Value of Perfect Information

Although I use E-wave as a primary Technical Analysis method in my trading, another major factor in my trading is Tactical Analysis. How I would describe this is that I look at things like the monetary policy backdrop and market sentiment to give me a big picture directional bias. When the Tactical and the Technical line up saying the same thing that provides a strong edge.

Unfortunately right now is not one of those times. My Technical E-wave work looks bearish, but my Tactical Analysis tells me to expect higher prices. For those who are Mortie’s Premium subscribers you get to hear my Technical Analysis on a daily basis so I won’t rehash that here. But, suffice it to say 1090 ES is a major battle line IMO. I call it the “Maginot Line”. So, as long as we are below it I have to give benefit of the doubt to the bearish scenario. But, what I really want to review in this post is my take on the Tactical backdrop.

First let’s start with Monetary Policy. Like it or not (and most Permabears hate it) the Fed is a MAJOR factor in determining the direction of the stock market. So, what did this week’s Fed statement tell us? I won’t reprint the entire statement as those who wish to read it can do so www.federalreserve.gov. But, IMO the money quote is the following:

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

This answers the question everyone was asking about the Fed’s “exit strategy” from the ultra loose monetary policy that has been stoking asset bubbles in just about every risk asset under the sun. The Fed is spelling out the factors that must change in order for them to end the easy money. They are the following:

1) “low rates of resource utilization” – Translation: Unemployment rate must decline.

2) “Subdued inflation trends” – Translation: Core PCE must rises above their 2% comfort zone.

3) “Stable inflation expectations” – Translation: I think the Fed is watching the Long Bond Yield as their benchmark for inflation expectations. They certainly can’t be watching Gold as that would certainly not be signaling stable inflation expectations. So, it would take a significant uprising by the Bond market vigilantes to get the Fed’s  attention.

Out of these 3 criteria, the first 2 are severely lagging indicators, which means if the Fed waits for those signals to tighten policy it will be far too late and they will be well behind the inflation curve. Not to mention that we will have massive bubbles in stocks and commodities and a major collapse in the Dollar. Only criteria number 3 is forward looking, so really the only hope to avoid bubble mania is for the Bond market to revolt. That is why barring a major spike in Bond Yields the liquidity backdrop remains very bullish for stock here IMO. “Don’t Fight the Fed” is a Wall Street truism that has stood the test of time, and right now the Fed wants investors to take risk (ie. bid up stocks). So, to bet on a resumption of the bear market here and now is to bet the Fed will fail. And that is not a high probability bet IME. Of course that argument won’t dissuade the “P3″ cult one bit as they will just parrot the Prechter pablum about “social mood” and say the Fed is powerless. I always get a good laugh from that one as Fed and “powerless” is an Oxymoron as far as I am concerned. How can the entity that controls the creation of money be “powerless”. OK, enough of that rant but you get the picture…

Aside from Monetary Policy the next fly in the bearish ointment is trader/investor sentiment. I keep hearing how there are “too many bulls”. But for there being so many of them they sure are hard to locate . Don’t take my word for it though. Just go peruse a handful of the most popular trader blogs and read through the comments sections. I guarantee you will find a ratio of at least 10 to 1 bears to bulls (and I am being very generous as it really is probably more like 100 to 1). You will see that same thing in recent investor/trader opinion polls like AAII, or following the money by looking at things like Rydex fund flows and small trader options activity. The retail crowd is skeptical and cautious at best and downright frothing at the mouth bearish at worst. And it is amazing how eager everyone is to call THE top and resumption of the bear. If this was indeed THE top then IMO it will certainly go down in history as the most well called top ever. And you will soon see many newly minted millionaires in the comments sections of your favorite blogs as they all cash in on their lottery ticket P3 crash puts. Is it really that easy?

Now, I’ll be the first to admit that if I was just looking at E-wave counts I would strongly consider the mega-bear scenario and at the very least a substantial intermediate-term decline. But, the monetary and sentiment backdrops are not supportive of that scenario right now and that prevents me from getting too “beared up” just yet. Maybe, I will be wrong and it will be different this time. But in my 20 years of trading I have never seen a major top occur with this kind of monetary policy and this kind of widespread bearishness so soon after a top.

The only way I can reconcile the bearish Technical with the bullish Tactical is if we see a major dislocation in the bond market very soon and/or we see retail trader sentiment do a rapid 180 to bullish capitulation. Of those 2 bearish catalysts the former is the more likely IMO and the one to keep and eye out for. So, I will be watching the bond market closely, following all Fed speeches for subtle clues, and of course watching to see if the army of retail bears ever thins it’s ranks. If we can get some of those things to line up then we could be looking at a strong bearish edge. But, for now all I see is mixed signals.

First off I would like to begin this commentary by thanking Mortie for saving me all the time I would have spent working on an E-wave roadmap chart. If you want to see my E-wave roadmap just check out Mortie’s weekend update because they are identical . Well, OK maybe not “identical” but certainly close enough. The only point I differ on slightly is regarding the very short-term count, where I see Friday’s action as wave ‘b’ of an irregular flat 4th wave. So, I am ideally looking for sharp selling early next week but then one more run-up from there into Op Ex. Although I don’t expect ES to exceed 1020 by much if at all. 1035 area is about the max I can see from an E-wave standpoint before a more substantial correction back down to test breakout support in the 940-965 area. For early next week, support levels are 1000, 995, and 990. If my short-term count is correct and we have one more higher high to come before we begin a more substantial correction, then we should hold above 990 next week. Below 990 and I would concede that the correction to 940-965 is underway. Conversely, a rally above 1035 (although I don’t expect it) would suggest to me that the market is entering some sort of parabolic blow-off phase with 1050, and 1075, as the next upside targets, and if it really got nutty then the 1100-1120 super cluster of fib targets could come into play.

