The Tycoon Report

These Simple Market Indicators Clarify this Market

Thursday, March 8, 2007 | Chris Rowe

I'm going to hypnotize you today.  You are getting sleepy...  Your eyes are getting heavy...  I'm going to count backwards from 3, and when I snap my fingers, you are going to be in my office, working with a bunch of Wall Street veterans.  You'll read the charts below, and you'll turn down the volume of the hype in your e-mail box each day.  You'll look at the stock market as well as the other companies in my new (publishing) business through a different lens, and you'll laugh...  3... 2... 1...

It's funny.

I subscribe to all of these other newsletters because, as a businessman, I have to understand my competitors.  Watching our competitors play is one thing that keeps me in this business as opposed to going back to money management (where I'm tempted to go every day.)

Our competition is just so silly that they make our job easy.

I look at the subject lines of the e-mails that they send me.  A few weeks ago one competitor (whose name I won't mention) sends me an e-mail with the subject line that says something to the effect of "Top 10 stocks to own for the coming bull market" or something like that.  The same exact competitor sends me an e-mail a few days ago with the subject line to the effect of "How to take advantage of the coming bear market".  LOL!!  I'm telling you, these guys could have been the Wall Street analysts who told the little guy to buy while the firm that they worked with sold that same stock out of the institution's accounts.

At the end of 2006, we issued the report, "Tycoon's 7 for 07", where we talk about the high risks of today's market.  We, of course, talk about the bull side and the bear side, and the idea is that whatever direction the market is moving in is what our competition is going to highlight which puts YOU at a disadvantage (if you listen to them.) 

We helped people understand what cards are in the deck that could potentially be drawn and how to handle them. 

Anyway, now our competition is telling you to BUY-BUY-BUY. 

One day (a long time ago,) I realized that I had a bad track record for calling market direction.  I actually used to use logic based on fundamentals to try to predict the market's direction.  LOL!  Imagine that?  Silly, silly boy.  Quite naive I was.  Finally, I decided that I would increase my odds of being right if I were to focus on two things.

1) Instead of trying to call the direction, I have to understand the current market risk.

2) Go to the history books and understand that history almost never repeats itself exactly, but since human nature doesn't ever change, if I respect history and move accordingly, I will be right at least 7 out of 10 times.

Let's take a look at some history and some indicators and then you can write in and tell ME what you think will happen next...

I'm going to focus on the Nasdaq since it's the most volatile of the top indices (and more fun to look at.)

First let's take a look at the "trading range".

Below is a chart of the Nasdaq dating back to 1999.  Now, there are 1,000 different indicators when it comes to technical analysis.  But I'm only going to talk about the simple ones today as I'm sure you're very busy.

I've drawn two lines creating the trading range or "channel".  (Yep, that's why I make the big bucks.)



Seriously, though, if you take a look at the long-term trading range, it's pretty clear.  It's like just about anything in life: to get a clearer picture of what's going on, you should take a few steps back and look at the big picture.  Of course nothing is absolute, and like I said, the surest bet that you can make in the stock market is that history won't repeat itself exactly.  But if you trade based on the historic trading range, you are likely to be right 7 out of 10 times.

Let's zoom in a little bit here to a chart that starts with the bear market bottom in 2002-2003.  Inside the trading range, I have drawn circles with lines through them.  I almost turned them into unhappy faces, but thought that you might not take me seriously anymore.  I'd hate to shatter my image. >:-(



I've circled the points where the market reversed its trend with an above average long leg down, each time cutting right through short-term support.

Note that each time that occurred was after a continued market run to the upside, and each time was followed by continued decline.  The decline also happened right after the market hit the top of the trading range (aka the channel.)  Looks kind of like what just happened, huh?

Now, I'm not saying you should dump everything and go nuts selling your stock, but don't be "fooled" (hint hint) by the e-mail subject lines that pretty much mimic CNBC when it comes to whipping you around based on yesterday's market.

