Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

With precious little to report on the economic front the midterm elections and the ensuing shakeup in Congress dominated the news all week. Those predicting that a major defeat by the self-labeled business friendly Republicans would send the stock market heading south were no doubt surprised to see solid gains in the face of the Democratic Party regaining control of both the House of Representatives and Senate for the first time since 1994. With news of the Democratic triumph and Rumsfeld stepping down, the market even brushed off weakness in sectors expected to face challenges with a Democrat dominated Congress, such as pharmaceuticals and aerospace/defense.

After last week's slight retreat, the stock market came out swinging on Monday with broad advances across the major indexes. The main drivers were high profile buyout news in several industries. Technology stocks such as Cisco and BMC Software beating estimates and raising their guidance also helped push markets higher. With the exception of Thursday's slight declines on higher volume, U.S. markets gained steadily all week. The Nasdaq 100 index led the charge higher with a 2.77% gain for the week, followed closely by the small-caps in the Russell 2000 showing a 2.10% rise. The blue chips in the S&P 500 returned a more modest 1.22% which still managed to more than erase last week's losses. With this week's resumption in upward trending action our Buy signal remains in force.

Trend Timing School

Overbought and oversold indicators

Whenever the stock market advances in a sustained fashion over a period of time it frequently enters a technical condition known as "overbought", and this in turn brings out the alarmist crowd who urge taking profits before the pull-back which they predict is inevitable. We have had a good run with the Nasdaq Composite rising about 18% from its July 21, 2006 bottom to its most recent high on November 8. During that stretch, the largest pull-back came early September and amounted to no more than 2.3%. We are not quite in overbought terrain yet but pundits already warn of the coming correction.

We know that the stock market never goes straight up, or down, for any serious length of time. Even during prolonged bull markets it needs to pause and catch its breath from time to time. In fact, market historians view pull-backs and corrections as healthy or even mandatory for the continuation of the bull market. Alas, there are no hard and fast rules in the stock market, and corrections are no exception. Nothing says that there has to be one within a given period of time, or that it has to be of such and such a magnitude.

Technical traders have long been using overbought/oversold indicators to time their stock position entries and exits. Probably the oldest and still very popular indicator is the Relative Strength Index (RSI). The name is rather confusing because, unlike most types of relative strength analysis (such as the ones we apply in our own World Index Ranking) which compare momentum strength of several items, RSI involves only one stock or index in its computation. In a nutshell, RSI is a momentum oscillator which compares the magnitude of gains to the magnitude of losses of a security over a period of time. Its value fluctuates between 0 and 100 and generally, readings below 30 mean oversold and those above 70 are said to be overbought.

The most basic use of RSI by traders is to identify a long-term trend (for which RSI provides little help) and then use extreme RSI readings as entry and exit points. For example, if you identified a long-term up trend in a security, when its RSI rises from an oversold state above 30 you have a bullish buy signal. Contrary to popular belief, entering an overbought zone does not qualify as a sell signal.

There are many shortcomings with indicators like RSI, starting with the fact that they can trade in the neutral range for extended periods of time without entering oversold or overbought territory, leaving the trader stranded on the sidelines without signals. At other times such indicators can swing rapidly back and forth between extreme readings creating numerous whipsaws for the disoriented trader. Such drawbacks have led technical traders to develop ever more complicated indicators in attempts to better RSI, and they have devised increasingly complex rules to generate signals. There are advocates of centerline crossings, and looking for positive or negative divergence between the indicator and the underlying security has become quite popular as well.

Still, the strongest weakness of such indicators in our eyes is that the extreme readings can simply be indications of a strong trend and not of an overbought/oversold condition. As seen in Chart 1 below which depicts the behavior of three momentum oscillators (RSI, Williams %R, and Slow Stochastics) for the Nasdaq Composite during one of the strongest legs of the 1999-2000 bull market, the indicators can remain stuck at extreme readings for prolonged periods of time causing the overbought/oversold trader to miss out on some of the best gains the market can provide.

Chart 1: Example of prolonged overbought market conditions


Traders have one mission which is to exploit short term imbalances. For traders to develop and try to harness technical indicators and strategies about overbought/oversold conditions is natural. We are not traders. It is important to remember that Trend Timers are long-term style investors, and instead of attempting to time every shorter term pull-back or correction we focus on the longer term trend.

When investors begin to worry about overbought/oversold conditions, they are not really looking for a trading opportunity (unless they really are traders at heart who are stuck in the wrong strategy) but they are looking for signs of a top in an attempt to anticipate and predict the next trend change. As trend followers we have to accept the fact that trend changes can be recognized only after they occur, which inevitably leads to giving back some of the gains at the end of each signal. It is the nature of the beast and nothing can change that.

With the current Buy signal almost three months old it is approaching the average historical length. Does it mean we should be getting itchy and look for ways to exit early? Of course not. We can repeat our "We follow the trend and do not attempt to predict the market" mantra as much as we want, but we realize that as a signal stretches out in time and gains accumulate, some subscribers will invariably become nervous. Should this feeling arise, the absolute best remedy is to look at the data in Table 1 below which lists all the signals lasting one year or more that our current Model generated. Knowing that the five biggest gainers top the list helps fight the urge to bail out prematurely.

Table 1: TimingCube's longest duration signals

Signal	Trade Date	Return (Nasdaq 100)	Duration (days)
Buy	10/16/1998	236.73%	531
Buy	05/25/1994	55.95%	489
Buy	10/22/1990	93.88%	485
Buy	08/05/1996	64.62%	438
Buy	03/14/2003	38.74%	413
Buy	01/03/1989	11.42%	393
Buy	03/04/1993	12.21%	386
Buy	05/12/2005	13.07%	365

We don't know how long this signal will last and how high the market will go before the next down trend comes around. The one thing we do know is that we are not about to gamble on some overbought indicator.

FAQ of the Week

Question: Where can I find stock market data and statistics?

There are numerous sources of timely stock market data including online as well as print. For the online type, as you can imagine, there is an endless list of financial Web sites which offer all the stock market data you can dream of, and more. For our part, we always seem to gravitate back to two sites which complement each other greatly for stock market data, news and charts, they are:

• Yahoo!Finance
• StockCharts

For those who like the touch and feel of a newspaper better, there is no match for Investor's Business Daily:

Investor's Business Daily - Buy it here

For anyone interested more in historical stock market facts and statistics of all kinds, including some of the election cycle and other seasonal data and strategies which we mentioned in last week's editorial "Elections and the stock market", an absolute must have is the Stock Trader's Almanac 2007:

The Stock Trader's Almanac 2007- Buy it here

Warm wishes and until next week.

The TimingCube Staff