Weekly Market Commentary

Like most active investors, I spend hours each day staring at numbersfluttering across a computer screen and poring over research documents.

Like most active investors, I spend hours each day staring at numbers fluttering across a computer screen and poring over research documents. By searching for new ideas in the constant dataflow,
I can act quickly when opportunities arise. We embark on this quest for knowledge because we believe success will come from our hard work. Believers in the direct correlation between diligence and
positive results, we often blindly follow our routine without considering its detriments.

When we narrowly focus on day-to-day moves, we can lose our perspective. In today’s momentum-driven market, where each trader is fighting over the last tick, losing big-picture themes may not seem like a problem. However, the negative consequences can be enormous.

The performance of the Dow Jones Industrial Average (Dow) over the past few weeks provides a perfect example. After hitting an annual high of 9,829 on September 22, the Dow suffered a horrendous week and a half as it fell to 9,487 on October 2. I have stressed the importance of the Dow remaining above its support level of 9,465 in order to continue higher. As last week came to a close, the Dow resting a precarious 22 points above this support level offered great drama.

The market responded by going vertical. Over the last three days, the Dow has rallied 239 points and is now only 104 points from a new annual high. Those who have focused solely on this rally and failed to grasp the larger picture believe the recent decline was one more dip to be bought. However, taking a longer view it appears this rally is closer to a market top. During strong bull markets, all prices rise together.

When strength confirms strength, it indicates investor demand for stocks is high and the primary trend remains higher. Such uniformity does not exist right now. Over the past week, growing divergence has me concerned. Although Brazil is consistently pushing to new highs and the Dow is closing in on their recent highs, the rest of the markets are weak.

The rally has moved prices higher, but these indices are on average 2.8% below recent highs and will be unlikely to confirm recent strength. Another ominous sign is the performance of my proprietary timing model. The model aims to measure investor sentiment across a broad array of stocks. Relying upon price history, it determines
whether the underlying momentum of a stock is bullish (in which case the model offers a buy signal) or bearish (in which case the model offers a sell signal). While the effectiveness of the model with respect
to individual stocks varies, it offers an accurate indicator of overall investor sentiment.

Over the past three days, the Dow has rallied 2.5%. During the same period, the timing model has not moved. This indicates that the headline index strength has not altered the underlying momentum of the market itself. Over the seven years I have actively used this model and the 20 years it has been back tested, I have never seen such index strength refuse to move the bullish reading.

This is just another data point indicating that the underpinnings of this move higher are extremely week and the rally is nothing more than an oversold bounce in a quickly unraveling stock market.

For weeks I have indicated that buying the dips has been successful. However, just as patterns repeat, they also eventually end. Investors blindly buying each dip will eventually make one too many trades and be left with large losses. The ability to remain profitable begins with recognizing when the tide is turning.

That time is now upon us. The market resembles a massive top that will lead to a dramatic move lower. Investors have done well owning stocks, but now is the time for caution. If the Dow continues
higher it could add 500 more points to the rally. However, a top followed by a decline would create at least a 1,000-point loss. We have prospered in the past by owning stocks when the odds of success were in our favor. With potential losses outweighing gains by a factor of two, the odds of success are now much lower.

Sean Hannon, CFA, CFP, is the publisher of EPIC Insights, a weekly newsletter providing Sean?s timely stock ideas and market commentary. Sean?s goal in EPIC Insights is to educate readers, giving them accessible advice they can use to manage their own financial future. The transparent portfolio that Sean has created in EPIC Insights has outperformed the S&P 500 during many investment cycles. Through this portfolio Sean offers readers a thorough... More