Imagine getting a call from the business editor of a major newspaper.
He has a request…
‘The paper is running a share tipping competition. Can we publish your name, photo, and 10 stock selections for the next four weeks?’
What would you do?
Well, that’s exactly the position my old business partner and I were in. We had a fledgling stock advisory business. The chance to appear in newspapers around the country was irresistible.
I remember one journo commenting at the time. He said that picking the market over such a short period is like reading tea leaves. His view was that it was more a game of luck than skill.
We did OK in the end. Our first appearance was a win. The editor then asked us back for the end-of-year final. We won that too. This got us a regular spot on the panel for the next few years.
Timing the market is never precise — there’s always an element of chance. But you can swing the odds in your favour with the right strategies. An example is buying into strength.
Knowing the overall financial backdrop also helps. You’ll never know the market’s next move with GPS-like accuracy. But you can find some valuable clues if you know where to look.
Reading the tea leaves
I’d like to tell you what the All Ordinaries will do next. But I can’t. There’s no special formula to pinpoint the market’s every move. Trading is uncertain by nature.
But there are ways to gauge where things stand.
I’m going to share an indicator with you in a moment. It helps me access the market’s position within the bull and bear cycle. I think you’ll find it interesting.
But first, I want to show you a chart I saw this week. It’s from Bank of America Merrill Lynch’s monthly survey of fund managers. This will help set the scene for this week’s update.
Have a look at this…
[Click to enlarge]
You’re looking at the average cash balance for 213 money managers. The total funds under management for this group is US$563 billion. These are the big global hitters.
This is a fascinating chart. It captures the ever-changing mood of the market.
You’ll notice the cash balances swing between about 3.5% and 6%. The low readings are when managers are bullish overall, while higher numbers occur when they are fearful.
The charts list four keys events: 9/11, Lehman’s collapse, Grexit fears, and China’s currency devaluation. The peaks mark the end of equity selloffs.
Now, have a look at where the percentage was in mid-October. It was 5.8% — the highest level since 9/11. And it got there without a major bust. People were fearful of the potential for trouble.
Let me show you another image. This time, I’ll pair the graph of average cash balances with a chart of the All Ordinaries.
Check this out…
[Click to open in a new window]
Take a moment to study this. I’ve added vertical lines to draw your attention to some key points.
Now answer this: What tends to happen around the peaks in fear (i.e. high cash levels)?
I’ll tell you what I see — a series of market lows. High cash levels often lead to higher equity prices.
The cash balance graph is from October — so it’s pre-US election. There’s been a shift in November’s survey. Cash balances are now at 5% (down from 5.8%). But they are still historically high.
My take on this is positive. I don’t believe the backdrop for a major bear market exists. History tells us that markets usually don’t crash when cash levels are high.
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A second opinion
I’ve got another indicator to show you. This is one I made myself. You may have seen this before — it helps identify when the market is overbought or oversold.
This is how it works…
The indicator calculates how many of the top 300 companies are in a bullish trend. The stocks change over time, but the number remains fixed at 300.
I use two tests to determine the trend — a 100-day moving average and a 40-day breakout. A stock is bullish when its price is above both. The uptrend remains in place until the shares fall below the moving average.
OK, let’s have a look. There’s a bit to take in — I’ll explain it all in a moment.
[Click to enlarge]
The top chart is the indicator — I call it the ‘Quant 300’. It shows the number of bullish stocks. You can see it mostly ranges between 25 and 225. The data goes back to January 1993.
Below this is the All Ordinaries over the same period. I’ve aligned the charts so that the dates match.
The next thing to note is the red lines. These represent the lows for the Quant 300. I’ve marked the points where the number of bullish stocks fell below 50.
Now, this is where you need to study the chart closely.
Follow each line down to the All Ordinaries chart. A reading below 50 typically leads to a multi- month rally. Some have been major turning points — others strong bull market extensions.
Another thing you’ll notice is the timing of big declines. They typically occur when the Quant 300 is above 150 — it’s currently close to 50.
An exception to this was during the GFC. The indicator rebounded from oversold levels in January 2008. The market initially surged, but then began collapsing in May.
Make no mistake…this isn’t a GPS for stocks. I’d describe it more like a barometer for predicting the weather — it sometimes forecasts clearing skies ahead of a storm.
I have one more graph for you. It shows the recent years in more detail.
Check this out…
[Click to enlarge]
Many indicators work best near extremes. This is when I believe they can offer the most value. The cash balance graph you saw earlier is a good example.
The Quant 300 is also at extreme levels. The indicator was recently below 50. It’s now starting to rise, and is back at 53. This has often been a predictor of bullish conditions.
There are still plenty of analysts talking about potential trouble ahead. This could of course happen — anything is possible. But I don’t think it’s likely anytime soon.
Until next week,
For The Daily Reckoning
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