What Is Not Seen

On March 10, major U.S. stock market indices like S&P 500, Dow Jones Industrial Average, and Nasdaq, all reached there respective lows after the last stock market sell off. Since then, stocks have rallied, with S&P 500 up 11.94 %, Dow Jones up 10.62 % and Nasdaq up 16.57 % .

While some people seem to believe that we now are “out of the woods”, I strongly think that the economic troubles so far are only getting started.

For the stock market, we should expect a correction soon. For guidance, I turn to my favorite contrarian indicator, the Bullish Percent indicator. This indicator tells us how many percent of the underlying stocks of an index that are showing there first Point & Figures buy signal. At present, this gives us a way of gauging if stocks at given prices are over bought, and hence are likely to correct.

A reading above 70 is red alert for stocks, should they start declining. A reading below 30 in the Bullish percent is a good opportunity to buy, as only a small amount of additional money entering the market will push up prices.

Since the stock market started to increase, investors and asset managers have successively increased their exposure to stocks. This was captured by the bullish percent. Looking at Bullish percent for New York Stock Exchange, and for S&P 500, we see that the index reversed up into a column of X’s in the final weeks of March.

Now 40 days into the bear market rally, the Bullish percent indicators have all begun reaching higher levels. NYSE Bullish percent are currently showing that 58 % of the index stocks are displaying buy signals, and are still rising. S&P 500 shows that 62 % of the stocks are experiencing positive demand. Dow Jones on the other hand have recently reversed down from 66 % to 60 %. Suffice to say, current levels should start to raise some concern.

Given the present economic conditions, many managers and investors are still cautious. This can be interpreted that a Bullish percent reversal at present levels could be as serious as a reversal above 70 in the past when over all economic conditions were better.

When it comes to the Bullish percent indicators i don’t like trying to predict the predictors. As likely as a reversal, more capital may enter the stock market pushing prices and Bullish percent even higher. Personally I look at the indicator, and only afterwards take the apropriate action.

Although, should we see further gain, let say NYSE Bullish percent goes to 65 or even 70, we can expect the correction to be more severe and longer lasting, when it eventually comes.

Relative strength (RS), the indicator of relative outperformance have been negative for stocks since early 2007. During this time, yields have headed lower, resulting in favorable conditions for bonds. Compared to the Dow Jones Corporate Bond Index, RS for S&P 500 turned positive in the last weak of mars continuing it’s up trend so far in April. Other recent market movers have been mixed. VIX, the volatility index has dropped from it highs of 35 in mars to under 23 on 7/4. At the same time conditions have worsen in the credit market with TED-spread at 1.29 and the paper-spread at 1.22, signaling caution.

An interesting fact is that, in James P. O’Shaughnessy popular book, What Works on Wall Street (1996), relative strength is found to be the only reliable indicator for growth. How this will play out for stocks in the near future, still remains to see.

The goal for most investors is to stay ahead of the curve. Regardless of what ever asset class in mind, fixed income, equity, commodities or currencies the ultimate goal is to be well positioned, and in line with the market. This can be a tedious task especially when market movements go the opposite direction from economic indicators and the overall economy. I can’t remember how many times I have seen magazines, cover stories, etc. proclaiming, either the “The end of equities”, as did News Weak 1982 or “The end of the oil age”, as did The Economist 2003, just to see markets take off in the opposite direction almost the exact same date.

There is no doubt that markets tune in to fundamentals over the long turn. Just like a rock getting thrown up in the air under the act of gravity, markets that rise without fundamental support will eventually return to the ground or for equities to the historical average growth rate. Take a look at total return for GDP and S&P 500 since 1960. During this period, growth rates have varied, but total return is not surprisingly the same. During negative years for stocks, GDP sometimes had a positive return. This is one example when a belief in following the underlying economy can get you side stepped.

The search for economic indicators able to warn investors of such diverging tendencies made me think about the Bullish Percent Indicator. This indicator is a contrarian indicator constructed for the sole purpose of gauging the likelihood of a shift in market behavior. The Bullish Percent is based on the number of buy signals given from Point & Figure charts. The most interesting one is the NYSE Bullish Percent Indicator that shows the number of stock on the New York Stock Exchange currently in a buy signal. The logic behind this goes back to supply and demand, and the fact that changes in these dictates market movements. On Stockcharts.com you can find the index by the ticker name $BPNYA.

A low reading, below 30, indicates that less than 30% of the total 2500 stocks in the index are experiencing buying pressure. This situation is synonymous with one where most investors that don’t have an interest in stocks at the moment is outside the market. The lower this index drops the smaller amount of demand is needed to have a positive affect on market prices, making it a good time to get in the market.

