1-800-504-8505 | Contact us
Subscribe rss

3/9/2010 12:00:00 AM

Proactive investing is all about an identification of the market cycle

Proactive investing is all about an identification of the market cycle and allocating your portfolio in accordance with the prevailing trend. During bull cycles, such as the current one we have enjoyed for nearly a year, one of your more difficult challenges is to differentiate between a correction and a change from bull to bear cycle. During a correction, the market will recover to a new high and you’ll want to stay invested fully expecting your portfolio to recover to a new high watermark once the bull cycle resumes. Of course, if the cycle is changing over to a bear market, then the market won’t recover and you’ll want to sell to manage risk and protect your wealth.

Drawing a distinction between a correction and cycle change is a fine line. The proactive indicator set developed at the Institute is designed to help you identify action that is typical during corrections and differentiate it from action that is typical during cycle changes.

Every bull cycle will experience corrections, usually multiple corrections. A correction occurs when supply and demand for stocks come into balance. For most of the period from March 2009 until January 2010, demand strongly outstripped supply and the market trend was strongly positive during that period.

During the 2003-07 bull cycle there were meaningful corrections in 2004, 2005 and 2006. Corrections are part of a bull market cycle, helping to consolidate the previous strong gains before the cycle can extend further. The corrections that occurred in the 2003-07 bull cycle did just that, consolidated gains and allowed the market to regroup and push on to higher ground.

When the market cycle is changing from bull to bear, market action can resemble a correction during the early stages of the topping process. During the topping process, the market is generally unable to push ahead and capture higher ground once the correction is over, or at least minimal new gains are made during the recovery periods. The shallow recoveries are followed by yet another correction and the cycle repeats until the trend reverses down.

A pattern of corrections followed by marginal gains can repeat a few times during a major topping process. The bigger picture shows supply gradually taking over the reigns from demand. During a period like this, our indicator set will gradually turn negative to tell us that the important trend or market cycle is changing. The Universe Trend Indicator will usually be the first indicator in the set to turn negative. In fact, the UTI usually turns negative months ahead of the market top. Some time later, the confirming indicators of the set, the Cash Comparison and Long-Term Momentum (LTM) will also turn negative. Our sell discipline is programmed to this indicator set… when it turns negative you should sell. When it stays positive, you should remain invested.

When the market was transitioning from bull to bear cycle in 2007, the first correction hit in February 2007. The global stock index dropped more than 10% in five short trading days… that was the first shot across the bow. Our indicator set remained positive throughout this period. The Universe Trend Indicator, the early indicator in the set, peaked in April 2007, approximately six months ahead of the stock market peak.

The market recovered to a new high and then the next correction hit in July 2007, which lasted about one month. The market recovered and hit another high in October 2007, but the progress was marginal. This was the absolute peak in the 2003-07 bull cycle. In November 2007, the third correction in nine months occurred. This decline wasn’t a correction, it was the start of bear cycle.

The confirming indicators in our indicator set turned negative in November 2007. First the cash comparison, followed by the LTM eleven days later. When the indicator set turns negative, that is your sell discipline and signal to move to cash. When the indicator set turns negative, you know it is not a “correction”. Instead, it is a change in the market cycle.

A similar progression of events took place during the topping process in the year 2000. There were a series of corrections and our indicator set gradually turned negative. The Universe Trend Indicator was in a negative cycle since October 1999, well ahead of the market peak. The confirming indicators turned negative in September 2000 (LTM) and October 3, 2000 (cash comp), which is when the sell discipline kicks in.

Other indicators outside of our proprietary set can also help you differentiate between a correction and a cycle change. One of my favorite quick and easy indicators is a check of the number of stocks hitting a new 52week low. As a rule of thumb, you want to see the number stay below 40 during corrections. An occasional spike above is fine as long as it doesn’t persist for a week.

When the market is evolving from a bull to bear cycle, the number of new lows will exceed 40 and accelerate. The number of new lows was subdued in early 2007 during the corrections. With each subsequent correction, the new low numbers spiked higher and higher until hundreds of stocks were hitting new lows.

During the latest correction, the highest number of new lows occurred on February 5 with 23 NYSE stocks hitting a low. New lows have been on the decline since then and every day this week there were only 1 or 2 stocks hitting a new low on the NYSE… healthy numbers.

Other indicators such as the VIX (CBOE Volatility Index) and LIBOR rates remain very well behaved. In fact, the VIX index has now dropped back down close to 17 after touching an intraday high of 29 in early February.

Investing is always emotional; however, it is much more emotional for investors that do not have a well-defined discipline to know when to sell. Those investors are always second-guessing themselves, wondering if they are making the right decisions. Clueless media reports just make things worse. One recent morning CNBC flashed BREAKING NEWS: Volatility surging, VIX up 5%!!! The average investor wouldn’t know that a 5% move in the VIX is hardly breaking news and has happened most days in the last two years. Yet I can just see the face of an investor seeing that BREAKING NEWS flash and breaking into a cold sweat because they don’t know if that means they should sell, buy or vomit. You can avoid such displays of ignorance and indecisions because you have a proven indicator set and the peace of mind knowing that when the next bear cycle hits, you’ll be able to identify it AND know what to do.


Investor Education Institute © 2005-        Terms and Conditions |  Privacy Policy |  FAQ   (virtual)