Stock Market Choke Points

Part 7A

by Brian Stoll, TimingStrategies.com | July 14, 2009

This is not a recommendation to buy or sell any investment or security whatsoever.

Greetings, as I begin to write my reflections for the first half of the 2009 year I am neither positively surprised, nor negatively disappointed. What is being witnessed presently and for the last 3-6 months I would categorize as typical and to have been expected. I’m referring secondarily to the way the stock market traded, basically down from the second week of the New Year 2009 and a rebound now into the second quarter.

From my previous held estimation for the first half of 2009, I will attempt to formulate my best estimations for the second half of 2009 and convey how I am looking to apply them going forward here as simple and clearly as I am able.

What did surpass my estimation of the first half’s price action was the extent of severity on both sides of each move, down -30% from Jan. 6, 2009 – March 6 and then back up +43% to June 11, 2009 using the S&P. My best estimate at the start of this year was that the November lows were going to hold at about 780 on the S&P or Dow at about 7800-7400. Needless to say that estimate was about 15% premature.

What I am referring to primarily as typical and to be expected is the political insanity horror movie of power grab attempts at legislation, and to borrow/spend money that doesn’t exist under a guise of fixing the problem(s). This is what will shape the investment markets for the next several years. What is presently occurring is the typical behavior from DC that, if something is not working, do more of it! Welcome to the Richard Nixon/Jimmy Carter horror movie part II, have a seat!

First, let’s take a quick look at the big picture. Here is 30+ years of chart history for the Dow. Trend lines are drawn from the 1982-87, 1987-92 and 1992-95 lows. These are significant lines even though the Dow is only 30 stocks on a price weighted basis whereas the S&P is a market cap weighted index. They both tend to work in equilibrium for the most part. The first trend line (from top down) or the one with the sharpest incline trajectory, was just one of numerous technical metrics that I used to base my estimation for the first half of the year on and the November 2008 lows “should” hold and that the Dow and S&P would hold 7800-7400 and 780 respectively. Again I was about 15% premature, but we have only to work with what is known and manage risk from that point.

So now let’s take a look at a closer time frame with a brief look at the first half of 2009, but more in depth my estimations for the second half forward.

In summary, I started buying the stock indices in scaled pieces using a basket of Dow/S&P/Russell2K & NASDAQ 25% each, starting with 40% when the S&P hit 800 then 60% when it hit 780. At that point my estimate was 780 “should” hold and was willing to maintain the position through any minimal drawdown “noise”. Well from 780 the S&P went lower yet to print 666. (A bit more noise than I was anticipating) Then on March 6th I bought in ~90%. You can then see how I scaled out on the way back up and started initiating scale in short positions. This being due to the fact that every bear market bounce experienced prior to the March 6th bounce had been limited to approximately +20%, so at 860 on the S&P, I was operating under the estimate that a +30% bounce was sufficient to begin setting a top for at least a temporary range bound market, before any further significant move higher could be sustained, along with 840-880 as having been my target area for that range top, so 860 was right in line with my previous estimates at the beginning of the year. I began to set my shorts out in scale starting at the 860 level. Again, I was a bit early inasmuch that it went to 956 another +12% higher from there.

This estimation of a top at a 30% bounce and shorting into it ~12% early has obviously caused a temporary give back of some of the gains realized earlier in the year but not significantly. My first quarter estimate published on April 3rd called for an initial range top at 840-880 and a secondary significant range top high at 920-980 on the S&P. Hindsight being what it is, 840-880 pretty much got blown through and now the 920-980 is apparently setting the first range top limit.

That said, going forward into the second half of 2009 I will do my best to provide my current estimation of what I anticipate and how I will manage positions along the way at each potential juncture. This, as all things are subject to change based on price action and other variables. I do not attempt to predict a market, that is a fool’s game. What I will outline here are several of the most likely scenarios that I presently see emerging.

If the market diverges from these more likely scenarios, I will do my best to adjust accordingly at that time.

