*Cycle status is based on S&P 500

Been there. Done that. Déjà vu all over again. Once again, confronting the vagaries of the financial markets last week, we were compelled to ask, “When does the learning process begin?” In the wake of the week’s stock market losses, we were impressed with some of the reactions to unfolding events. First came the justifications, then the predictions again. Again.

On the heels of Thursday’s 175.98 point loss and then Friday’s 318.25 decline in the Dow 30, Minor Cycle market trending took on a decidedly negative tilt. In fact, losses Thursday and Friday finished off the majority of the gains in the Dow and S&P 500 since the December 18 short-term lows. But what followed is probably only the tip of a wobbly analytical iceberg that will melt forth in the period just ahead, as many opinions dip into the well of déjà vu market history. “We’ve got a relatively favorable market. As long as the economy continues to accelerate and liquidity is still pretty strong….” Or, “…the markets are leading the fundamentals rather than the fundamentals…leading the market.” Or, “…we recently have seen some readings that point to some uncertainty.” And, our favorite, the “markets have not played out as conventional wisdom expected.”

Those comments tend to underscore why we perform our analytical chores deep in a metaphorically isolated cave while hovering over a candle with no telephone within easy reach. Only a winking computer screen with a high speed data feed is necessary. In that context, any reader of this column has probably come to the conclusion that we like to take a more basic approach to the stock market by letting market pricing reveal trend direction. The methodology is a lot like following a bird dog in pursuit of a duck. The task of digesting information becomes somewhat easier to the extent we can preclude a lot of useless opinion. In that vein, we present, again, the “Top Ten Realities of Wall Street,” a list written with Robert W. Colby, of Robert W. Colby Asset Management some years ago:

The Top Ten Realities of Wall Street:

1. The market is never wrong. Only opinions about the market are wrong.
2. The conventional wisdom of Wall Street, "Buy good stocks and hold them for the long-term," is likely to work – but only if you live forever. For mere mortals, timing is overwhelmingly important.
3. A company and the price of its stock are not the same thing. Even stocks of good companies can decline. An investor can lose a lot of money owning stock of the best firm in the world when its major stock price trend turns lower.
4. Earnings per se do not cause stock prices to rise and fall. Rather, the balance of demand and supply for the stock itself is the cause. Expectations of future earnings are but one of many factors to be weighed. Earnings news and estimates usually lag stock price action.
5. Knowing when to buy is important, but knowing when to sell is even more critical to investment success.
6. Even though there is a surplus of "investment research," unbiased and intelligent analysis is extremely rare. Such analysis is valuable in direct proportion to its rarity.
7. Without proper analysis, news, data, charts, and, especially opinions and "chat," can be harmful to an investor’s wealth.
8. An investor’s hopes and fears work against his ability to make objective and rational investment decisions. Consequently, the more an investor thinks about buying or selling, the greater the odds he will make a mistake and lose money.
9. So-called "conventional wisdom" which advocates "buying the dips" can be a short-cut to financial ruin if performed at the wrong time in a market cycle.
10. Knowing the true direction of the most relevant trend is the single most important contributor to investment success.

Also, given the fact that we believe the two most important things in the stock market are where you “Buy” and where you “Sell,” buying becomes a function of committing when prices are rising with selling, the opposite. As a consequence, justifying the direction of price action simply becomes an adjunct to actual price movement, not that justification is ever required. In other words, knowing that earnings are trending higher in XYZ is only relevant information to the extent the price of XYZ heads higher. But even then a correlation between the two could prove to be elusive since higher earnings do not necessarily mean prices will rally. It’s a conundrum for the investor relying on lagging fundamental data.

Market Overview – What We Know:

• Sharp losses characterized trading in all of major indexes last week.
• Weekly market volume declined just over 16%, but that was a function of truncated holiday, trading week.
• S&P 500 has turned negative on Minor Cycle and must rally above upper edge of 10-Day Price Channel (1844.74 through Monday) to suggest positive reversal. Intermediate Cycle remains positive until lower edge of 10-Week Price Channel is penetrated (1781.63 through January 31).
• Our daily VIX-based volatility indicator, VBVI, dipped sharply lower last Friday from 82.68% on Thursday to 59.63%. Larger Intermediate Cycle reading declined to 92.06% from January 17 plot at 96.21%.
• Daily MAAD was negative by 2 to 18 Friday and sank marginally below rising uptrend line stretching back to November 2012. Daily MAAD Ratio confirmed negativity by declining below 1.00 to .87. Weekly MAAD was negative by 5 to 15 with Weekly MAAD Ratio last marginally overheated at 1.21.
• Daily CPFL rallied to new short-term high last Thursday and to best level since early August 2011. Via last Friday’s losses, however, indicator was negative by 2.83 to 1 with Daily CPFL Ratio still “Overbought” at 1.85. Weekly CPFL Ratio was at 1.29.

