Money & Finance - Further Downside Expected

We thank all our clients for their patience and understanding in giving us the time required to get back to 100% operationally. While the devastation from Sandy is far from rectified, we are pleased to announce that we are back to our regular schedule.

That said, it has been two weeks since our last letter when we were warning about a potential market correction. Indeed the market has softened over the past few weeks and we remain in cash positions or “short” the market in some cases.

The question comes to mind on how deep this sell-off will actually be. While our behavioral model is certainly not a crystal ball, but it can offer insights on when to act.

Our strategy will be as follows. As seen in figure 1, the behavioral model is just now passing through the “zero” level to the downside. Once we break firmly through that point, we will start to scale out of our short positions and de-lever the portfolio.

From that point we will wait for the market to provide us with our next course of action. Should this correction end up being a severe one and the trend line falls to the “fear” or “extreme panic”, then we will wait for the appropriate buy signal and take an aggressive long position into the final quarter of the year.

If the correction proves to be shallow as it was in June of this year, then we will take a less aggressive long position. In the end, it comes down to trusting the instruments and staying true to the methodology.

What the model tells us

Investors need to understand that we usually get one high probability opportunity per year coming off a major correction. In figure 1, the model offered us aggressive buying opportunities in March/April of 2009, June/July of 2010 and August/September of 2011. We haven’t had a major correction in about a year so logic would suggest that we are overdue.

Put / Call Ratio

The put/call ratio is the comparison of put volume relative to call volume. For those unfamiliar with how put and call options work, put options are derivative securities that move in the opposite direction of its underlying asset. For instance, if one were to purchase a put option against the S&P 500, if the index went lower, the put option would appreciate. Put options are generally used to hedge against market weakness or bet on a decline.

Call options are just the opposite. Unlike put options that have an inverse relationship with its underlying asset, call options have a direct relationship with the underlying. Call options are used to hedge against market strength or bet on advance. A put/call ratio above 1 signifies put volume exceeding call volume. When the ratio is below 1, then call volume is greater than put volume.

The theory goes is that when the put/call ratio is registering high numbers (in excess of 1.0), market sentiment is deemed bearish. If this ratio stays elevated for a period of time, one would look for clues of an oversold “skittish” market and would consider buying stocks. Conversely, when the ratio is nearing excessively low levels for a period of time, one would determine the market as too “complacent” and look to exit.

Observing figure 3, one can see the daily tracking of the put / call ratio for U.S. equities. We are seeing a new uptrend in this ratio. After a period of complacency, the put / call ratio has been above 1.0 for the past few weeks. This may be indicating some renewed “fear” entering the market.

Bottom Line: A continuation of this upward trend will surely indicate further market weakness.

Volume Indicator

We at JSK Partners have several proprietary models that we use to help navigate the market. One such model is our Volume Indicator. This model accounts for strength or weakness in market direction based on the amount of volume during the trading day.

More specifically, if the market is going higher but on declining volume, the bullish score will start to weaken, many times before stocks start to head lower. Separately, if the market is selling off on declining volume, the bullish score will start to strengthen, many times before stocks start to head higher.

This model is included in our overall behavioral model, but given the readings that we are collecting; we thought it wise to single out this model. When our volume indicator reaches a level of 105, which is one standard deviation from the mean, this is typically a warning sign that the market may experience some near-term weakness. As of the last four weeks, our model registered a high of169 and has trended lower since. 

The latest reading is -20.2. This model needs to drop to -200 for this to turn into a major correction.

Bottom Line: If this model continues its downtrend, this market will go much lower from these levels.

Point & Figure (P&F)

Part of our behavioral model consists of market analysis using point and figure (P&F) patterns. P&F charts consist of columns of X's and O's that represent filtered price movements. X-Columns represent rising prices and O-Columns represent falling prices. Each price box represents a specific value that price must reach to warrant an X or an O. Time is not a factor in P&F charting. These charts evolve as prices move. No movement in price means no change in the P&F chart.

P&F charts provide a unique look at price action that has several advantages. P&F charts:

1 - Filter insignificant price movements and noise

2 - Focus on important price movements

3 - Remove the time aspect from the analysis process

4 - Make support/resistance levels much easier to identify

5 - Provide automatic and subjective trendlines

We take this analysis one step further and track the percentage of companies in the S&P 500 that are in a bullish pattern. For instance, as of last Friday 65.4% of the companies in the index (327 out of 500) are in bullish formation. The proper way to interpret this model is to view it as a contrarian indicator. Typically, when the percentage of bullish P&F patterns exceeds 82.8%, it usually signals a near-term pullback for the stock market. When the percentage of companies in bullish P&F patterns falls below 25%, then it is a good time to enter the market.

Bottom Line: With 65.4% of the companies in the S&P 500 in bullish P&F patterns, near-term market softness should be expected to continue.

Joseph S. Kalinowski, CFA

Twitter: @jskalinowski

 

 

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