First and foremost these markets require patience. As volume continues to decline and trading ranges continue to compress, many will be enticed into doing things they might not otherwise have done. Primary among these will be the urge to buy the market as higher closes become more and more commonplace. The size of gains associated with these higher closes will be fairly small, but their frequency will cause many to believe that a new trend is at hand. The funny thing is that they're right. A new trend has formed. However, the questions is not whether or not the trend is higher, but rather whether it's a positive trend within a larger downward move. To truly mark a new higher trend, longer-term charts (weekly and monthly) need to be consulted to provide the proper context. The charts below are a case in point.
As you can see from this daily chart of the S&P 500, the rally over the past 5 trading days has been a nearly vertical move, which could suggest that the market has seen a bottom. However, this move is still well contained within the larger price channel denoted by the blue lines. For this new trend to truly have legs, a move, first through 1,100 (upper bound of the price channel) and then through 1,130 (the previous high move) would be needed for confirmation. From a practical standpoint, those holding short positions (like myself) will be watching with great interest when/if the S&P's near the 1,100 area as this will be an early warning sign that the trend could be reversing. Shorts willing to take a little more risk will wait to see if 1,130 is breached before covering. But the primary take away here is that the while the move of late has been powerful, for now it's just a powerful move within an exceedingly powerful downtrend. The weekly chart shows this even more clearly.
This longer-term look at the S&P's does an even better job of providing the context needed to trade in this environment. As you can see, equities have been in a nearly unbroken downtrend since mid 2007. This move lower culminated in February 2009 when the S&P 500 printed 666 intra-day. In the year subsequent to that day, the market experienced a historic relief rally that actually punctured the downward trend line in late February of this year. However, this stint above the trend line ended only 11 weeks later and appears to have resumed its downward march. The price channel (as seen on the daily chart also) further confirms this renewed move lower, which has seen the market struggle to sustain a close back above this trend line.
All this technical 'voodoo' is certainly helpful in gaining the proper perspective, but it can't be used exclusively. You've got to do your homework. You've got to know where the fundamentals of the market stand and what they translate into in terms of value. As I've mentioned before, my fundamental outlook for equity prices over the next year or so is mostly bearish (best case the market goes sideways). I've noted a lack of job growth, both in the near term as well as in coming quarters as one of the major headwinds to economic growth. Furthermore, I've shown that stock prices are fair-valued at best and more likely slightly expensive at this point in time, which is certainly not bullish. The third fundamental driver that I see as likely to hold any rally back are the upcoming changes to the tax code.
Right, wrong, or indifferent, taxes will be going up for everyone despite what the rhetoric from Washington might be. Simply by doing nothing (which is usually a good thing), our representatives in Washington can let the tax cuts that were passed during the Bush administration expire and thereby raise marginal tax rates for all. Will this be the end of the world financially for individuals and corporations? No. But it's idiotic to think that any action that reduces a family's disposable income will actually end up stimulating economic growth and, consequently, provide an economic environment that is conducive to a stock market rally. Think about it. If you've got fewer dollars coming from your paycheck, what are you going to do? Buy more stuff? Invest in additional securities? Of course not, you simply don't have the funds available. And unlike the years since 2002, there are severe limits on the amount of capital that will be extended to consumers. So levering up the individual's balance sheet simply isn't a plausible 'way out' of reduced consumer spending either. (As an aside, the use of debt, in all forms, is simply a means of bringing future consumption forward. As a result, when it finally comes time to pay down that credit line, mortgage, or credit card balance, additional consumption has to be foregone to service the loan. Sure, you can default and push the burden to the bank, but that simply reduces the amount of funds they can lend to others, which also retards economic growth. This is the challenging cycle we face in the coming years on a extremely large scale.) Sadly, the expiration of these tax cuts is are likely not the only tax hikes that will be seen. As the federal government's budget deficit and debt load have skyrocketed in an effort to underpin the economy, the need to raise additional revenue has grown in lock step. Without getting into the benefits/costs associated with this action, the difference has to be paid somehow. Tax revenues either have to climb or spending has to fall precipitously to plug the gap. Either action will have negative economic consequences, that are likely to push share prices lower.
Tomorrow, I look for more of the same in the day's trading action. Many traders are on vacation and, as before, the machines are in control. In the meantime, I'll be looking for price action that starts to get extreme and ripe for a trade. With that said, it may take a while for these markets to get to that point. Patience, patience, patience.....
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