Would you trust a broken navigation system? Like a broken navigation system, news coverage is leading investors in the wrong direction. To illustrate:
Sunday, June 10, 2012:
“US stock futures gain 1% on Spain aid deal”
“Global markets buoyed by EU aid for Spanish banks”
Monday, June 11, 2012:
“Global market rally fizzles as Spain bank bailout details unclear”
“Spain bank bailout optimism gives way to fear”
Tuesday, June 12, 2012:
“Wall Street rallies despite unease of Europe”
“With much unclear on Spain rescue, markets yo-yo”
Perhaps I’m just not bright enough for news-based investing, but if I had invested based on the above news coverage, I would have bought high and sold low.
Money Flow Trumps News
More important than news events is money flow and investor sentiment (sentiment is an indirect money flow indicator).
A number of money flow/sentiment indicators pointed towards a rally in early June. One such indicator tracks the so-called “smart money” and “dumb money.” In late May, insiders (smart money) were buying stocks while retail investors (dumb money) bailed.
In addition, newsletter writers were not just bearish; they were actually recommending short positions on a scale that rivals prior extremes.
Based on measures institutional firms use, investors also turned extremely risk adverse.
The contrarian message of the above indicators suggested higher prices.
Enhancing Money Flow
Although the month of June is generally part of Wall Street’s summer lull, election year June’s have a bullish bias.
Technicals also pointed towards some sort of bottom in early June. The June 3, ETF Profit Strategy update pointed out that: “Both RSI and the McClellan Oscillator are above their May 18 low despite Friday's heavy selling. We've been looking for a price low against that kind of divergence because it commonly signifies a bottom of some sort. Both indicators could drop a bit further. In fact, another low in combination with a reversal day (stocks decline and recover thereafter) would further increase the credibility of any new low."
Based on the message of literally dozens of indicators, the June 3 ETF Profit Strategy update prepared subscribers that: “The next support is at 1,267 and 1,248, which is the most likely range for a bottom” and recommended to: “Scale out of short positions while in the bottom target range (1,284 - 1,248) and pick up some long positions.”
The Newsletter also drew a parallel between the bottom process that led to the October 2011 low and the current process and published the chart below on June 4 (the S&P fell as low as 1,267 that day and created the expected reversal day).
What Sort of Rally Will it Be?
How far will this rally carry? Here are lessons we’ve learned from prior rallies:
1) Rallies have gone further than expected
2) Each rally had a shakeout decline before another relentless leg up
3) The sentiment and money flow extremes mentioned above signify a bottom about 8 out of 10 times. However, when they fail and a bottom isn't found the bottom will fall out. That's why it's crucial to know the must-hold support level and use it as stop-loss for long positions.
The message for investors is to hold on to long positions and provide enough breathing room, not to get stopped out by a shakeout decline, but to be aware of important support that – once broken – would likely lead to a meltdown.
This week’s performance of the S&P (SNP: ^GSPC), Dow (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC) and Russell 2000 (Chicago Options: ^RUT) illustrates the need for patience. Patience is much easier when your buy decision is based on facts, when you know the odds are in your favor and when you know the trigger level (key support) that tells you when you're wrong.
The ETF Profit Strategy Newsletter distills the message of dozens of money flow, sentiment, seasonality and technical-based indicators into easy to follow buy/sell recommendations along with short, mid and long-term forecasts and the target for this rally.