Predicting The Market's Mood Swings
When the Federal Reserve cut interest rates in December, it appeared as if nothing could hold back stocks. But subscribers to one market letter got a different message. Mark Leibovit, publisher of Volume Reversal Survey, advised his followers on Jan. 10 to start selling.
The reason? Leibovit's proprietary trading system--which focuses solely on trading volume--was signaling that the rally was about to peter out. With the Standard & Poor's 500-stock index down nearly 2% since then, his call was on the money.
Chalk one up for the technical analysts. A pure "technician," like Leibovit, is anumbers freak, poring over data on stock prices and volume to predict market moves on the basis of recurring patterns. Such analysis is based on a belief that stocks, and the market as a whole, have an eerie quantitative life of their own, apart from mundane influences like interest rates.
Technicians admit that the method is not a perfect science. "You're not looking at a balance sheet," notes Leibovit, who is based in Sedona, Ariz. "You're trying to quantify human emotion, and ultimately, that's a subjective call."
For that reason, many market timers take into account less arcane measures, including company fundamentals, market valuation indexes, transactions by insiders and short sellers, and government monetary actions. These are signs that all investors can follow.
Experts don't recommend that small investors use timing systems to flip in and out of stocks. For most folks,buy and hold remains the best policy. But by learning howto take the market's temperature, more aggressive investors may be able to trimtheir stock positions before expected downturns and rebuild them before marketrebounds.
Indeed, Robert Nurock, a Paoli (Pa.) technical analyst, believes that given current trends, investors who are heavily into stocks "should be thinking of allocating some assets to other investments."To be sure, no one indicator can predict what the market will do. But some measures, when studied together, have proven reliable at signaling changes. Here's a look at some of the more basic indicators and how to read them:
-- Price-earnings ratio: This essential calculation represents the multiple of a company's trading price to its earnings and reflects the public's sentiment about the prospects for future growth.
Gauging the proper market p-e is trickiest coming out of a recession, as we are now. The current p-e ratio for the Standard & Poor's 500-stock index--25--hasn't been as high since the 1987 crash. True, in today's lower-interest-rate environment, high p-e's look less alarming. But analysts fear that investors may be depending on higher profits than corporations will be able to deliver. The market is valued at 15.1 times next year's profits--still high by historical norms.
-- Price-dividend ratio: Given how profits can gyrate, many analysts look instead at the relationship between stock prices and dividend yields, which often are more stable. Newsletter editor Norman Fosback says the price-dividend ratio historically has proven to be one of the most accurate barometers of the market's trend.
With the Dow Jones industrial average yield now at 3%, investors may wish it otherwise. According to Fosback's research, whenever the average yield of Dow stocks has fallen below 3% since 1941, the market tumbled 10% within a year. But the signal "can persist for a year or more, by which time people tend to forget or ignore it," says Bernadette Murphy, technician for M. Kimelman & Co.
-- Initial public offerings: One of the best gauges of market sentiment is the volume of new stock issues. In the latter stages of bull markets, investors have shown a penchant for being careless about what they'll buy--and Wall Street is only too eager to take public a lot of highly speculative companies. Fosback measures the volume of initial public offerings (IPOs), then uses the gross national product as a benchmark. What Fosback found is that when IPO dollar-volume exceeds 0.5% of gross national product, the market has probably become too frothy. At 2.11%, the current level marks one of the highest readings ever.
As a backup, Fosback also studies "secondary" offerings by public companies, such as General Motors' recent $2.3 billion stock sale. He finds that 10 or more a week usually portends a correction. Since March, secondary offerings have been averaging 8.9 a week--the same pace as before the 1987 crash. Again, that's bad news.
-- Short sales: For the realstory, technicians put their ear to the trading floor gfthe New York Stock Exchange. There, the specialists take the market's pulse every day, handling trading in more than 1,500 stocks. To get a reading from specialists, technicians compare how much stock they are selling short vs. the public's short sales. Short-sellers, who bet that stock prices will drop, sellborrowed stock, planning to repay the loan with stock bought after the price slumps. Analysts take note whenever specialists' short sales exceed the public's. With specialists now shorting 1.4 times more stock than the investing public, analysts consider that a moderately bearish signal.
-- Insiders' transactions: Specialists may know the trading floor, but nobody knows individual stocks like the executives and directors running the companies. So another good barometer is what they're doing. According to technicians, insiders were selling heavily during March and April, but began buying again in May. Although this indicator is giving off mixed signals, it could be a sign of a coming rally.
-- Trading patterns: Some technicians, known as "tape watchers," insist it's important to look beyond stock prices to indicators that track trading volume and patterns--the crosscurrent beneath the surface that could augur tide changes. One closely watched indicator is the "advance/decline" ratio, which compares how many stocks rose and fell in a given day or week. This information gives analysts a sense of whether a rally is losing steam or is in its infancy. Alan Hadhazy, senior analyst for the Institute for Econometric Research, says it often takes the market time to gain momentum and "the fuel for any price move is alwaysvolume."
A common calculation is to subtract the number of declining stocks from the number of advancing stocks, then divide by the number of total issues traded. When averaged over 10 weeks, analysts have found the norm to be 25%, with anything above 40% bullish and below 15% bearish. Since February, this indicatorhas dipped below 13%. It's back up to 15.4%, but the number of advances and declines has recently been equal, suggesting a market top.
-- Federal Reserve: One thing that causes technicians to throw their p-e and volume charts out the window is any move by the Federal Reserve to tinker with monetary policy. Many analysts believe it's the credit supply that governs the economy and the markets. "If there's anything you learn, it's to go with the Fed," says Martin Zweig, editor of The Zweig Forecast.
Technicians have devised a simple timing system thatis triggered by a series of Fed actions. Any successive moves to change stock margins, the discount rate, or bank reserve requirements in ways that uniformly ease or tighten credit sets off a signal. Fosback calls three bouts of Fed tightening "three steps anda stumble," since the market almost always falls afterward. Two consecutive Fed easings--known as "two tumbles and a jump"--have historically produced an average 31% rise in stocks a yearlater.
Fosback swears by this system, and with good reason: Had an investor bought on each of the 19 tumble signals since 1914, and sold a year later, $10,000 invested in the S&P 500 would now be worth more than $870,000--far better than buy-and-hold.
Despite Leibovit's bearishness, the Fed's accommodative posture is leading many technicians to ignore their longer-term signals right now. They're betting that the government's willingness to ease credit will enable stocks to climb higher by the end of the year. That's because Wall Street believes the Fed will continue stoking the economy to ensure that President Bush wins reelection. In fact, since 1920, the S&P has risen an average 11% between June 1 and Election Day in Presidential election years.
What happens after that? Some technicians feel a correction is inevitable.
Will they be right? Only market timing will tell.