One justification often used for stock market movement is the direction of the economy. Many analysts continue to suggest that the economy and the stock market are one in the same. But even an ardent fundamental analyst would probably accept the premise that the stock market is a “discounting mechanism” and a “leading indicator.” If so, and the stock market looks “forward,” then how can it operate synchronously with the economy? The fact is, it can’t and doesn’t. Usually equity prices LEAD the economy up or down by from six to nine months. All the more reason to avoid using lagging economic data to make stock market decisions.

Market Overview – What We Think:

• Concerted short-term selling last Thursday and Friday not only confirmed end to Minor Cycle uptrend begun after December 18 lows, but sets up possibility more weakness could have negative effect on elongated intermediate-term advance initiated in November 2012.
• Fact that market experienced worst weekly decline in nearly 19 months, as it hovered in vicinity of our upside Measured Move targets as calculated from March 2009, is noteworthy. That reality could prove to be more than interesting since now nothing but new highs will reassert long-term advance that is toward beginning of its fifth year.
• But since selling at this juncture is only a hint of possible future negativity, burden of proof remains with bears since on several occasions over past 14 months short-term pull backs have simply been followed by more buying that propelled prices to new highs. An exception will ultimately break that rule, but for the moment it remains to be seen if recent selling will be defining exception.
• Weighing in bullish favor is fact that Daily MAAD that has traditionally put in place a negative divergence in front of more important market tops (March 2000, October 2007, May 2011) has yet to exhibit much negativity except to fractionally penetrate objectively drawn uptrend line stretching back to November 2012. Only Daily MAAD Ratio based on MAAD data has confirmed short-term negative by dipping to .87 below neutral 1.00 threshold.

Over the weekend, during one of those analytical moments when we connect with the outside world to get a “fix” on market events, we contacted a long-time analyst and trader who is a frequent ray of light when we are attempting to look through market fog. Our question was simple, “Why do we keep hearing the same worn out reasons for stock market price action?”

His answer:

“A series of myths have been propounded by the ‘Sell’ side of the financial industry that seek to correlate economics and business with stock market pricing. There is only one time when price and fundamentals coincide and that is during an initial public offering. Thereafter there is a total disconnect between the fundamentals of a stock and its price.”

And we will add, between economic data and the broad market.

Daily S & P 500 with Cumulative Volume (CV)

Weekly S & P 500 with Cumulative Volume (CV)

Aside from some of creative opinions floated recently as to why equity prices have been sinking and where they may be headed, we prefer to look in other directions.

First, the bull market initiated in March 2009 remains intact. So does the elongated Intermediate Cycle that began in November 2012. But the Minor Cycle is now negative in all of the major indexes we follow, and how that trend evolves will decide the staying power of the larger trends. In a best case scenario the “correction” will be shallow, short-term “Oversold conditions will develop quickly, and weakness will prove to be merely a pull back within the context of the larger cycle trends. If the Minor Cycle gains negative legs, then the Intermediate Cycle could be in jeopardy, and then the entire long term bull begun in March 2009.

Daily S & P 500 Emini Futures contract with Cumulative Volume (CV)

Weekly S & P 500 Emini Futures contract with Cumulative Volume (CV)

Second, we find it interesting that last week’s worst week for the stock market in the last 19 months developed within inches of long-term Measured Move targets (see Table) we have been posting over the past several months. In fact, at last week’s highs all of the major indexes had exceeded upside targets, on average, by 2.05%. By week’s end and after sharp selling, however, all five indexes were down relative to those upside targets by 1.35%. Is it possible market equivocating over the past few weeks could be coincident with those targets relative to the long-term trend?

Third, since the nature of many comments last week underscored the fact some analysts, using fundamental measurements, think selling will prove to be nothing more than a brief pull back in the long-term uptrend, there is all the more reason to wonder if it could be more. Repeatedly we noticed the comment that a 5% to 10% correction could encompass most of the selling. Valid suppositions if you presume “conventional” wisdom moves the market. But is it time for something more unconventional to unfold?

Note: Stop levels, a function of the extant trend, are based on the trailing moving average price channels for the Highs or the Lows of an index. Whether or not a specific index is suggesting a “Buy” or Sell” is determined by whether or not index prices are above or below the current channel Stop levels. Stop levels should only be used as an entry or exit guide and in conjunction with other market entry and exit strategies.

