TSX TrendWatch Weekly

I’m sure we’re all wishing for a bottom sometime soon, as the S&P/TSX Composite Index declined yet another -1.4% last week, bringing the year-to-date figure to -2.2%. It’s pretty boring just sitting on cash that’s earning no income to speak of.

The trend and consistency pairs for the S&P/TSX Composite Index and S&P/TSX Venture Index are now -0.9%/54% and -1.9%/69% respectively… suggesting more downside.

But some analysts are starting to talk about bottoming formations, however, particularly in the US equities markets and more specifically in the hardest hit area… financials.  The rationale is that crude oil and natural gas have turned lower, easing pressure on the economy. More upbeat earnings reports from a small handful of US banks have turned some heads too.

The CBOE Volatility Index rose to above 30 early in the week, then declined to 24 by Friday. Some see that kind of thing as characteristic of bottoms too, but I think the argument is tenuous. Volatility is not directional. You can have high (or low) volatility in both bull and bear markets. I wouldn’t put a lot of weight on that. [BTW, we’d be giving you the Canadian volatility counterpart, but the numbers for the S&P/TSX Composite Index counterpart are not easy to find.]

Others point to the NYSE McLellan Summation Index, a technical indicator of market breadth. Extreme readings to the downside are taken as market bottoms.  Here is a quote from the McClellan Financial Publications website…

“Among the most significant indications given by the Summation Index are the identification of the end of a bear market and the confirmation of a new bull market. Bear markets typically end with the Summation Index below -1200. A strong rise from such a level can signal initiation of a new bull market.”

The NYSE McLellan Summation Index accelerated to the downside reaching –1218.42 on July 16, 2008, before recovering to close at –1187.75 by the end of the week.

Again, readily available Canadian counterparts are hard to find, which is why we create our own (hopefully better) measures.  Our Percentage of Stocks Trending Up chart provides similar information in what we consider to be a more useful index. The NYSE McLellan Summation Index keeps a running total of advancing minus declining stocks. We keep a running indication of the percent of stocks that are advancing (in their underlying trends), which implicitly factors in the decliners too.

Our “special guest” chart this week provides a longer term perspective than the 52 week chart you routinely see here.  We go back to July 2000, providing 8 years of weekly %-Up data.  Naturally, with over 400 data points, the chart is going to look pretty choppy and dense, but we’ll walk you through the aspects that you should take away from it.

The black line is nothing more than a simple linear regression… the best fitting straight line through that data series. The simple message there is that you’re better off buying stocks than selling them short in the long run (if 8 years can be considered the long run).

The odds are almost 60:40 in your favour over that time frame, even if you chose your stocks randomly.  Obviously, you wouldn’t do that, so if you picked some of the best performing stocks in the best performing sectors, your odds would be much higher.  That assumes of course that you’re also checking the fundamentals and news about each company before clicking on the “buy” button.

The next thing to notice is that most of the action over the years has been between 20% and 80%, with few weekly data points remaining beyond those limits. When those spikes did occur, there was typically a sharp reversal in the opposite direction.  On the downside the extent of the reversal in each case brought the reading from below 20% to 40% within a week or two, then up above 50% a week or two beyond that. The summer 2002 rally was a bit of an exception, since the index didn’t quite reach 40%, then dipped back below 20% again before finally surging about 50%.

Now that we’re sitting at 19% as of Friday, we’re waiting to see if there’s a further spike downward, before the pop up that we’ve seen in the past. In the 400+ weeks of data in the chart above, our index was only below 20% for 11 weeks in total (3% of the time), so we shouldn’t have to wait much longer.
But having said all this, we want to issue our typical words of caution…

1. Although we believe that our %-Up index for S&P/TSX Composite Index stocks can act like the McClellan index in spotting overbought and oversold markets, we advice against buying right at what appears to be a bottom. Some reversals from bottoms can be temporary (as in 2002).  It’s excruciating to start losing again just after investing a lot of your capital.
2. A conservative approach would be to wait until the odds are back in your favour again (i.e. above 50%). You can be even more conservative by waiting for 55%, 60%, 65%, etc.
3. If your impatient, you could consider easing back in to the best (or least worse-) performing stocks in the best sectors.  In declining markets our rough rule-of-thumb is to move into cash as the odds move against you. For us that means being approximately 80% in cash right now (100 minus the current 19% reading). We’ll probably wait for a 50%+ reading before considering purchases other than special situations. If that sounds too conservative, then consider that in the chart above the index was above the midpoint 68% of the time. But if you can’t wait, you could shift to a 60% cash/40% stocks portfolio when the index bounces up to 40%, 50:50 when it reaches 50%, etc., so that you’d be roughly 70% or more invested when the index hits 70%.
4. While there may be more downside, it’s probably too late for short-selling.  You can lose big-time if the market really is at a bottom and there is a sudden flood of buy orders.  If you’re going to play that game, make sure the company you’re shorting is very liquid (i.e. large daily trading volume and low bid/ask spreads). Otherwise, you may not be able to cover your shorts without major losses.

This coming week or two could be quite interesting. Stand by!