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Saturday, 28 July 2007

All Good Things Gotta Come to an End

The stock market has been on a dizzying ride over the past year, up almost 30% over the past 12 months. And by following a number of seasonal and sentiment models – many of which I have written about in the past – I have been able to convince myself to sit tight and enjoy the ride, rather than trying to "outguess" the market and take profits prematurely. But as the old adage goes, "all good things gotta come to an end." Now that statement in this context should not be construed to mean that the stock market is due to top out and embark on a major price decline anytime soon, nor that investors should "sell everything" and run for the hills. It simply means that investors should probably not expect another 30% gain on top of the one we have just experienced.

To get a sense of why I am pulling in my horns a bit, let's look at a few of the "gathering clouds."

THE 40-WEEK CYCLE FLIPS TO THE BEARISH PHASE

As many Optionetics and ProfitStrategies students know, the 40-week cycle – which I first wrote about in Stock & Commodities magazine in 2003 - just ended a bullish phase as of the close on 7/20/07. As you can see in Chart 1, the market rallied nicely between the start (3/2/07) and end of this latest bullish cycle, all in all registering almost a +10% gain in about four and a half months.

Chart 1 – Bullish 20-weeks of latest 40-week cycle
(Click here for larger view.)

Chart 2 displays the growth of $1,000 invested in the Dow only during each 20-week bullish phase since 1967. This equity curve advanced to a new all-time high.

Chart 2 – Growth of $1,000 invested in Dow Industrial only during each 20-week bullish phase since 1967
(Click here for larger view.)

On the more sobering side, the next "bearish" phase (which would more accurately be described as the "non-bullish" phase since sometimes it is up and sometimes it is down) will last until 12/7/07. As you can see in Chart 3, this phase has no real predictive value other than the fact that it has been down a total of -29% overall since 1967.

Chart 3 – Growth of $1,000 invested in Dow Industrial only during each 20-week bearish phase since 1967

Nevertheless, the fact that we are now in the "bearish" phase does not automatically mean that a bear market is imminent. It simply means that the boost that the market typically gets during the bullish phase has now passed.

SEPTEMBER THROUGH NOVEMBER OF PRE-ELECTION YEAR

Dovetailing with the 40-week cycle is something I wrote about in an article dated June 27, 2007 and titled "These Are the Good Old Days." In that article I pointed out the fact that while pre-election years tend to be quite bullish (there hasn't been a down pre-election year since 1931), the September/October/November time frame during pre-election years typically witnesses some difficult market action.

Chart 4 displays the growth of $1,000 invested only during the September through November timeframe of each pre-election year since 1935. While some years are up and some years are down, the net result is decline of over –55%. So this is another piece of information that in no way should be taken to imply that a bear market decline is imminent – only that a bit of caution may be in order.

Chart 4 – Decline of $1,000 invested only during September, October and November of each pre-election year since 1935.

UTILITY/TRANSPORT BELLWETHER SYSTEM

Another analysis tool that I have written about in the past (November 1st, 2006) is the Utility/Transport Bellwether System (UTBS). In a nutshell, it turns out that it is a bullish sign for the market overall if the Dow Transport and the Dow Utilities are outperforming the Dow Industrials. Specifically, the percentage return for the Dow Transports over the past 100 trading days is compared to the performance of the Dow Industrials over the same timeframe. If the Transports have outperformed the Industrials that is considered bullish. The same comparison is also made between the Dow Utilities and the Dow Industrials. Here too if the Utilities have outperformed the Industrials it is considered bullish.

Chart 5 displays the decline in the value of $1,000 invested in the Dow Industrials only when both measures are bearish since 1986. As you can see, extended rallies in the face of a bearish reading here are the exception rather than the rule.

Chart 5 – Growth of $1,000 invested in the Dow Industrials when the Industrial have outperformed both the Dow Transports and the Dow Utilities over the past 100 trading days (since 1986)

To further illustrate the usefulness of these measures, Chart 6 displays the growth of $1,000 invested in the Dow Industrials only when both readings are bullish (since 1986 also). As you can clearly see, the stock market has a strong tendency to advance when the Transports and Utilities are both outperforming the Industrials.

Chart 6 – Growth of $1,000 invested in the Dow Industrials when the Dow Transports and the Dow Utilities have outperformed the Industrials over the past 100 trading days (since 1986)

In recent weeks, the performance of the Transports and the Utilities has tailed off thus presently leaving this indicator in unfavorable territory. While this does not by itself portend a meaningful market decline, it is another piece of a growingly worrisome body of evidence.

SUMMARY

So, as you can see, little by little a number of historically reliable indicators are beginning to flash warnings signs. Does this mean that it is time to "sell everything" and brace ourselves for a stock market meltdown? Not necessarily. Am I "calling the top"? Would it matter if I did? Not likely. As always, the market will do whatever it's going to do. What we need to do as traders and investors is try as best we can to be aggressive when the weight of the evidence is bullish and to exercise a bit of caution when the clouds darken. The evidence I am looking at and have detailed herein suggests that the days of endless sunshine may soon be drawing to a close.

ay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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