How Technical Analysis Can Improve Fundamental Analysis

Between 2006 and 2009, most economists fell into one of two groups. A small number of economists saw the housing and credit crisis coming, but they were a bit early and turned negative in 2006. Although housing prices peaked in June/July 2006, the S&P rose from 1225 in July 2006 to its high of 1576 in October of 2007. Given subsequent events and the severity of the crisis, being early was certainly not a character flaw. But missing the 28% rally from July 2006 to October 2007 was significant. The second group of economists failed to see almost any aspect of the credit crisis and severe recession coming, and greatly outnumbered the few prescient economists who did. Amazingly, many in this second group were still forecasting there would be no recession as late as July and August in 2008.

What I find fascinating is how these two groups believed the economy would perform after the second quarter in 2009. The first group, who correctly anticipated the crisis and recession, expected the economy to bounce and then dip again and form a W pattern. A few felt the economy would remain in recession until 2010. For the most part, this group did not see the rally in the stock market coming. With the S&P still up 65% from the March 2009 low, they believe valuations are too high, especially if a second dip is coming and the negative impact it will have on corporate earnings. (Although the National Bureau of Economic Research has yet to officially identify the precise end to the recession, they will likely determine that the recession ended in June or July 2009, as I discussed in the July 2009 letter.)

The economists in the second group have been the most stringent supporters of the V-shaped recovery. After failing to see the deepest recession since the Depression coming and a 50%+ decline in the stock market, V also represents a measure of Vindication for these seers. They readily point to the sharp turnaround in GDP that has occurred since the low in the first quarter of 2009 as unassailable proof. However, they conveniently over look the substantial role fiscal stimulus and numerous government programs played in lifting GDP, such as Clash for Clunkers and first time home buyers tax credit, which have goosed short term economic activity at some expense of future demand. As I wrote in the June 2009 letter, "We're going to get what looks like a V-shaped recovery in GDP, and it will pack the nutritional value of a Twinkee." By almost every metric, the 2009 recovery is weaker than any post World War II recovery. This isn't a surprise. As I have discussed in almost every issue since July 2009, this recovery is facing a daunting list of cyclical and secular headwinds that suggest a self sustaining recovery was anything but a sure thing.

After the 1981-1982 recession ended, the economy expanded for almost eight years, for ten years after the 1991 recession, while the recovery that began in 2001 lasted six years. None of those recoveries faced the type of secular and cyclical headwinds that will dampen growth in the next few years. In 1982, household debt was just 44% of GDP, and the savings rate was almost 10%, and interest rates were 15% to 20%. In coming years, consumers need to reduce household debt from 97% of GDP currently, to something less than 90%, and increase their savings rate from 3% to near 8%, or higher. That's the foundation consumer's balance sheet will need to support a lasting self sustaining recovery. With interest rates near generational lows, consumers will need to pay off their debt from income, rather than a lower cost of money that ensued after 1982. If interest rates rise from their current low levels, the task of paying down consumer debt will be more difficult. Credit availability will never get as loose as it was between 2001 and 2007, so consumer's reduced access to credit will curb consumer spending. Home prices are likely to fall a bit further before bottoming out in a process that could take three more years. It is highly unlikely that home prices will be appreciating much anytime soon, so the opportunity to pull equity out will be virtually nil. Bank lending is still contracting, and the banking system will remain under pressure well into 2011, as home prices remain soft, commercial real estate losses mount, and unemployment and underemployment remain distressingly high. Furthermore, implementation of new international banking standards (which are being discussed in Basil Switzerland now) will require banks to increase their reserves by at least $1 trillion. The only question is whether banks will be forced to meet the new standards in 3, 5, or 10 years. The net result is that global bank lending will be less, which will inhibit global growth. Small businesses in the U.S. are being squeezed by weak cash flow and bank's high lending standards. Since small business is responsible for the majority of job creation. As we have seen, job growth has been far weaker than in prior recoveries. Tax rates trended lower after 1982, but that is changing at all levels of government. As discussed in detail last month, every developed nation will be tightening fiscal policy in order to reduce their respective debt to GDP levels to under 4% of GDP over the next 3 to 5 years. Most of the heavy lifting to pare budget deficits will come in the form of higher taxes and fees. In the United States, even those who are not in the top 5% of wage earners will feel the bite of higher taxes, and learn to live with less disposable income. As the United States, Japan, Britain, France, Germany and every other developed nation tightens their individual fiscal belts, an unintentional coordinated global slowdown will become evident as the Paradox of Thrift Sovereign Style takes hold. Spending by states represents 12% of GDP, and after growing at an average annual rate of 6% over the last 30 years, most states will be forced to lower the rate of increase in spending, cut services, and raise taxes as they formalize their 2011 budgets July 1.

