Where Is the Market Going Next?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 20, 2014 1:26:00 PM

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where is the market going next?We’ve seen a market downdraft, a bounce back up, and now . . . what next? This is the big question everyone’s asking.

One saying I’ve used over the last several years is that fundamentals tell you where you’re going, and technical factors tell you when you’re leaving and how you’re getting there. As I’ve noted many times before, fundamentals remain overvalued, but that in and of itself doesn't mean a correction is approaching. It does mean that, when a correction comes, it could be worse.

If the fundamentals allow for the possibility of a correction, what do the technicals tell us about where the market is going next? The most consistent indicator is the 200-day moving average, which the market just recently broke. At this point, it’s worth paying attention but not panicking; two-thirds of the time over the past couple of decades, the market has recovered after such a break. The problem, of course, is the other one-third of the time.

So, which one is it? There are two components here: the signal (in this case, the 200-day moving average) and the filter you use to weed out spurious signals.

What’s the 200-day signal really telling us?

There are two ways to filter a signal like the 200-day moving average.

The first is a simple time criterion—if the signal persists for a certain amount of time, it is considered valid. One method is to look at month-end figures only. For instance, in this case, if the market remains below the 200-day average as of October 31, the signal is considered valid. Another method is to use a specific time period, such as one week or one month; if the market remains below the 200-day average for that period, the signal is valid. Both methods have their merits and problems. (I use the month-end simply because it’s the one I have tested.)

The other way to filter a signal is to use a significance band. If the signal is triggered and the market continues to drop by a certain amount, the signal is confirmed, regardless of the timing. The benefit of this technique is that, in a rapidly falling market, the signal can be confirmed without waiting until the end of the month, or whatever the time period may be.

By either metric, we remain in a relatively weak position, technically. The strong recovery of the markets at the end of last week still leaves them under their 200-day averages, and therefore at risk. Using a time metric, every day it stays below brings the market closer to triggering a valid signal, whether at the end of the month or after a week or so. Using a significance band, the signal may already have been confirmed and will remain so until we move above our reference level (which will also have to be confirmed).

Stock market story far from over

Either way, the trouble hasn’t gone away. With weak fundamentals, the risks remain higher; with weak technicals, those risks are more likely to be realized. Despite the strong fundamental factors underlying the U.S. economy, which will continue to provide support, expect to see more volatility until the market makes a strong move upward.

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