But fourth, if selling last week is going to develop into something larger than many might be expecting, we would have preferred a negative divergence in our Most Actives Advance/Decline Line (MAAD). While weakness caused Daily MAAD to fracture a rising uptrend line stretching back to November 2012, the indicator was more bullish into its January 15 high than was the S&P 500. Only the decline in the Daily MAAD Ratio below 1.00 into negative territory at .87 statistically confirmed short-term vulnerability. These observations may sound contradictory, but pricing and MAAD will soon clarify the discrepancies.

In sum, once again the market has spoken, loudly. This time its voice could prove to be more forceful than at any time since the early May through early October 2011 decline when the S&P lost nearly 22%. With the S&P currently 3.2% below its January 15 intraday high of 1850.84, if the bellwether is going to mimic the 2011 decline in terms of overall loss it would have to sink to nearly 1450. Unfortunately, a decline of such magnitude would place the S&P well below the lower edge of its 10-Month Price Channel (1551.80) and the downside “failsafe” point for the Major Cycle trend in effect since March 2009. Put another way, there may be a lot less positive margin on the downside in this market than would seem evident before the long-term trend could be in trouble.

McCurtain Most Actives Advance/Decline Line (MAAD)

Daily MAAD did its part last week by keeping in step with market pricing on downside, but indicator has been remiss in that if selling proves to be something more important than just a Minor Cycle decline in larger advance, it provided no advance warning of impending weakness. We find that omission bothersome since the indicator has tended over the past 60 years, via the daily and weekly data we have available, to create negative divergences into important market tops. Not always, but usually. In the “less helpful” category Daily MAAD provided no warning prior to the ’87 Crash, but it did give ample lead time prior to the March 2000 and October 2007 bull market highs and the May 2011 intermediate high that preceded the worst correction in the bull trend begun in March 2009.

Nonetheless, presuming MAAD was late on the draw this time around, it nevertheless has fractured on the downside a rising and well-defined uptrend line stretching back to November 2012. The Daily MAAD Ratio confirmed short-term negativity with a dip below 1.00 and “Neutrality.” If that’s the best MAAD is going to demonstrate, then the least we would look for is confirmation of market weakness going forward.

On the other hand, if the lack of a negative divergence into the recent short-term high is simply an indication this correction will prove to be marginal like all of the others since November 2012, then we would look for pricing to stall on the downside relatively soon. At that point it would become evident that Smart Money has not seriously shifted its strategy to one of selling on strength from one of buying on weakness. Then, nothing but new highs would be required and the relationship of MAAD to new highs would become important since a failure of the indicator to validate new highs could prove to be the unfavorable divergence for which we had been hoping.

McCurtain Call/Put Dollar Value Flow Line (CPFL)

CPFL scratched out it best levels since August 5, 2011 last Thursday at a point that was also the best since short-term strength began developing in the indicator following its October 9 low. There is also the reality, however, that while CPFL has shown marked improvement for the better part of the past four months, it still has yet to create a new high by rallying above a peak created February 23, 2011 prior to the May/October 2011 correction.

So the indicator is currently bullish near term, but still appears to have longer term problems to the extent options players have not been as bullish since October 2011 as they were from March 2009 until February 2011. Unfortunately, this is one of those instances history will have to decide to the extent it will reveal the value of the long-term CPFL reading when a final market price high is ultimately created. The fact that the S&P has rallied nearly 36% since February 2011 in nearly three years will not be a particular vote of confidence for the predictive powers of options players based on Cumulative Dollar Value, unless the subsequent stock market downturn is of historic proportions.

Conclusion

Last week’s selling in the stock market, as measured by the major indexes, will either prove to be the tip of an iceberg in preparation for selling that could develop into something more problematic for the larger cycles, or it will prove to be a corrective phase in the long-term uptrend begun in March 2009 and to a lesser extent in November 2012.

Considering the imprecision of fundamentally-based opinions as to “why” the market declined in the first place, let alone as to “where” it is headed next, we far prefer to let price action dictate the outcome. For the moment we know the short-term trend is negative and that the next larger Intermediate Cycle, while still positive, has little room in which to maneuver before it too could be in negative territory. In any case, to simply presume a continuation of the extant trend because it has been in effect for nearly five years is no justification for its continuation, especially when such presumptions might be based on lagging data.

*Note: Unchanged issues are not counted.

**Note: All data is for calendar week ending on Friday even though ending date may be a holiday. Unchanged issues in MAAD calculations are not counted.