Now let's take a very quick look at "moving averages."  The main advantage of moving averages is that they smooth the data in a chart which can be confusing when you look too closely at the details.

There are two types of moving averages:

"Simple moving average" and "exponential moving average".  The simple moving average (SMA) averages the closing prices over the period of time that it highlights.  (50-day moving average tracks the average price over the last 50 days.  Hence the name "simple.")  The exponential (EMA) averages the closing prices of the last number of days, but assigns a greater weight to the more recent prices, so it's more sensitive to current price action.

Take a look at the chart below which shows the 10, 50 and 200-day SMAs.  The 10-day average (hard to see yellow) is more for short-term thinking, so to illustrate my point, we'll focus on the 50-day SMA (blue) and 200-day SMA (weird brownish.)


Based on the chart above, you probably understand why the hard core fundamental analysts dismiss charting methods as the "squiggly line theory."  Best of luck to them...

But take a look at each point that I highlighted in red when the Nasdaq slices right through the 50-day moving average (blue.) 

Each time this happened since the market bottomed in 2003, the Nasdaq continued trading lower and made its way below the 200-day (longer-term) moving average (brown.)  I highlighted in green any point when the market moved below the 200-day.

Now, don't make the mistake of taking action any time the averages are only slightly broken.  But when the market (or a stock, or a sector) slices right through the average like this, it is time to pull the reins back a bit and be at least a bit more defensive. 

If you are a long-term investor and don't want to pay taxes on the sale of your stock, there are other ways to go about doing this, like buying ETFs that have an inverse relationship to the market, or by using options to hedge your portfolio.

SIDE NOTE: You might also notice the flip side of the coin if you look to the far left at the 2002-2003 bottom.  The market was below both the 50-day SMA as well as the 200-day SMA.  But when the market made its bottom, it sliced right through the 50-day in a big way, to the upside, and then did the same with the 200-day.  That was a clear indication that the market had bottomed.  That was also when I was shouting at the top of my lungs to investors that they need to step in and buy, but it was nearly impossible to get anyone to listen.

Now let's take a quick look at the same chart using the "exponential moving averages" (10, 50 and 200-day.) 



This shows a similar picture which is only slightly different.  Although the Nasdaq is closer to the 200-day "EMA," you can see that the Nasdaq is still quite far from the bottom of the channel.  This tells me that while it looks like much of the selling has already taken place, it is still a good idea to pull in the reins and exercise caution.

Now, as you probably know, the fact that the market had been so far above its 200-day moving average, as well as the top of its channel, tells us that we may have been overbought relative to where we were.  But that isn't good enough if we want the complete picture of the current risk. 

Let's take a look at another indicator which paints a picture of the "breadth" of the market.  The NYSE Bullish Percent indicator was shown to me by Teeka Tiwari in 1997 when we started working on Wall Street together, and it helped me tremendously to navigate my way through the 1998-2001 period.  (My clients thank you, Teek.)

The NYSE BP is not a directional indicator, but it is a risk indicator.  And when used in conjunction with other tools such as the ones that we covered so far, it gives us a much clearer picture.  This is because when the market bounces off of the top of the channel, and/or cuts through the 50-day moving average, I want to know whether we were in what is considered to be "high risk territory," or "low risk territory".

That is what the NYSE BP tells us.  It is a chart that tells us whether the bulls or bears are in the driver's seat, and by looking at the chart below, I know that the bears are in the driver's seat (whether the market happens to be up or down that day.)

The NYSE BP which ranges from 0-100, gives us a reading of what percentage of all stocks on the NYSE are on point and figure bull signals.  The basic idea is that if 80% of the stocks on the NYSE are on bull signals, then the NYSE BP will be at 80.

When the NYSE BP was over 70 (it was up to 74 in February,) we were considered to be in high- risk territory (but this wasn't to say that the bears were in control yet.)

When the NYSE is below 30%, we are considered to be in low-risk territory.

