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Conviction - please!



One of the greatest problems with the market right now is that there is no conviction in either direction because there are solid arguments coming from both the bull and bear camps - and each camp knows it. That leads to very limited follow through due to limited conviction, which allows sentiment to shift very quickly. The lack of conviction follows three lousy years accompanied with very high volatility - both up and down. Traders have been forced to carry smaller positions and question their most recent move on a daily basis because one day the market is breaking out and within a couple days it is breaking down. Frankly, there is no trust in the fundamental or technical framework of the market. It doesn't matter if that is right or wrong; it just is what it is.

For three years, investors have waited for the environment to become more friendly and each time it looked more friendly excitement picked up and both individual investors and portfolio managers chased the strength due to all the evidence that things couldn't get worse, which could only mean they could get better and stocks would ultimately move higher.

Unfortunately, we have all found out that things can get worse and even if they don't, it doesn't mean they have to get better. The uncertain geo-political environment has been with us since the September 11th terrorist attack, the Fed rate reductions have not had the historical benefit to economic growth and higher stock prices, earnings have only really improved due to cost cutting measures vs. demand growth, valuations remain at the high end of the historical mean and no one trusts the earnings reports that do come out. These factors have all been in place for some period of time and there remains no identifiable resolution to them. That limits conviction for any bulls.

On the other side of the coin, we know that the third year of a President's term has never been negative since FDR and that it is extremely rare to have three years in a row of losses, much less four years (that hasn't happened since '29-'32). In addition, pre-announcements seem to be running below levels of the last few quarters, some tech companies are giving better guidance on demand and interest rates remain near historic lows. These factors help limit the conviction of the bears.

So we are left with a very volatile tape with no sustainable follow through in either direction. Without conviction, there is no buying the dips or shorting the spikes, there is just a "quick trade" where exposure and therefore risk is kept low. Typically, when the fundamental backdrop is murky, many look to the charts, which in large part haven't worked so well either. Just look at IBM over the past six weeks. There was the obvious breakout in November, followed by an even more obvious breakdown in December. Yet the current rally that has the makings of a breakout. The bottom line is that price levels and signals are in large part giving conflicting signals to the point where I as a technician also don't trust my "price" indicators. So as a result, I have been using a variety of proprietary overbought and oversold indicators coupled with the Stochastics, which I have written about here before.

Most of my propriety work (the stuff clients pay Kirlin for) suggests that the market is overbought, but that the overbought levels are not high enough to suggest a serious decline - yet. My stuff (research) continues to confirm my twilight zone thesis. That thesis is that right now there is no way to prove (or not prove) whether the market is in bull or bear phase. Basically, the twilight zone indicates a trading range environment where the market is going to move based on psychology and overbought/oversold levels.

Right now, the psychology has become more optimistic and the near-term stochastics (14-period with a 3 sk&d) suggest the markets are within earshot of losing momentum just as they retest the early December highs (Exhibits1&3). The intermediate-term stochastics continue to move lower from an extreme overbought level in the context of a downtrend (lower highs and lower lows)(Exhibits 2&4). Basically, this means to me that unless the market is beginning a new powerful bull phase (very little evidence of this), the best that can be expected over the coming couple of months is sideways action where enough time and mediocrity would go by to allow both the near and intermediate-term indicators to move back toward oversold without a huge price decline. The worst that can be expected is...well...kinda what investors have become accustomed to.

My main point I want to make in this article is to convey that the vast near-term upside is likely behind the tape as the early December highs have been tested and that doesn't mean the market goes straight down. That would take conviction and right now that seems to be in the shortest supply. What it does mean is that the stars are aligning to have a retest of the late December levels - so adjust accordingly.

Exhibit 1 - Near-term (daily) look at overbought/oversold indicator on SPX

Exhibit 2 - Intermediate-term (weekly) look at overbought/oversold indicator on SPX

Exhibit 3 - Near-term (daily) look at overbought/oversold indicator on NAZ

Exhibit 4 - Intermediate-term (weekly) look at overbought/oversold indicator on NAZ

Charts courtesty of Baseline, Inc.

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