Financial Sense   Home  l  Market Monitor  l  Market WrapUp  l  Storm Watch  l  About Us  l  Contact Us

"The importance of context in interpreting the readings of technical indicators"

During the past six weeks, the popular indices have lost on average about 4%-5%, which represents a rather mild pull-back. On the other hand, many indicators such as the put/call ratio, the McClellan Oscillators, Summation Indexes, and the Arms Index, just to name a few, have reached levels that match or exceed the ones reached at major market bottoms in September of '01, in July of '02, and in October of '02. Consequently, brokers have been busy calling clients and telling them that if past history repeats itself, the markets should rally equally strong and thus investors need to be long in order to avoid missing out on the spectacular capital gains the markets have in store for them.

If you received such an urgent call in the past few days from your broker, but you did not act upon his advice to jump into the equity markets with both feet, you are probably wondering whether you did the right thing. You probably wonder, "How about if he's right? Am I being too cautious at my own expense? After all, as an American I am entitled to 20%-25% capital gains on a yearly basis. Maybe I should reconsider!"

Ladies and gentlemen, if you are having such agonizing, sleep depriving thoughts, I am here to categorically tell you: RELAX, you are not missing out on anything and here is the reason why:

Technical analysis consists of two parts, first comes the collection and study of the raw data, and second and more importantly, comes the correct interpretation of the data based upon the prevailing state of the market, which may be different than other times when similar readings have been observed. In other words, you need to put things "in context," otherwise you are not comparing apples to apples.

When novice investors first discover technical analysis, they think they found the "Holy Grail" and they approach it with a "one case fits all" type of mentality. For example, if they read somewhere that an RSI reading below 20 signifies an oversold condition, they automatically assume that every time the RSI gets below 20, the market is a "buy." If it was that nice and easy, everyone would be buying when the RSI fell below 20 and everybody would be selling when it went above 80. Everyone would become fabulously wealthy. But that is not the case, is it? The exact same numerical readings mean different things, if the environments in which they occurred are materially different.

I'll give you one more example by comparing two identical McClellan Oscillator readings. In the first case, the NYSE has been declining for several weeks and all of a sudden we get an upside reversal, which is followed by 6 consecutive up days, while the McClellan Oscillator in the same period goes from -50, to +250. In case two, the NYSE has been moving sideways to higher for several weeks, while the McClellan Oscillator in the same period went from -50, to +250, moreover, the NYSE has gone up six out of the last six days. The readings are identical in both cases (+250). Are they saying the same story? Should we draw the same conclusion?

Of course not! In the first case, more than likely the action by the Oscillator and its corresponding high reading indicate an "initiation thrust" to the upside. This means despite the highly overbought condition of the market, any pullbacks will be minor and higher prices will be the most likely outcome. Thus, we ought to be long and looking to add to our positions. In the second case, more than likely the action by the Oscillator and its corresponding high reading indicate a highly overbought condition created after several weeks of sideways to upside action, with the last six days representing the conclusion of the move. Consequently going forward, lower prices will be the most likely outcome. Thus, we ought to be in cash or short and looking to add to our positions.

Therefore, the exact same reading (+250) when it is put in the proper context, leads not just to  simply different conclusion, expectations, and course of action, it leads to a diametrically opposite conclusion, expectation, and course of action!

I hope the example I just gave you illustrates clearly that looking at indicator readings only in terms of their raw numerical value without putting them into proper context can be misleading and a recipe for disaster. So, if someone told me that many indicators are currently at the same levels they were following the decline after 9-11, instead of automatically concluding that the markets "must therefore be" at a bottom to be followed by a similar 25%-30% advance, I would want to know if the similar indicator readings have taken place within the same context. If they haven't, then we are comparing apples to oranges, which is illogical.

Let's discuss a real life example. The Eliades New 10 Trin, is near the same levels it got after 9-11 and in July of 2002. It fell marginally below -1.75 in the middle of May after six consecutive down weeks, during which the NYSE fell just 504 points (7.5%) from its high of 6715 on 4-5-04 to its low of 6211 on 5-17-04. During the same period most SP companies reported earnings that either exceeded expectations or were in line. The economy as measured by things such as employment, capacity utilization, help wanted ads, etc., continued to improve and analysts have been raising earnings expectations. Although the U.S. is involved in a war, it is happening in  a far away place and it hasn't affected consumer sentiment in any dramatic way. There has been no terrorist attack on U.S. soil and investors -once again- are pouring billions of dollars into mutual funds, reaching a new record in January of 2004. Interest rates are expected to move gradually higher, while commodity prices have risen steadily and oil prices have remained stubbornly around $40.00 per barrel, creating fears of "inflation."

The last time the Eliades New 10Trin gave a similar, if not identical reading, was on 7-12-02, after the NYSE had  fallen for 19 weeks from 6492 on 3-19-02 to 4423 on 7-12-04, losing 2,069 points (31.8%) During the same period most NDX and SP500 companies reported earnings that either missed expectations or were actually losses. The economy, as measured by things such as employment, capacity utilization, help wanted ads, etc., continued to show signs of deterioration and analysts were lowering earnings expectations. Allegations of  rampant corporate fraud had taken its toll on investors' confidence in the markets and consumer sentiment had reached one of its lowest levels in years. Investors had been pulling billions of dollars out of mutual funds. Interest rates were expected to move lower and the FED was becoming increasingly pre-occupied with deflation fears. The NYSE rallied 53.19% from its lows before topping out again on 4-5-04.

