What Do The Market Models Say?

Okay, let's break it down. It's August. It's the height of the vacation season (and mine doesn't start until the 21st). The markets are going sideways. Volume is very light (SPY volume has been below average for 27 straight trading days). Earnings season has just about ended. There hasn't been an important piece of economic data in a week (although that will change soon). The computers have been in charge on an intraday basis. Sentiment is complacent at best and overly optimistic at worst. Valuations are debatable. And in short, it just "feels" like something bad is about to happen.

Whenever this type of environment occurs, I like to put my emotions aside and check on the readings of our favorite market indicators. For me anyway, there is just something cathartic about looking at some cold, hard numbers when things are "iffy."

To be clear, we actually look at most of the indicators we are about to discuss on a daily basis. However, looking at indicators over different time frames is an important way to diversify your analysis. As such, we utilize both daily and weekly market environment models. So this morning, I thought we would review the readings as well as the implications of our intermediate-term oriented, weekly environment model.

The "State" of the Market Environment

Although there are some overlapping areas, the Weekly Environment Model is comprised of ten individual indicators or models. These ten can then be broken down into the following categories: tape, trend, sentiment, economic, monetary, and the overall risk environment. In terms of weighting, we give the majority of the model weight to tape and trend indicators (60 percent) while the "external" factors account for 40 percent of the model. This fits with our view that the price/tape action of the market should be the final arbiter of the action. In addition, tape and trend indicators serve as excellent stop-loss signals for those times when the market's moves diverges from the "logic" of things like economics, news or earnings.

To give you an incentive to continue reading, let's first review the performance of this particular model. Due to changes in data availability, the overall model was reworked at the end of 2011. However, the live performance hasn't been too bad. In 2012, using the leveraged ProShares Ultra S&P 500 SSO when the model is positive, the ProShares Short S&P 500 SH on negative signals, and a cash equivalent on neutral signals, the test of the model would have produced a return of +46.2% (compared to the S&P 500 cash index return of +16.3%). And then so far in 2013 (through 9-Aug), the model's return would be +25.4% (versus S&P 500: +19.7%). As such, the cumulative total return would have been +83.3% for the model since 2012 as compared to +34.5% for the S&P 500. So, while history isn't long, we are watching what this model has to say very closely each week.

Since the explanation of the models and indicators that make up the weekly market environment model as well as the analysis of the current readings covers a fair amount of ground, we will break the review up this week. This morning we will take a look at the state of tape and trend indicators.

The Trend Indicators

Let's start with the easy stuff - the trend indicators. The weekly environment model contains three indicators that are dedicated to the trend of the overall market. For starters, we rate the short-term trend of the S&P 500. For the purposes of this model, we define short term as between five and fifteen trading days. Next is the intermediate-term trend of the market. Here we focus primarily on the market relative to its 10-week weighted moving average (which we move forward two periods). And finally, we look at our cycle composite, which is combination of the one-year seasonal, four-year presidential, and ten-year decennial cycles.

Currently, our short-term trend rating is neutral, for fairly obvious reasons. However, the rating of the intermediate-term trend is clearly positive. A quick peek of the S&P 500 weekly chart versus its 10-week moving average should confirm this rating. And finally, our cycle composite suggests that stocks could struggle a bit next week. So the rating for the cycle composite is moderately negative. When assigning a score of +1 for positive readings, 0 for neutral readings and -1 for negative readings, the overall rating for our trend components is dead neutral for the upcoming week.

The Tape Indicators

The weekly environment model incorporates three "tape" indicators. While I may get an argument from some, I place momentum-oriented indicators into this category. These are the indicators that tell us the internal health of the market and helps us to determine the "oomph" behind a move in either direction. Our tape indicators include a breadth-confirmation system, a review of the supply/demand volume, and a model that rates the technical health of more than 100 S&P industry groups.

Currently the tape indicators remain fairly strong. Our breadth-confirmation system is positive as both the trend of the market and of the stock-only advance/decline line are above their appropriate smoothings. Our supply/demand volume relationship indicator is also quite positive currently as demand volume remains well above supply at this stage. And finally, our model that rates the technical health of more than 100 industry groups is moderately positive at this time. So, while these indicators are all intermediate-term or longer in nature, the group as a whole is positive.

Spoiler Alert: While we still have a handful of model components left to review, the overall rating for the weekly environment model is currently moderately positive. This tells us to give the bulls the benefit of the doubt should things get sloppy in the near-term. To clarify, this model does not attempt to "predict" what is going to happen in the market. No, the goal is to first identify and then stay on the right side of what "is" happening in the current environment.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of Fed/Global Central Bank Policies
      2. The Outlook for the U.S./Global Economy
      3. The State of the Budget (starting to come up on traders' radar screens)

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Neutral
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Positive
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

• Near-Term Support Zone(s) for S&P 500: 1680
  
• Near-Term Resistance Zone(s): 1710

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

• Trend and Breadth Confirmation Indicator: Moderately Positive
  
• Price Thrust Indicator: Positive
  
• Volume Thrust Indicator: Neutral
  
• Breadth Thrust Indicator: Neutral
  
• Bull/Bear Volume Relationship: Positive
  
• Technical Health of 100 Industry Groups: Moderately Positive

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

• Overbought/Oversold Condition: The S&P 500 is neutral from a short-term perspective and is low neutral from an intermediate-term point of view.
  
• Market Sentiment: Our primary sentiment model is low neutral .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: Positive - Our weekly model is positive. This tells us to continue to favor the bulls.

If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.

Turning To This Morning...

It appears that the bears will get another shot at getting something going to the downside this morning. The much weaker than expected GDP data out of Japan as well as some renewed worry about yet another bailout in Greece is getting the blame for the mood. While Chinese markets were higher and neither the Japanese market nor the European bourses are down hard, U.S. futures traders are not happy in the early going as it appears that the bears may be threatening a break below important technical support at the open.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Japan: -0.71%
- Hong Kong: +2.13%
- Shanghai: +2.38%
- London: -0.29%
- Germany: -0.48%
- France: -0.23%
- Italy: -0.27%
- Spain: -0.29%

Crude Oil Futures: -$0.34 to $103.63

Gold: +$12.40 to $1324.60

Dollar: lower against the yen, higher vs. euro and pound

10-Year Bond Yield: Currently trading at 2.592%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -9.02
- Dow Jones Industrial Average: -60
- NASDAQ Composite: -12.42

Thought For The Day...

“If your actions inspire others to dream more, learn more, do more and become more, you are a leader”-John Quincy Adams

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
StateoftheMarkets.com

Positions in stocks mentioned: none

Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them in the stock market during bull markets and on the sidelines (or short) during bear markets. The Daily Decision System Can Help

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

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