leonardo Fibonacci's sequence and the Golden Section — “any length can be divided in such a way that the ratio between the smaller part and the larger part is equivalent to the ratio between the larger part and the whole.” (Frost, A.J. and Robert Prechter. Elliott Wave Principle. New Classic Library, 2001. Print.)
The Golden Section
The Golden Section can be used in dividing the 5-wave pattern such that waves 1-4 subdivide the entire length of the trend into one section and wave five is the other. There are some guidelines to use here. If the final wave doesn’t extend, then it typically forms .382 of the whole length of the five waves as shown below:
If the fifth wave is unusually large, it may become the larger section (.618) of the whole 5-wave pattern as shown below:
It is my belief that we are in the final ((5)) wave of the III wave of this bull market. If that’s the case, we can use the Golden section to predict the length of the ((5)) wave of the five wave pattern that began in December of 2011 when the ECB turned highly accommodative with Long-term Refinancing Operations (LTRO) and our Federal Reserve Bank began QE 3 and 3.5 in the second half of 2012.
Because we are so close to seeing the Federal Reserve begin the slow process of removing accommodation, it is my estimation that up until 1655 (wave ((4))), we have already seen .618 the length of this bullish cycle. I don’t think the market will be able to extend that much further, but mathematically, it is possible. Speaking of mathematics, let’s look at the numbers here given the information we have on the current trend and the golden section ratio.
Using the daily closing values of the S&P 500, the start of this cycle began at 1099.23 in 2011. Wave 4 just finished at 1656.40 (using TradeStation’s data). That distance (beginning to the end of wave 4) equals 557.17 points and represents .618 of our total trend. The other .382 portion would equal 344.40 points using proportional math. If we add that length to the end of wave 4, at 1656.40, we get a final price target of 2000.8. That is, if the final move up here doesn’t extend. Is it possible? Yes, given we’ve only seen two sub waves of this final leg up already, and the first wave took us from 1656 to 1771.95 — that’s 115.5 points!
Price Target
There are many means of establishing price targets for the market. When you hear a guru say Dow 16,000 or Dow 5,000, or even gold 2000, they’re making predictions based on extrapolating from economics, earnings growth, or technical analysis. My discipline just happens to be technical analysis. I have a methodology and toolbox by which I can make my investment decisions. Decisions based on objective analysis, not guru-speak or emotions. Right now, I’m still bullish on stocks; however, that’s beginning to temper due to trendline analysis, sector rotation, breadth deterioration, and Elliott Wave analysis. Even though my price target is higher on the market, it’s a good idea to begin adjusting those stop losses, sector allocations, and begin the general mental preparation for a major correction next year.
What is your investing discipline? If you don’t have one, begin researching the different market schools. The other option is finding an investment profession that isn’t just a salesman, but one who studies the markets, company fundamentals, and economics.
