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Turbo Signal
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Turbo Model Returns (Long & Short Strategy)
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Nasdaq 100
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Russell 2000
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Classic Signal
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Classic Model Returns (Long & Short Strategy)
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World
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Russell 2000
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All the world markets entered into a new round of panic after the Standard&Poor surprised everybody by downgrading the U.S. credit rating from AAA to AA+. As expected, the U.S. indexes opened sharply down on Monday and, while some thought that the worse was more or less contained, a new wave of selling pressure took control of the market mid-day, sending it into another free fall. The Dow Jones
dropped 634 points, making it the worse day since the 2008 financial crisis.
Tuesday saw a huge reversal, especially after Fed chairman Ben Bernanke took the stand, trying to instill some confidence in the investment community by promising that he would keep interest rates exceptionally low through the middle of 2013. Stocks started to plunge on the announcement but quickly reversed into an explosive rally during the last hour. The Dow regained 4%, almost erasing the market collapse from the previous day. On Wednesday, worries about debt problems in Europe resurfaced (the rumor was out that France could lose its AAA rating too) causing the selloff to intensify on Wall Street. The bank system was on the hot spot this time. One of the main french banks, Societe Generale, saw its shares tumble almost 15% on rumors that it was on the verge of collapsing. Gold shot up into record high territory. By the end of the session, the Dow Jones had dropped 519 points, its 9th point loss of all time!
Thursday, the roller coaster continued. There was some easing over Europe's finances, plus some positive economic data (It's the first time the unemployment number had dropped below 400,000 in four months). All of this helped bargain-hunters regain control of the market, sending the Dow another 400-plus point higher.
By Friday things started to settle down a little, as everybody was cooling off after this irrational week. Fueled by some mixed economic data, the indexes inched higher keeping some of the previous day's momentum.
Despite these huge market swings, all major indexes managed to finish the week with only some modest losses. The S&P 500 (SPY) is down 1.63% for the week. The Nasdaq 100 (QQQ) and Russell 2000 (IWM) dropped 0.48% and 2.16% respectively. With no change from last week, all indexes are below their 50 and 200-day moving averages.
Our World portfolio is posting a loss of 3.14% for the week. Since we now have an active Classic Model Cash signal, the World approach calls for staying in cash if you follow the "Long Only" or "Long and Short" strategy. Only if you follow the "Buy and Rebalance" strategy should you remain invested in the top 5 ETFs from our world ranking. Please go to the Classic Model "Description" page for details.
Our Classic Model is on a Cash signal while our Turbo Model remains on Buy after a brief Sell signal mid-week.
Bear market behavior
We didn't have to wait long for an answer to our question
last week of whether the bear market had indeed arrived. Bears put
an exclamation point on their control of the market with a heart-stopping
plunge Monday.
Chart 1: A bear's path through the market
The S&P credit rating downgrade of the U.S. got
much of the headline, but it was just the latest in a series of
almost nonstop confidence-crushing headlines over the past two weeks.
Investors have sought refuge in gold, "safe" currencies,
and those downgraded U.S. Treasury bonds. Having now fully entered
the bear market phase, we thought it helpful to map out what typically
happens through the average two year bear market process. We turn
once more to the crystal clear charts and analysis of efficientish.blogspot.com. Bear markets march through three distinct phases as shown in Chart 1.
The first phase is marked by a failure of stocks to build on prior
gains, a sort of standoff between tired bulls and emerging bears,
if you will. The rolling range-bound channel trading behavior of
the market from February-July of this year typifies this phase.
The second phase is where the bears really take control. As sellers
come to influence trading more and more, bulls seek to lock in their
profits often as a result of some surprise event or news item. We
are currently in this phase. See Chart 2 below. The initial selling wave runs its course
with remaining bulls stepping in to buy newly created "values"
because the economy and earnings are usually still looking decent
at this juncture. The market is viewed as heavily oversold after
the sharp wave downward to further encourage buying. Ultimately,
this buying spree fails to change the mind of most investors for
long as events and news continue to provide evidence of concern.