Something each group of economists and strategists do have in common is the omission of technical analysis as part of their analysis. It is a critical omission, and accounts for why each group missed the significant turning points in October 2007 and March 2009. And, if a second dip in the economy develops, will be why most economists won't see that coming either.

As I discussed in the October 2009 letter, "The next potential challenge within the current period of instability will develop in the next six to nine months, as the U.S. economy will: A) smoothly transition into a self sustaining economic expansion, B) experience a modest dip, with GDP growth sagging to around 1% to 1.5% before reaccelerating, C) experience a more pronounced dip lasting up to two quarters with one quarter of GDP near 0% before rebounding, D) perform a flawless one and one-half gainer after the V-shape recovery stalls and go to hell in a hand basket. The correct answer to this question is important since the financial markets will obviously respond accordingly. Experts suggest that when confronted with a multiple choice question, and a distinct lack of certainty, go with C. If for no other reason, correct does begin with C. However, since forecasting and investing involves a high degree of probability, I would assign the following odds: A 5%, B 30%, C 45%, D 20%."
It has been 8 months since that was written, so it is a good time to review what insight technical analysis can provide at this juncture, specifically my proprietary Major Trend Indicator. We will first look at some history, and then I will show where the Major Trend Indicator is now.
Numerous studies have shown that the overall direction of the stock market contributes 50% to 70% of an individual stock's price movement. On average, 85% of all stocks go up in a bull market, even stocks of poorly managed companies. In bear markets, more than 90% of all stocks lose value, including companies with excellent management. Identifying when the stock market is in a ‘bull market phase' or ‘bear market phase' is statistically more than half the battle, since most stocks follow the major trend.

The Major Trend Indicator (MTI) is a proprietary indicator I developed to confirm when a bull market has taken hold, and to determine when an intermediate low has occurred within a bull market. The MTI defines when a bear market is in force, and signals when a rally within the context of a bear market is beginning. This provides the opportunity to make making money from the long side during a bear market.

In order to illustrate the effectiveness of the Major Trend Indicator, we're going to first examine the experience of three hypothetical investors. One investor implemented a Growth portfolio, the second a Value portfolio, and the third investor utilized the Flexible Asset Allocation (FAA) program I also developed. The MTI is an important component within the Flexible Asset Allocation program, which is discussed in outperformed because the MTI did a good job of identifying when the bear markets of 2001-2003 and 2007-2009 were beginning and ending. Please note: The figures cited for the FAA program are based on back testing performed by Larmee Associates, Evanston Illinois, a third party custom programming firm. There is no assurance that future results will approximate past returns.

The 2001-2003 bear market began on 9/11/2000 and ended on March 20, 2003, based on the Major Trend Indicator. During the 2001-2003 bear market, the growth oriented investor saw their diversified portfolio of quality growth funds lose -45.1% (Table 2 next page). The value investor fared better, as the value funds only lost -5.9%. However, during the 2007-2009 bear market, the value investor was shocked to see their portfolio lose -43.2%. The growth portfolio plunged by -45.9% during the 2007-2009 bear market. The long only FAA program was able to make money during the 2001-2003 bear market, by going long ETFs after the MTI provided bear market buy signals in 2001 and 2002. The process used to identify which ETFs to buy is explained in the Flexible Asset Allocation brochure. The bear market rallies during the 2007-2009 bear market were too weak to generate gains, after MTI buy signals. However, the MTI did far better when compared to the losses suffered by value and growth investors.