Prior to 7-12-02, the Eliades New 10 Trin reached a slightly lower level on  9-21-01 after the NYSE had fallen for 17 weeks from 7014 on 5-24-01 to 5223 on 9-21-01, losing 1791 points (25.5%), including 802 points that were lost in just five days following the re-opening of the markets after the 9-11 attack. The country had suffered the worst terrorist attack ever, which took a heavy toll on the national psyche, obliterated consumer confidence, and dealt a devastating blow to the economy and to its chances of recovery. During the same period most NDX and SP500 companies reported earnings that either missed expectations or were actually losses. Corporate chieftains refused to give guidance and analysts had no other choice but to lower earnings estimates. Lay-offs accelerated, while industries such as the airlines and hospitality teetered on the brink of bankruptcy. Fear, uncertainty and doubt were the order of the day. Interest rates were expected to move lower and deflation had once again become the topic of conversation and concern. The NYSE rallied 23.5% from its lows before topping out again on 3-19-02.

Now, let me ask you this: Does the current environment have any similarities with the market environment that was prevalent during the previous two times that the Eliades New 10 Trin fell to the same levels?

From their lows in March of 2003 to their highs in March-April of 2004, the NYSE gained 53.8%, the Dow gained 43.3%, the SP500 gained 48%, and NASDAQ from its lows in October of 2002 to its highs in January of 2004 gained almost 100%!  Given that the Eliades New 10 Trin is at the same levels from which in 2001 we were rewarded with 25% rallies and in 2003 we were rewarded with 50% rallies, does that mean investors ought to expect at least 25% gains if they bought right here? Should NASDAQ gain another 100% and run up to 4,000?

CHART COURTESY OF CARL SWENLIN & www.decisionpoint.com

So, the point is, in the previous two times that we had similar readings, in order to get there, it took a 25% decline. It took a period of 18-20 weeks of falling prices. It took the worst terrorist attack ever. It took major corporate failures such WorldCom and Enron. It took the worst corporate earnings contraction in the last 50 years. It took a total collapse in consumer confidence.

None of the above is present now. The markets have only lost 5%-7% and the decline has been going on for only six weeks. The economy is growing, employment is improving, most companies exceeded or met earnings expectations, deflation fears are gone, and capital spending shows signs of life! The fact that the internals got so negative and so quickly, in the absence of a catastrophic exogenous event, should tell people that although many indicators are at the same levels that in the past three years marked important bottoms, the markets are not the same, and thus these readings do not have the same meaning and they won't have the same result. The SP is not going to rally another 25%-50% from here for the next 10 consecutive months!

In order to correctly interpret indicator readings, it would make sense that first we try to find if there have been  any periods in the past that match the current market both in context and in technical measurements. Therefore, at the very least we are comparing apples to apples. If we can't find anything in the market's recent history that resembles the current situation, then we can start hypothesizing!

Lucky for you ladies and gentlemen, you do not need to start digging as I've already done it for you!  Based upon my research, in my view, the recent market action is quite similar in many ways with what happened in the first quarter of 2000.

In the fourth quarter of 1999, the economy grew at a record-setting annualized rate of 8%. Employment continued to grow thru-out the first quarter. Companies and analysts were predicting record earnings for the rest of the year, not to mention that most companies beat first quarter earnings expectations by the customary and obligatory penny. The FED was raising rates, mutual fund inflows hit record levels during January-February of 2000 and amid all this nirvana the Dow and the SP turned down on  1-14-00. They declined roughly 10% in six weeks' time and NASDAQ followed their fine example in March. In addition, breadth deteriorated rather quickly, and volume started to contract on rallies and expand on declines, just like now. The McClellan Summation Index reached -1785 on 3-14-00 and on 5-18-04 it stood at-1631, closely resembling the action and the readings  during the first part of 2000.

As we all recall, the markets -with the exception of NASDAQ- did NOT collapse. In fact the SP and the NYSE made new marginal highs in late March of 2000! The markets traded sideways to higher until October. It was  the 3rd quarter earnings and guidance -or should I say the lack of- that sunk the markets, and it was further undermined by the bombing of USS Cole and the election fiasco!  We now know that between March and September of 2000, the markets were in the process of completing a massive distribution top. The "strong"  price action in the popular indices helped to hide the enormous deterioration that had taken place in the internal structure of the market. Once again, we are seeing the same type of behavior now. I pointed that out in a recent article titled "Fraud And Deception Are The Order Of The Day."

I believe the recent extreme oversold readings indicate that the markets have entered a topping phase which could last a few more months. In the absence of an exogenous event, the extreme oversold condition will continue to provide a floor for the market and at the same time the poor internals will prevent the markets from doing anything more than perhaps marginal new highs by some of the indices.

Ike Iossif

Home  l  Broadcast  l  Market Monitor  l  Storm Watch  l  Sitemap  l  About Us  l  Contact Us