Even the remaining bulls throw in the towel, selling their newfound
holdings and fully stepping aside. With an absence of buying support,
at almost any price, stocks plunge to their bear market lows before
some institutional leadership emerges to halt the decline. In 2008,
this bottom was first put in when the Fed stepped in explicitly
to support the bond market in November 2008. This support kicked
off a rally in high yield and other bonds carrying more risk. Confidence
rebuilt from there to the launching of stocks out of the fog in
March 2009. High yield bonds, being something of a proxy for risk
in the bond world, often provide a good leading indication of investor
willingness to step a little further out on the risk scale. Dividend
stocks being a next step up from there.
Chart 2: Rolling top followed by initial plunge
Chart 3: 2001 drop around the 9/11 attack
 The recent plunge in stocks reminds us a bit of the 2001 drop around
the 9/11 attack. Then, as now, the economy was not in a recession,
but markets had already started showing a little strain. The 9/11
attack closed markets for a few days, but still provided cause for
heightened selling, not all that dissimilar to what we've witnessed
recently where markets become unglued by emotional reactions to
events and news moreso than raw economic information. The unsettling
news of late has been a failure of political and economic leaders
to inspire confidence, to demonstrate an ability to come together
to resolve large problems. Add to that ongoing worries about slowing
growth in China, India, et al., and you have the recipe for weak
stocks. Without coordinated work to resolve these issues, markets
will remain on edge and likely react negatively to each crack in
the facade of progress.
The alternative to the bear market scenario
would be the 1987 crash or, to a lesser degree, the 1997 Asian crash
and quick rebound. These occurred during strong bull markets, and
were therefore quickly recovered. Today, we are in the midst of
a dragging secular bear market period with a sluggish economy that
appears unlikely to rev higher anytime in the foreseeable future.
Thus, we wouldn't expect such a quick recovery this time - maybe
retrace a portion of the decline. But that should just set the stage
for another drop - basically, we should expect choppy market behavior
at best as examplified by the wild market swings that we saw this
past week. There will be opportunities to play rallies, of course,
but they shouldn't be protracted and we would expect them to not
deliver new highs and to instead be met with another round of selling.
Being in a bear market cycle does not mean we have to drive all
the way down to new lows either, but we shouldn't be surprised if
we approach them either.
Question: How did Classic and Turbo "manage" this
decline?
Not surprisingly, many of our subscribers are wondering how our models missed the recent sharp decline in markets - a plunge downward of some 20% in stocks within an extremely short couple of weeks.
As we see it, the problem has been a combination of ill-fated situations for our
Models. The Turbo Model mixes trend-following components and mean-reversion
(contrarian) components. As seen in our backtest, Turbo usually switches
nicely between the two modes. This was not the case lately. For the last 6
months or so, the market action has been staging right where our indicators
switch modes from one behavior to the other, a situation rarely seen in our
backtest. In other words, the market is moving just far enough to trigger a
change before shifting course and leaving us in the wrong state.
This problematic range-bound period was followed by a very quick and steep
correction, which pushed the Model into contrarian, mean-reversion mode. But
there again, the market gave us no rebound (not even a short one) which
would have triggered a reverse of our signal (a Sell to take advantage of
the decline). Having the market crash like this with little consistent
previous weakness is a rare situation which is obviously not something our
model was built to detect. Being out of sync with the new bearish market
tone ended with this week's Sell signal issued just after the surprise rally
on August 9. As we've noted, Turbo is at its best during volatile bear market
periods. With the volatility feeding numerous trade opportunities, and the Buy signal
that followed immediately after seems to prove this point so far..
As for our Classic Model, it is based on a much more steady and slower
trend-following approach. Classic did what it was supposed to do. As the
market started dropping, it switched to a safe Cash position, noting the
significant trend change. So why isn't Classic giving a Sell right here?
You will note that Classic is careful not to switch too early to Sell mode
during a cyclical bull market (the 50-day moving average is still above the
200-day moving average). This prevents us being harmed from the market
reversing higher while being short - a common danger in trend-following
systems. We've moved into a cyclical bear market. But right now, the
oversold indicators are all blinking red and the market could
stage a bear market rally any day. Should the bear market continue, as we
think it will, there will be some relief from the oversold condition and a
Classic Sell signal will become more likely.
Warm wishes and until next week.
The TimingCube Staff
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