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Investors: Forget the Market Theories; Watch These Two Sectors to Determine Broader Strength

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Considering semiconductors are in almost everything consumers buy, and all consumables have to be transported, these sectors typically lead economic expansion.

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"87% of all statistics are made up on the spot."
– Anonymous



Here we are, the last week of the third quarter with most asking where this year has gone. Time, a precious commodity with finite resource; imagine if this traded on the futures (no pun intended) exchange? When I was younger I can remember always being told, "Wait till you get older Kevin, time goes by faster the older you get." Of course I never believed it until now as I find myself saying the same thing to my 13-year-old son. Nevertheless, this week should be rather exciting given the idiosyncratic and bifurcated nature of this market.

Since the August 2011 20% sell-off these two terms have been tossed around and employed quite often. In all honesty, I looked up the definitions a while back to validate their proper use by market pundits and trade rags. Webster defines idiosyncratic as a behavioral characteristic relating to a temperamental peculiarity of a particular group (paraphrased). On the other hand, bifurcated is defined as a dynamic system which develops from orderly to chaotic by exponentially increasing its possible outcomes. Idiosyncratic. Yeah, that works and fits like a glove. Yet bifurcated doesn't really seem to fit as the number of market outcomes is static – up, down, and flat. In reality, it is the number of influence on those outcomes which is increasing exponentially. Some would call this splitting hairs, but who am I to say. Although interesting, does it really matter?

Coming into the end of the year is always tricky considering the 'September-October' customary nature of the markets. Within the next week investors will begin to hear about how on average, over the last 100 years, these two months provide the worst returns – the calendar effect. But why stop there, Alice? In continuing down the rabbit hole there is the presidential cycle to contend with, and the idea that the first year after the election is typically the worst of the four. Where should investors draw the proverbial theory line?

(The January effect, the quarter-end effect (window dressing), "sell in May and go away," leap-year phenomenon, Halloween Indicator, Super Bowl (AFC/NFC) winner correlation, and let's not forget the lunar cycle theory. We could go on for pages with theories developed over the last few decades. Truth be told, anything can be verified with the appropriate statistical data, and this week, which involves the quarter-end effect, is packed with economic statistics: Tuesday: Case-Shiller Home Price Index, Consumer Confidence, Investor Confidence; Wednesday: New Home Sales; Thursday: Durable Goods, GDP, Jobless Claims, Manufacturing Index; Friday: Personal Income & Spending, Chicago PMI, Consumer Sentiment.)

Ascertaining probabilities based on empirical data – that is, on observation rather than theoretical data – is where my firm hangs its hat. Over the last two weeks we've discussed how the market (the S&P 500 Index (INDEXSP:.INX)) has broken above the technically important 1,425 resistance level. Conversely, our editorials have also discussed the necessity to see further empirical evidence to give credence to the longevity and conviction behind this move. Last week's action, not seemingly apparent in the market's return, was not good as the probabilities leading to the underlying confidence behind this move deteriorated rather quickly.

This confidence comes in many forms, such as price action, volume, and secondary indices. With price action being relatively decent and volume having to be tossed out due to the SPX rebalancing on Friday, investors should evaluate the broader strength from two of the most important sectors: transportation (Dow Jones Transports (INDEXDJX:DJT)) and semiconductors (PHLX Semiconductor Index (INDEXNASDAQ:SOX)).

Not to digress on a tangent but… considering semiconductors are in nearly everything consumers can buy off the shelf (excluding food) and all consumables, i.e. inventories, have to be shipped, these typically lead economic expansion. The last week or two have not been technically kind to these areas. Not only did these not break out to the upside with the broader market having ample opportunity, but they have begun to do just the opposite -- break down.


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So what's holding the markets up? It seems the PHLX Bank Index (INDEXDJX:BKX) and the PHLX Housing Index (INDEXNASDAQ:HGX), which have been underperforming since 2007 for obvious reasons, are the catalyst. Thanks, Ben Bernanke. With that said, it's not just in these two areas where strength is rising; it's emerging in the high-beta names as well. To opine further, this is simply due to momentum players chasing return -- a dangerous game to play.

Regardless of why and how, the question becomes: Is it enough to sustain longevity of a higher move and push the market to the 2000 & 2007 highs? (~1,550)? Momentum is a tricky animal; the more it surfaces, the more it feeds on itself, but it only lasts until there is no one left to continue the buying. As sad and as big a faux pas as this is to pen, especially in the financial business, it's akin to a Ponzi scheme as it only begins to crater when the last buyer is finished, hence the danger in a move based solely on momentum. One indication of its peril is when the move becomes parabolic.


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Now that I've got your attention, let me conclude with this parting thought: It is not necessarily bad, it could even be fruitful, to invest in momentum-based trends, as long as you bring your umbrella and are willing to use it at the first sign of clouds. The SPX, on a purely technical basis, can easily have a 4% drawdown to ~1,400 -- the August base -- with the market remaining technically sound. But keep in mind this one caveat: It's what causes the drawdown that matters, not the drawdown itself.



I hope this helps and finds you well.

Editor's Note: Read more at Tesseract Asset Management.

Twitter: @TAM_News
No positions in stocks mentioned.

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