But when the NYSE BP moves from being over 70% (in a confirmed up-trend) to below 70% (in a confirmed down-trend,) it is a very bearish signal referred to as a "Bear Alert."  This is what we are in right now as the NYSE BP is around 62%. 

This is when it is time to get defensive.  That means you start to sell your lagging positions, and reduce your exposure to risk.  You don't have to go nuts here as the long-term trend is still intact, and we are not in a bear market.  But reducing your exposure any time you see all of these things happening will likely help you 7 out of 10 times, and that's what it's all about.

(A SIDE NOTE: The worst possible signal is called "Bear Confirmed" which has the same criteria as above, but also shows the NYSE BP on a point and figure sell signal, which we have not seen so far.)

I said I would keep it simple here, and you don't have to understand all of the point and figure lingo to see in the chart above that a larger and larger number of stocks are coming off of bull signals.  What this tells us, basically, is that we are seeing broad-based selling.

One last indicator, and then I have to get back to business at The Trend Rider...

I have talked about the VIX on a number of occasions in past articles that you can find at TheTycoonReport.com.  The VIX is the fear gauge for the S&P500 which is a contrary indicator.  But what about the fear gauge for the Nasdaq?  The symbol is VXN, and the chart is below.


Notice what happened when the market corrected in May of last year.  The VXN spiked higher.  Now, they say that when the VIX (which is related to the S&P500) is under 20, there is excessive complacency, and over 30 is excessive fear.  But just as the Nasdaq is more volatile than the S&P500, the VXN is also more volatile, so I would say that under 25 is excessive complacency, and over 35 is excessive fear which usually happens when we are close to a bottom.

Now as you can see, the VXN definitely spiked higher, but unlike last year when we saw three spikes, we have only seen one spike so far.  Sure, the market was rattled a little bit, but I don't think people are as scared as last year.  And they don't have to be. 

Also, you may notice that while the VXN popped, it wasn't as much as it did back in May.  Not that comparing the this year to last year is that important, but I want you to understand what this means.

We have to take all of what we can gather, and then go with our gut. 

What do we know so far?

1) We bounced off of the top of the trading range, and we're still nowhere near the bottom of it.
2) The 50-day moving average was sliced through, and hasn't yet traded under the 200-day.
3) The NYSE BP went from 74% to close to 62% ("Bear Alert".)
4) The VXN did, in fact, pop higher.  This shows us that people got scared, but not overly scared, and usually the first drop in a market is not the final, especially on high volume like we saw on this drop. 

Oooooh - all right.  One more chart to show the high volume sell.  The significance?  Institutions are forced to trade large trends like the channel that we show you at the top of the page.  Why?  They're like bulls running through a china shop.  It's obvious when they start to sell because the charts show us the volume and large price swings.


That's all folks.  The takeaway here is that you shouldn't panic, but exercise caution in this new market.  Don't listen to Jim Cramer and "buy-buy-buy" like crazy unless you are trading for a few percentage points here and there.

Here are the facts: We are in the middle of a short-term decline in a long-term trading range.  The last four times this happened, the market moved below the 200-day SMA which hasn't happened yet.  The economy is "strong" right now and we are in a pre-election year which is usually a strong one, so we don't want to throw the baby out with the bath water.

There are four basic stages of the stock market cycle:
1) Basing (after a decline.  An example would be the 2002, 2003 bottom)
2) Rising
3) Topping
4) Declining

In phase 3, which is likely where we are for at least the short-term, the price increase loses its upside momentum, fewer industry groups show rising average trends, and rallies should be looked at as selling opportunities.  This is because, as the market slows, the earlier buyers are distributing stock to the late coming investors.  Typically, many investors are more fearful of missing a profit than taking a loss and are hesitant to believe that the bullish fun may be coming to an end for the time being.

Remember folks, follow the rules and win 7 out of 10 times.  That's the name of the game.

3...2...1...SNAP!  You're back.  (Remember?)


“Profit from the Trend”

Chris Rowe
Chief Investment Officer
The Trend Rider