Had you only looked at the underlying economy for guidance or the currant negative trend of historical equity prices, the likelihood is high that you would have missed a potential shift. Historically Bullish Percent has been a good contrarian indicator as it warned us prior to both the crisis around 9/11, and last year of the subprime crises that got to Wall Street in august.

As we have seen stock markets and fundamentals tend to diverge from time to time, making it even harder to get a good read of where the market is heading than usual. Bullish Percent is one of many contrarian indicators, grounded in economic theory that can assist investors in foreseeing possible bottoms and tops in asset prices.

Finally, I would like to clear up one misunderstanding with regards to the Bullish Percent. Most investors have herd the expression that “the trend is your friend”, even Point and Figure analysis is centered on this concept. This idea implies that a stock experiencing upwards- or downwards pressure is likely to continue in the same direction. The obvious question whit regards to Bullish Percent is: What if every stock – let say in the broad NYSE index – had signaled buying opportunities, would not that contradict the logic of Bullish Percent and trending prices? Absolutely not!

If one stock rises, it doesn’t say anything of the overall market demand. Market demand may be slowing, but some stocks always go the opposite direction. Let’s say for the sake of argument that every stock is signaling buying opportunities. This has almost certainly resulted in surging prices as every available demand has entered into the market. With every one willing to participate in buying stocks already owning stocks, there is extremely little demand left to continue acting as upward pressure on prices. This is a situation where a marginal increase of supply will have a significantly large impact on market prices when there is no longer any counteracting force holding prices up.

The last couple of weeks I’ve been reading books about technical analysis and trading. Technical analysis, some times ridiculed by academics for the lack of rigour, is at best regarded as a pseudo science. Although, this method of analysis is widely used by practitioners in the financial world its usefulness is often highly questioned. At the moment I am reading Thomas J. Dorsey book about Point & Figure Charting. This method is one of many tools available for the individual investor interested technical analysis or trading.

Economics in general and Austrian economics in particular properly deal with fundamental causal relationships. When it comes to the content of these relationships or economic laws, theory does not say very much. Instead, this area is what economists call entrepreneurial activity or entrepreneurship. This is the heart of the economic process, where business men offer their different services to each other and consumers in exchange for money, resulting in the formation of market prices.

As mainstream economics primarily deal with economic equilibrium, entrepreneurship does not even enters the picture. Fortunately this process – which allocates capital and adjusts prices according to supply and demand – is thoroughly analysed by the Austrian school of economics.

But still when it comes to the content of entrepreneurship, e g the currant real life relationship between supply and demand Austrian economics does not provide the complete picture. Knowledge of the inner workings of the business cycle and the fact that e g, a price ceiling for product X will raise prices, ceteris paribus, is necessary. But in real life the ceteris paribus assumption does not hold (everything is not equal). Prices can very well move in a counter intuitive fashion. The only thing that we can know is that prices tend to move according to fundamental factors over time. So for the business man or the private investor interesting in trying out the stock market, Austrian analysis and other qualitative assessments is not sufficient, especially not in the short term, where prices move along investors’ sentiment.

It doesn’t matter if you are looking at the price of fish or the price of a stock ABC, both are determined by supply and demand every minute every day. The only different feature is that the prices of stocks tend to change more frequent than the price of fish.

On Wall Street there are an old saying that: “the market can stay irrational longer than you can stay solvent”. If you would enter an investment solely based on the ceteris paribus assumption, the odds that you would loose money is to big to be ignored. So the million dollar question then becomes how you take a logical and rational approach to overcome this problem. Since investing is entrepreneurship and no one knows what will happen tomorrow, there is no closed formula to how one would do this successfully.

Because of the entrepreneurial element of this problem the concept of truth and falsehood does not enter, as in economic propositions. In technical analysis or in investing, concepts like, consistency and accuracy are more suitable for evaluating any particular method.

Thomas Dorsey’s idea about both consistency and accuracy is found in the method of Point and Figure charting. Based in the fundamental truth of supply and demand, first formulated by Charles Dow, P&F charting aims to give the accurate picture of this supply and demand relationship. Simply put, if demand for stock ABC is in control over supply, prices will rise. On the other hand if supply of stock ABC is in control over demand, prices will fall. Based solely on this fact, P&F charting then offers a hint for investors of whether prices will tend to fall, or if they will tend to rise in the future.

Compared to many other analytical tools P&F charting reduces volatility in price movements. Because of this, one can more easily discern important price changes from unimportant noise.

Point and Figure Charting by Thomas J. Dorsey is a valuable tool and a good friend to lean on when you are evaluating the often times erratic market.

According to famous investor Jim Rogers: “Everyone who’s involved in financial markets must understand Point and Figures charting in order to get the full picture, whatever your view of technical analysis”

For more information of Point & Figure charting visit www.DorseyWright.com