Meltdown is Possible, According to Technical Indicators

by ETFguide | August 11, 2010 2:56 pm

Smart investors look at the risk/reward ratio before investing and periodically re-evaluate. Who wants to hitch his wagon to a losing horse?

Would you buy a stock that has a 70% probability of losing money? Would you hold a stock that has a 70% probability of losing money?

The answer is so obvious that you might assume it’s only a rhetorical question. It’s not. In fact, anyone invested in stocks (NYSE: VTI[1]) right now is running a 70%-plus risk of losing money over the coming weeks and months.

That’s a bold statement, so allow me to back up and explain why.

A Technically Sick Market

On July 2, 2010, the 50-day simple moving average (SMA) for the S&P 500 crossed below the 200-day SMA for the first time since December 12, 2007. The Dow Jones Industrial Average followed on July 6, the Nasdaq on July 14, and the broadest measure of the U.S. stock market, formerly known as Wilshire 5000, on July 8.

The 200-day SMA is perceived to be the dividing line between a stock or index that is technically healthy and one that is not. When the price drops below the 200-day SMA, a red flag is raised. When the 50-day SMA drops below the 200-day SMA, a clear break of a trend is signaled.

Throughout the recent rally, the S&P’s 50-day SMA remained below the 200-day SMA. Even though the S&P has spent most of the past three months trading below its 200-day SMA, the index has flirted with and stayed above the 200-day SMA since late July. Today is fell cleanly below the 200-day SMA.

A brief pop above the 200-day SMA does not invalidate the larger downtrend. On July 26, the ETF Profit Strategy Newsletter noted that, “it is not uncommon for counter trend rallies of larger degree to persuade even technical indicators to move into bullish territory. This would most likely stir up the kind of bullish sentiment often seen at secondary tops.”

A Solid Track Record

An analysis of the SMA crossover buy/sell signals triggered for the S&P over the past 10 days shows that six of the eight signals (75%) were correct. The average winning trade returned 19.72%, the average losing trade returned 6.95% (see table below). A 75% probability of success with a risk reward ratio of nearly 2.8:1 is about as good as it gets in the investing world.

If we expand the track record to include the 10/40-week SMA crossover, which was triggered as well for all the above-mentioned indexes, we get a 70% probability of success along with a risk reward ratio of 3.7:1.

If we expand the time horizon from a 10/40-week SMA to a 10/40-month SMA, we get a track record of 100% with an average return per trade of 17.68% (detailed analysis available in the August ETF Profit Strategy Newsletter).

Interestingly, the longer-term 10/40-month SMA did not trigger a buy signal in 2009, unlike the 10/40-week SMA and the 50/200-day SMA.

Lagging but Accurate

Many dismiss the 200-day or other SMAs as lagging indicators. Although an indicator may be lagging it doesn’t mean it’s incorrect or should be dismissed.

To illustrate, imagine a beautiful sunny day, with no clouds in the sky. Even though it seems impossible at the time, the weather man sees a storm coming your way. A few hours later, clouds are moving in and the breeze is picking up. Just shortly thereafter, the first raindrops are hitting the ground.

Would you go out and fire up the BBQ after the first raindrops fell? No, the raindrops only confirm the weatherman’s prediction. In fact, you might liken the raindrops to the SMA crossover. Even though a lagging indicator, the rain does confirm that a storm is coming.

A Proactive Approach

You’d expect Wall Street and the financial media to be the financial weatherman and warn you of upcoming storms. Unfortunately, that is not so. Leading up to the April 2010 recovery highs, Wall Street and the media proclaimed the skies are clear. “Sunny throughout the year” was their weather forecast.

Only after investors got drenched, did Wall Street recommend pulling out the umbrella. Sure enough, as soon as the umbrellas came out, stocks switched into rally mode and the sky cleared up.

Unlike Wall Street, the ETF Profit Strategy Newsletter warned of the brewing storm while it was still sunny. On April 16, the newsletter warned that “historically, there has rarely been a more pronounced sell signal. The combination of sentiment extremes clearly point toward a correction. The upside potential is much more limited compared to the massive downside risk.”

Shortly thereafter, the S&P dropped over 17% from its April 26 high at 1,219 to its July 1 low at 1,011.

On July 5, with the S&P 500 futures at 1,003, the ETF Profit Strategy Newsletter noted that “the S&P is butting against the 100-week SMA, lower accelerations band, 38.2% Fibonacci retracement levels, round number resistance at 1,000, and weekly s1 at 994, there is a good chance we will see some sort of a bounce develop from the 990 – 1,015 area.”

This bounce has certainly developed. In fact, the market rallied over 8%. Has this rally changed the outlook? No.

Not only do the major indexes bear the mark of the death cross, the following sectors do also: Financials (NYSE: XLF[2]), technology (NYSE: XLK[3]), consumer staples (NYSE: XLP[4]), energy (NYSE: XLE[5]), materials (NYSE: XLB[6]), utilities (NYSE: XLU[7]), industrials (NYSE: XLI[8]) and health care (NYSE: XLV[9]) all share the same fate.

The consumer discretionary sector (NYSE: XLY[10]) is the only sector to escape the grip of the death cross thus far. It is somewhat surprising and unusual to see the economically sensitive consumer discretionary sector buck against a recessionary trend.

A look at Visa Inc. (NYSE: V[11]) and MasterCard Incorporated (NYSE : MA[12]) provides a peak for what lies ahead, even for the discretionary sector. When consumers spend, they do so with credit cards. Visa and Master Card both got hit with a death cross. It’s just a matter of time until the discretionary sector follows.

Wait, There is More

Dr. Copper is the only metal with a PhD. This sounds corny, but as an industrial metal that’s used in everything from houses to tech gadgets, copper has an uncanny ability to foretell the future for stocks. High copper prices are reflective of high demand and a humming economy. Lower copper prices signal trouble ahead. On June 22, an ominous death cross visited copper’s chart.

Putting the Odds in Your Favor

Investing is a game of probabilities. While you always want to have the odds in your favor, you never want to bet against the odds. Right now, the odds are piling up on the bearish side of the ledger. Even though Wall Street is saying that the sky has cleared up, “meteorologists” with a better track record are warning of the storm ahead.

In fact, there is one rare chart formation that strongly suggests the onset of a 2008-like decline, a development that’s certainly supported by the number of death crosses spanning a variety of markets.

The August issue of the ETF Profit Strategy Newsletter includes a detailed short-, mid- and long-term forecast, along with the one chart that tells the market’s story and true bearish potential.

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