Since there is not much to add to what Mortie wrote from an E-wave perspective, I think for the rest of this post I might focus instead on some thoughts I have on Tactical Analysis versus Technical Analysis.

Long story short is that I believe the easy money has been made on the long side, and near-term risk/reward favors the short side. Friday’s action looked very much to me like the pros were distributing into the good news rally, a classic case of “buy the rumor, sell the news”. And no matter how many times you hear the financial media telling you that “it’s different this time”, the jobs report has ALWAYS been a lagging indicator, and I don’t believe for 1 minute that “it is different this time”. Think about this, when was the jobs report the scariest? Yep, early March of this year and that was exactly the time the pros were accumulating while the public was running scared from all the doom and gloom. The market anticipates the news ahead of time, hence the enormous rally we have seen off the March low was in anticipation of the “good news” that you are finally hearing now.

So, now that the public is finally feeling relieved due to the improving economic data and thinking the “all clear” has been sounded for the bull market, we need to keep an eye out for signs that the pros are distributing in anticipation of maybe some not so good news 5-6 months from now. I see some of tentative signs of that now, call them “redshoots”. One of them is the notable recent under performance of the Tech sector which had clearly been in the leadership role since this the bottoming process began in late November 2008. This doesn’t mean the market immediately tops here but it does suggest we are likely beginning a topping process and that this rally off the March low is in the late innings.

Here’s a quote I read this weekend that really caught my attention from a Contrarian standpoint:

“strong evidence that an initial impulse capable of launching another major up leg has taken place. And the similarity between the present and the 2002-2003 bottom, leads me to believe that it is more likely that we are at the beginning of a bull market rather than at the end of one.”

Really??? Near at the “beginning” of a bull market? Wow!… OK. Let’s see… We are up 50% off the March low. The entire 5 year bull market from 2002-2007 saw the SPX rise approx 100% from trough to to peak. We have already gone up 1/2 as much as the last bull market. So if we were comparable to 2002-2003 bottom, as the author suggests (and which I think is overly optimistic), that would mean the bull market would already be halfway over. That is hardly what I would call the “beginning”.

Here’s another interesting sentiment read:

“Encouraging U.S. manufacturing and employment data this week pushed all three major stock indexes to nine- and 10-month highs. And analysts said the enthusiasm from the better-than-expected reports should carry over into next week.
“All the fundamentals for recovery are now aligned,” said
XXXX, managing principal of XXXX, based in New York. He expects stocks to climb next week.”

Gee that’s good to know that everything is finally aligned bullishly AFTER we have already seen a 50% rally off the low. I guess everything was aligned bearishly back in March .

And, one more point I will make on Tactical Analysis, is that if there was one major “Hook” that kept all the TA guys bearish all the way up from the March low it had to be “Low Volume”. I can’t even count how many times I saw hand wringing about “Low Volume” and how it had to be a Bear Market Rally and that it was unsustainable without volume picking up. And yet up it went defying all the skeptics and top pickers. Now this weekend I am hearing from TA experts that we are finally seeing “confirmation” from volume and that means much higher highs are on the way. But from a Tactical standpoint I have been expecting just the opposite, that once the volume finally did come in that would likely mark the ending stages of the rally. The way I think about it is that heavy volume means alot of shares are changing hands, and the critical question that none of the volume experts seem to address is whether those shares changing hands are going from weak hands to strong hands or vice versa. When I see heavy volume AFTER a 50% rally has already taken place in just 5 months, AND that heavy volume is taking place on “good news”, that strongly suggests to me that shares are moving from strong hands to weak hands. Why? Because I seriously doubt the strong hands chase momentum after a 50% straight up rally has already occurred in just 5 short months. And I’m also pretty sure the strong hands buy the rumor not the news. Consequently, I for one do not view the heavy volume occurring under current conditions as being bullish confirmation. In fact I view it as quite the opposite.

That’s all for now. I will post some E-wave updates throughout the week if anything changes or if by some chance my wave count stops exactly matching Mortie’s.

Smart/Dumb Money indicator at 42/63

The more Dumb Money is confident in a rally, the more bearish this indicator is.
Smart/Dumb money historical perspective: Historically, difference of +/- 25% has been the threshold for extremes.

Smart/Dumb Money at 42/58 for July 27, 2009

[tags]Smart/Dumb Money[/tags]

Well it has been a nice bull ride since the lows of March.  Back in early October 2008 I came very close to predicting the low in terms of level and time as can be seen in the enclosed chart.

There are currently some troubling signs out there.   Some surveys that gauge investor surveys are starting to show signs of real euphoria for this market; these bullish readings have contrarians forecasting danger for the indices going forward.

Take for example the American Association of Individual Investors survey which last week was 48% bullish in contract to a historical average of 39%. Happy days are here again!  Inquiring minds might wonder what levels yield a market top and the 70% level would be required.  Still safe you might say!  Yes but we better have continual good news to stay above the historical average to keep marching higher.

Also, the Investors Intelligence advisors famed bull ratio has joined the stratosphere with a reading not seen since late 2007 at 67%.  So professional advisors like me are as bullish on stocks now as they were in 2007 before the bear market started to growl and showed it claws. 

Oh and the Smart Dumb money indicator gap is more than 25%.  For more read more about it by viewing the Smart/Dumb money category on the right. The more Dumb Money is confident in a rally, the more bearish this indicator is.  From a historical perspective, a difference of +/- 25% has been the threshold for extremes.

Smart/Dumb Money 46/63

http://slopeofhope.com/2009/05/09/max_pain.htm#comment-9160649

Read more about Smart/Dumb Money indicator on the category to your right or click here:

http://www.bostonwealth.net/category/markets/market-indicator/smartdumb-money/