If you look at the chart below, to the right of the last daily red bar in the chart, as of July 2nd 2009 I currently have a 90% short position on since July 1. This 90% is at the present time the largest position for the most aggressive long/short Rydex accounts. There are other accounts such as Schwab accounts that have short positions of less than 90% but on balance most are still net short from 30% up to the full 90%.

The break lower on Thursday July 2nd with the Dow -220 and S&P – 27 gives a strong indication to me that an intermediate high is in place. A daily close back above 8580 on the Dow and 830 on the S&P, before a further sell-off below 8200 on the Dow and 880 (solid thick lower blue line) on the S&P, would refute this estimation temporarily. A follow through break below the 880 S&P level, brings into my first target area for a bounce at ~840 on the S&P. This is one of several possible bounce potential areas only, not a hard line buy level. From that level (first solid green line) one of several rebound patterns is possible to emerge between the first and as low as the second solid green line which are at 840 and 780 on the S&P.

At 840 on the S&P my current inclination is to go flat ½ to all of the short position and or possibly buy a small long position for a re-test back up to the break down level of 880. A recovery back above 880 on a daily/weekly closing basis is the key level I am defining to be net long 60% - 90% thru the end of the year. Should a break below and then recovery back above the 880 level transpire, my end of year target is at a minimum of 1020 on the S&P, following the dotted white lines to the second higher blue line, above local range top.

A sell-off to 840 that does not reverse immediately back positive within 1-3 days from the 840 level will be a indicator to me that 780 is more likely to be reached and that to hold at least a ½ short position, or full short. The 840 level is pretty critical but also subjective as is anything in most markets. A daily close below 840 will initially act as the line to maintain short only positions as would the 880 level to be long only. I have set up with dotted white lines how I currently estimate a break and recovery might play out under several analog/patterns. The solid red lines below 780 indicate that a daily close for more than 2 days below the lower second green line at 780, would indicate to me that the bear market is more likely to resume and the March lows will at least be tested if not broken for a deeper sell-off.

We are approaching the beginning of 2nd / 3rd quarter earnings this second week of July. There is no shortage of various estimates as to how companies earnings, specific and generally, will report and their near term impact on the stock market. I will not attempt to critique nor divine what it means. Most of you already know my opinion of corporate accounting. The recent stock market’s rally best performing stocks and sectors was fueled by those companies with the worst earnings, while those with the best earnings dramatically underperformed. My bottom line estimate at present is that we are experiencing a cyclical bull move in a secular bear market. That cyclical move “should” be able to carry the S&P to a minimum of 1020 to as much as 1140.

My current longer term secular estimation though is that the S&P lows of 666 will ultimately be broken much lower. The first chart at the top of this client update shows the secular picture of the stock market’s past, take a second look at it, and ask yourself the two most important questions going forward. One, what were the most significant macro-factors which drove it up over 1400% within a time span of 20 years? Two, what factors are there going forward that will determine its next 20 year returns. I realize the second question is much more subjective than the first, but history has a way of repeating itself to help guide those looking for direction.

There are numerous other markets of greater significance to the economy than just the stock market. The currency, bond, oil and commodity markets are of greater impact on our day to day lives. These are the areas that should command an equal or greater focus than the previously held exclusivity of stocks alone. These other markets are also a secondary type barometer for stocks and the economy, inasmuch that a company’s earning potential is determined by the supply / demand equation of these various other markets. I would be happy to discuss any questions you may have regarding my current estimations related to these other various markets, or anything else for that matter, but in the interest of brevity, I shall exclude any further lengthy musings regarding such.

I wish everyone the very best second half of 2009 and please take anything you read here or anywhere else with the usual large grain of salt. People and opinions are a dime a dozen and often wrong. It is usually more so the ability to manage mistakes and continue to persevere that makes the greater differences for successful outcomes than most anything else.

contact information

Brian Stoll | TimingStrategies.com | Registered Investment Advisor
Newport, California | Email | Website

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.