When the Major Trend Indicator confirms a bear market is in force, it suggests that the stock market will experience a decline of 15% or more is likely in coming months. For those interested in going short during a bear market, the MTI provides a sell short signal when it reverses lower, after a bear market rally. During the bear markets of 2001-2003 and 2007-2009, these short trades enabled the FAA program to capitalize on the declines in those bear markets. Comparing the "long only" of the Long Only FAA program versus the Long/Short FAA program (Lg/Sht) indicates how much the FAA program benefited from going short in the 2001-2003 and 2007-2009 bear markets. (Table 3). Please note: The figures cited for the FAA program are based on back testing performed by Larmee Associates, Evanston Illinois, a third party custom programming firm. There is no assurance that future results will approximate past returns.

 The chart on the next page illustrates how the MTI performed during the 2001-2003 bear market, which began on September 11, 2000. When the MTI reverses up and generates a bear market rally buy signal during a bear market, any short positions are closed out, and longs are initiated. These bear market buy signals are indicated with a green arrow. Once the bear market rally has run out of steam and the MTI reverses lower, the long positions are sold, and short positions are established. The short trades are indicated with a red arrow. As the S&P 500 was making a low in July 2002, the MTI was deeply oversold. Historically, when the MTI reaches such an extreme oversold level, the S&P will bounce for a number of weeks, and subsequently decline to a lower price, or at least ‘test' the peak momentum low. This indeed occurred in October 2002, as the S&P 500 dropped to a new low. Although the S&P was lower low than in July, the MTI was not as oversold, which generated a positive divergence. A positive divergence is usually a sign that selling pressure is weakening, and a stronger rally is about to begin, which was the case after the October 2002 low. In March 2003, the S&P 500 tested the lows of July and October 2002, but the MTI was far less oversold, which was an indication of underlying strength. The MTI reversed up and gave a bear market rally buy signal on March 20, 2003. By late May 2003, the MTI had strengthened significantly and reached the level necessary to confirm that a new bull market had begun.

The bull market that began on March 20, 2003 lasted until January 2, 2008.Along the way, the S&P 500 experienced a number of intermediate declines within the context of this bull market, as can be seen on the chart on the next page. Had any of those declines pushed the MTI below the red line on the chart on the next page, a new bear market signal would have been generated. The area between the red line and the green line is considered a Transition Zone. During bull markets, intermediate bottoms are often registered after the MTI dips into the Transition Zone, and then reverses higher. Those bull market intermediate buy signals are noted with a green circle. These buy signals provide an excellent entry point for new money, and an opportunity to add to existing positions. The MTI provided intermediate buy signals in May, August, October 2004, May and October 2005, July 2006, and March and August 2007.

Bear market rallies during a bear market often end in the Transition Zone, when the MTI reverses lower. In the chart above, these bear market sell short signals were provided in June 2001, January and April 2002, and in January 2003, and are identified with a red P.

Bear Market - Begins on January 2, 2008 and ends on March 13, 2009.

On January 2, 2008 the Major Trend Indicator suggested that another bear market was beginning. This was further supported by the breakdown in the chart of the S&P 500 that also occurred in early January on the chart below. The market made a temporary low in March 2008 after Bear Stearns failed. The MTI provided a bear market buy signal soon after. That rally ended in late May, and was followed by a sell short signal and sell off into mid July. The bear market buy signal following the July low was very weak. Take a second and compare the significant improvement the MTI displayed during the bear market rallies in 2001 and 2002 in the first chart. As you can see, the improvement in the MTI during the 2001 and 2002 bear market rallies was much larger. The 2001-2003 bear market rallies provided more opportunities and stronger profit potential than the two weak rallies in 2008.

