Monday Market Update

Buying exhaustion may be setting in. The selling today reversed yesterday’s gains and leaves the market about a percent below the Monster Rally seen on Monday of this week.

The DOW finished at -1.87%, the S&P 500 at -2.03% and the Russell 2000 at -3.66%.

But the week still ended nicely up because of the Monday Monster. The DOW finished the week at +6.8%, the S&P 500 at +6.2% and the Russell 2000 at +7.2%. And all major indexes remain in a hovering pattern over their 50-day moving averages.

So how often do you think the S&P 500 has seen three consecutive weeks up since the economy and the stock market began to fumble in the summer of 2007?

Twice!

The most recent 3-week gain was in April of 2008 and prior to that in September of 2007. This marks the third time since the bear market truly began in the summer of 2007 – yes, the worst of the pain was last fall, but the writing was on the wall in mid 2007, if you remember any of my old updates.

Something different is happening in the equity markets and I want to illustrate it for you.

Notice the market swings in the Wilshire 5000 during the end of last year through the first week or two of February, this year. Note that all of the swings on this chart are large – much larger than seen in previous years.

But even these large swings (seen in late 2008 and early 2009) have changed dramatically. They have gone from 10-15% to twice that volatility. The last two market swings have been in the 20-30% range.

Why might this be so?

Prior to this bear market and especially in the late 90’s the mantra was “Buy and Hold”. Investment advisors made their living deciding what sector to buy versus evaluating overall market risk. There was virtually no real reason to be “out of the market”. Allocation was the name of the game, not timing by any measure at all.

The bear market in 2001-2002 shook things up a bit, but not for long, as the year-long bull run in 2003 convinced nearly all professional investors that the traditional allocation and diversification methods taught in all the top business schools was the only effective way to create wealth in the stock market. It would always go up.

The 2007-2009 bear market has changed that opinion – dramatically.

Even the talking heads at CNBC wince when they talk about buy and hold allocation strategies. And you will never hear an investment advisor boldly proclaim the gains his buy and hold allocation strategy has created for his clients. They don’t exist.

In fact, these buy and hold allocation advisors all feel lucky to even be in business anymore.

I have often mentioned the “window dressing” period, from the last week or so in the month to the first week of the new month. This is where large institutional buyers who have for decades subscribed to the traditional buy and hold allocation strategy often make their monthly allocation purchases.

These large institutional groups have been hurt like no one else in this bear market. They have held on much longer than you or me.

It is the opinion of some very intuitive and insightful analysts that the institutional players have finally opted out of the buy and hold mentality, realizing that some sort of timing is essential to try and gain back their huge losses.

So now instead of a small number of investors using swing indicators for entering and exiting the market based on intermediate cycles the big boys are now trying to play the same game. And the net effect is the destruction of what we have normally thought of as short cycles (1-2 weeks) and intermediate cycles (one to several months).

We now are seeing an intermediate cycle of extreme volatility crammed into an expanded short cycle time frame, accounting for the unbelievable 20-plus percent swings seen in early 2009.

I would also like to draw your attention to the Fibonacci Retracement I have drawn on the above chart. The Fibonacci retracement lines are often a reliable tool for gauging how much the market will swing back the other way. It has now swung back to the positive side a Fibonacci retracement of 61.8%.

61.8% is the typical maximum retracement seen in large market movements, and presents another reason for being cautious about joining the bull’s train at this point.

I’m not saying that there will be no further upside potential, here in 2009. I am just saying that another big swing down is queued up and could take off any day.

Once a decent pull back has been completed we may very well have an excellent opportunity for an0ther strong advance, especially if the institutional buyers are committed to exploiting the swing opportunities in the marketplace.

The Euro was hammered today on poor economic news in the European press. I will let you research what happened. What matters to me is the direction of the Euro.

I rarely talk about the dollar and the euro in the same breath, but I know many of you follow the currency market and also know that the dollar and the Euro often run inversely to each other.

I have been charting the Euro for several months now because of a unique leading relationship that it is showing for the U.S. equity market. Check out the chart:

The black line is the Euro, with values on the right side. The green and red lines are 13-day and 5-day moving averages of the Euro. The grey candlestick pattern in the background is the S&P500, with prices illustrated at the far left.

Do you see the correlation between the direction of the Euro and the stock market? Do you also see that the Euro changes direction slightly before the U.S. stock market?

Do you also notice that the lagging crossover of the two moving averages has coincided pretty closely with the major swings in the U.S. stock market?

This kind of effect is called a leading indicator because it leads in the direction of trend changes in the stock market. I don’t know how long this relationship will last, but it has done fairly well for the duration of this bear market.

Now notice what the Euro has recently done. It appears to have set a lower high about the middle of last week and was really knocked down today. Also notice that the moving average crossover point appears to be converging – another indicator of caution for you “long” investors out there.

I will try to keep you regularly updated on this Euro leading indicator chart over the next few months.