Market Higher in 2007 Series: Handling Adversity

How should one react when expecting a big move, but the market moves against you?

Having laid out our basic thesis, the potential for major gains in U.S. equities, we are immediately faced by selling that is described as "ugly" by most traders.  What this really means depends upon one's time frame.

A Good Example

CNBC today featured an interview with a technical analyst who does good work.  Let us recap his comments, with the S&P 500 daily chart in front of us.

 

The analyst was asked whether it was a good time to "buy the dip."  The market was down about 1% at the time.  His response was as follows:

• It was good to take money off of the table from the run-up.  (It was not clear whether that was to be done at the moment of the statement, a week earlier, gradually, or on yesterday's close.
• There would be continued selling.
• The basic trend was upward, so one should be getting long in the 1450-1475 range.

Let us suppose that an active fund manager or trader had followed this advice.  Since there was no specific guidance and days or amounts, we shall assume that he sold 20% of his position at about 1500 give or take a few points.  (This was a popular technical point, 1503 in the SPU's and a bit less in the cash.)

Let us further suppose that the fund manager sold another 20% with the market down 1% today.

What is the plan?  Is he to buy some at 1475 and the rest at 1450, assuming that point is reached?
Even if everything is executed to perfection, the trader makes about 0.4% on one leg (20% times 2%) and 0.8% on the other leg (20% times 4%).

Most traders are neither so agile nor so accurate.  Meanwhile, what if the full dip does not occur?  Most traders have trouble "chasing" when the predicted dip does not happen.  The risk is that they are under-invested during a major run.

It is tricky to time the market for a small gain.

Longer Time Frames

Investors should look at the longer time frame, better represented by a weekly chart.  On this basis the selling seems like a minor setback.

Our modeling guru is Vince Castelli, a consultant who completed a distinguished career as a Navy scientist.  He has a method for trend-following situations.  It may lose something at turning points, but catches all of the big moves.  The time frame is relatively short, measured in days.  Vince's models remain bullish on all market indices.  He uses indicators similar to others, but measured in ways we regard as superior.

Our Take:  We remain long even in our short-term trading accounts.  Please note that the trading position is model driven.  The charts are just for illustration.

For another technical view and better charts, we always read Trader Mike, who today sees a bit of technical damage.  Worden also went to a downtrend on the shortest of their four time frames.

Psychology

Today's psychology illustrated exactly what we had predicted.  There are many active traders and hedge fund managers who want to be the first to anticipate a poor economy.  The highly negative sentiment has many poised to jump at any sign of economic weakness.

Fundamentals

Fundamental analysis should be the watchword for long-term investors.  That means looking at forward earnings projections compared to risk-adjusted returns from other asset classes.  As long as stocks are so cheap compared to bonds, the buy signal is in place.

Those who believe they are wiser than economic forecasters seize upon any piece of evidence to support that viewpoint.  At "A Dash" we are consumers of forecasts, including the following:

• The ECRI, repeatedly stating that leading indicators show strength in the economy.
• David Malpass, who continues to see economic strength, with risk coming from eventual inflation.
• Consensus economic forecasts, showing solid growth in the rest of the year.

At "A Dash" our emphasis is on education -- picking the best sources, choosing the right indicators, and interpreting data.  We do not offer trading advice.  So many who blog about trading do that better.  We do wish to help long-term investors get on the right side of major moves.

We remain quite happy with what our friend at Abnormal Returns calls a contrarian position.  This is good.

Comments

[will rahal]

During the recent extraordinary climb of the stock market, the Consumer Discretionary
Sector failed to reach its February high.
I believe that this is indicating a change. The US Economy is heavily influenced
by the consumer-oriented sectors. This change suggest lower Profits Margins ahead.

Factors contributing to profits such as reluctance to hire, a soft US Dollar and
a steadily rising Capacity Utilization will slow or reverse their contribution.
The squeeze on profits put by higher commodity prices will soon be felt.

To get a perspective go to:
http://wrahal.blogspot.com/2007/05/lower-profit-margins-ahead.html

[RB]

Some further studies here:
http://www.phil.frb.org/files/spf/spfbr.pdf

A good summary is on page 10 and page 12. What I take from this is that forecast error is biggest at turning points where it might be most necessary. Hence, I wonder whether a simple trend-based model as described above may do just as well. Secondly, forecast is definitely important for the Fed since inflation expectations of professionals should be factored into monetary policy so that they don't become self-fulfilling.

Today the Fed model and normalized earnings give conflicting pictures.

The investment world has well-known outliers, frequently based on strategies that do not involve economic forecasts. After issuing a novice alert, I just don't know if the same holds true with regards to professional forecasters.

[RB]

CXO has a review of Abby Joseph Cohen's record of stock market forecasts. "Sunny" is more likely to win out in the long run. Hey, even Don Luskin ranks pretty highly in their study. The studies I linked to show that any forecaster is not better than the median. CXO has some stock market forecasts studied to show that the median forecast is not better than a mechanical trend-based one. For better or for worse, I am partial to ECRI's approach -- of trying to predict turning points instead of making GDP forecasts. They also show that ECRI is a coincident indicator for the market however, so it may not be a profitable strategy necessarily. It seems to me that GDP forecasts are not worth factoring into investment decisions. Not that I know what is worth factoring into either. But for GDP forecasts, just for the heck of it however, I nominate a mechanical trend-based annualized GDP from 1960-current.

[oldprof]

Sound observations by RB. Some things are difficult to forecast. We like to look at the expected error and keep it in mind.

But what about those who argue as follows: No one is any good at these forecasts so all opinions are equal.

The article you cite shows the flaw in this thinking. The perma-bear recession forecasters have been even worse. All are not equal in this enterprise.

Whom would you nominate to beat the consensus pick?

Thanks again,

Jeff

[RB]

This is getting a bit trite, but fashionable as it may sound, so much for the track record of this particular group of experts
http://macroblog.typepad.com/macroblog/2007/05/the_wisdom_of_f.html

30% accuracy?! I personally don't see the usefulness of these forecasts as far as strategy goes.

[RB]

Perhaps one ought not to get too wishful in expert source #3 after reading this:
http://www.econbrowser.com/archives/2007/05/tales_from_the_2.html

[will rahal]

Today’s report on CPI came at .4% . PPI(all commodities ) was .9%
In the last few years ,the PPI has been accelerating more rapidly than CPI.

The implication is for an overall stock market P/E contraction.

Ex-Fed Chairman Greenspan’s favorite way of measuring relative valuation
between Stocks and Bond is the Earnings-Yield to Bond-Yield ratio.
This ratio oscillates around one.

When should this ratio be above one?

The answer is: in an environment of PPI relative out-performance to CPI.
That is the environment we are in. This is due to the P/E contraction that
results when the PPI/CPI ratio goes up over time.

To see this behavior historically go to:

http://wrahal.blogspot.com/2007/05/earnings-yield-to-bond-yield-vs-cpi-to.html

[tisoros]

I came across this site.The blogger predicts the index value of dow one day in advance.His outlook for 15 th may is +72 points.http://www.manojsai.mynewblog.com

[mike]

weekly charts gives the direction of the trend

[MarlynTrades]

Again a perfect column for the retail trader. I often advocate using weekly charts to time the market especially if you are trading in a day to day mode.

[Bill aka NO DooDahs!]

I dig the redesign!

Having gotten my ass bitten off and handed to me recently, while trying to time outside my timeframe, I can identify totally. Actually went up from 85% to about 100% long this a.m.

[RB]

Consensus forecast for Q1 2007 GDP was 2.4%. Let's hope the forecasters are more accurate going forward at least.