MDM - Model switches to sell signal standby - Commentary included

Published : June 22 2012 at 5:44 ET

Prior to June 21, over a period of a few days, we saw a number of quality stocks issue buy points, and the market reacted strongly in a positive manner to central banks saying last week they would provide a safety net in the event of a crisis situation, using the aftermath of the Greek elections as one example. Further, the general market moved just high enough, breaking its downtrend. This was enough to trigger a BUY signal on June 20.

Then yesterday on June 21, one day later, the market had a high volume day that took the averages down around -2.5% causing a number of strong stocks to fall hard. This is troublesome action. Indeed, these are frustrating times where the market just reaches its tipping point then instead of moving higher, reverses direction. It is somewhat equivalent to the first half of 2011, when the model has a series of false signals due to the markets just hitting tipping points then reversing such as the sell signal on January 31, 2011, or the buy signal on March 3, 2011. But then the model launched into a series of true signals starting on August 2, 2011.

While stomaching a series of false signals can be tough, the model has more than made up for them with true signals as can be seen on the results page. Over any market cycle, the model has always well outperformed the market averages. While 2012 is turning out to be even more challenging than 2011 which has been said to be the most challenging year in the history of the NASDAQ due to its trendless, volatile, gap-up/gap-down, news driven nature, the model is operating as it should. Patience is key to capturing the next big move(s) in the market while keeping stops tight, thus the fail-safe that typically keeps losses on the NASDAQ Composite to within 2%. If you are investing in a leveraged ETF, assume the loss is roughly twice or three times this amount, so position size according to your risk tolerance levels.

June 21 was the fifth distribution day so while this does not mean the model automatically goes into a sell signal standby, after examining the troublesome price/volume action behind leading stocks and major indices, the model has moved to a sell signal standby. Should the NASDAQ Composite hit 2856, the model will switch to a sell signal.

While the model does not use fundamentals but rather the price/volume action in major indices and leading stocks, here are the salient bull and bear arguments:

In the camp that argues for market strength ahead, central banks around the world are acting to mitigate the global crisis, but these arguments imply that the markets would have to fall further before strong action is taken:

=While the market wanted to hear that the pace of quantitative easing would accelerate sooner than later, the U.S. Federal Reserve Central Bank and European Central Bank indicated they will step in if needed.

=China's central bank lowered key lending rates.

=Australia said they are willing to step in if needed.

=Spanish banks will get bailed out.

And the fifth bullish argument is difficult to time if it even occurs:

=Since markets are forward looking, an anticipated change in leadership in the U.S. could prompt a rally. Thus a Romney Rally could be similar to a Reagan Rally that occurred in April 1980. The Wisconsin election this Wednesday shows we may be at an inflection point in terms of the public's tolerance of large deficits resulting from public employee benefits/retirement which are by far the largest part of federal and state budget shortfalls. In 1980, the markets ralllied from April to November then corrected sharply.


In the camp that argues for market weakness ahead:

=Economic reports were mostly disappointing Thursday, June 21. Initial jobless claims, existing-home sales, and Philadelphia Fed's business activity index all pointed to weakness in the economy. Could recession be next? Since the markets are forward looking typically by 5 to 9 months, a resumption of the downtrend could be an ill omen of recession on the horizon.

=UK and more than half of the Eurozone countries are in recession. Since markets correlate more than ever before (unlike 20 years ago when US was far less correlated to European markets), this could continue to put a weight on US markets.

=Gold pulled back and is still well within its base, underscoring that market sees quantitative easing (QE) in its current state as insufficient.

="Sell in May and go away." Going all the way back to July 17, 1974, the odds of follow through days (FTDs) in May and June succeeding were the lowest. July and November were only slightly better than May and June.

=Spanish bailout solution is merely temporary. PIIGS problems within the Eurozone remain unaddressed. When will the next domino fall?


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