The S&P 500 was deeply oversold as the market bottomed in November 2008. As noted previously, when the MTI reaches such an extreme oversold level, the S&P will usually bounce for a number of weeks, and subsequently decline to a lower price, or at least ‘test' the peak momentum low. If you compare the chart of the MTI as the market was making a bottom between July 2002 and October 2002, with November 2008 and March 2009, you'll see that the form looks almost identical. The decline to a new price low in the S&P 500 occurred in early March 2009. Although the S&P was lower low than in November 2008, the MTI was not as oversold, which generated a positive divergence. A positive divergence is usually a sign that selling pressure is weakening, and a stronger rally is about to begin. The MTI reversed up, and generated a buy signal on March 13, 2009. By late May, the MTI had strengthened enough to indicate that a new bull market had begun.

One of the ‘cool' aspects of the Major Trend Indicator is how it leads into new bull markets. When the MTI gave a bear market buy signal on March 20, 2003 and March 13, 2009, there was no way to know with any degree of certainty whether these buys signals were just another rally within the context of a bear market, or the beginning of a new bull market. The beauty of this approach is that it is not necessary to make this determination. The MTI established positions on those dates, which were subsequently well rewarded as the market powered higher, confirming that a new bull market had begun in April 2003 and May 2009.

On April 8, I sent out a Special Update reiterating my view expressed in the March letter that "the market is likely close to a short term high, and vulnerable to a pullback of 4% to 7% in coming weeks.

Selling into any additional strength, or becoming a bit more defensive is advised." In my April 20 letter I noted, "The market should get above the high at 1,214 to finish the rally phase that began on February 5. The major trend is up, and will remain positive as long as the S&P holds above 1,044. The intermediate trend is positive as long as the S&P remains above 1,086." The S&P did exceed 1,214 on April 26 when it reached 1,219.80. The fact the anticipated decline has turned out to more severe than 4% to 7%, only makes the advice to sell and become more defensive above 1,210 more valuable.

As noted in the May letter, the technical damage done during the decline from the April 26 high has been significant. Although the S&P dipped to 1,040 on May 25, and 1,042 on June 8, it has held above 1,044 on a closing basis, and bounced off this critical support level. However, the MTI now suggests that a new bear market is not far off.

In January 2008, the S&P broke below important support as the MTI indicated that a new bear market had begun. The market established an intermediate low in March, after Bear Stearns failed. This low led to a rally that allowed the MTI to generate a bear market rally buy signal that held until the end of May. So far, the S&P has not yet broken below 1,040, which is a positive in the short term. A breach of 1,040 on a closing basis would represent an important technical breakdown.

Although the MTI suggests a new bear market has begun, I think the market will hold above 1,040 in the next few weeks, and establish a trading low. The coming rally should push the S&P above 1,100 and its 200 day average, which will trigger some additional buying. This rally could reach 1,135-1,150, which was the January high. The odds that this rally could carry the S&P back toward the recovery high in late April near 1,220 have diminished significantly. Once the expected rally ends, the FAA program will generate a sell short signal. The only thing that can change this negative outlook is if this rally is strong enough to push the MTI back into bull market territory. The fundamental back drop suggests this is not likely, since the economy is going to slow in the second half of 2010. Most institutional investors and economists are not expecting the economy to slow, and are likely to be disappointed. In addition, any slowdown will curb job growth and sustain default rates for all types of credit at high levels, which won't be good news for banks.

Since the March 2009 low, the stock market has been in a cyclical rally within the context of a secular bear market that began in 2000, and could last until 2014-2016. The Major Trend Indicator suggests that this cyclical rally is nearing an end. If I'm right, and the S&P does rally, it will provide investors another opportunity to sell and get defensive. Ideally, the MTI will generate a bear market rally buy signal in the next few weeks. The quality and strength of any upcoming rally will determine when the next phase of the secular bear market is beginning. Sooner or later, I anticipate a decline of 20% to 30% to develop, if the fundamental headwinds exact the economic toll I expect. If the past is any guide, economists are not likely to see the next phase of the secular bear market in stocks coming, since they do not incorporate technical analysis into their analysis.