Do not ignore this chart

A handful of patience is worth more than a bushel of brains.

Because I continue to post bullish setup for stocks, some may think have thrown in the towel and have given up on my watch for a bear market. The fact is that couldn’t be farther from the truth. It’s just that until the weight of the evidence says otherwise, the trend is your friend and you must respect the current trend, which is up. I have learned the hard way picking tops or bottoms is a fool’s game. What is not foolish is having a proven investment process/plan and sticking to it. That said, in no way have I abandoned my vigilant watch to protect my client’s hard earned capital from the ravages of a bear market.  The beat goes on, I have just tried to dampen the bearish overtones.

When looking for clues we are reversing course, one of my default charts I find not only very helpful but historically significant is what I refer to as “risk on/risk off”. It is the ratio of US stocks to US bonds, specifically the SP500 to the 30-year Treasury bond.  While you may be scratching your head wondering why this is worth watching it actually does make sense. In a bear market, money flows out of stocks due to their risk component and into the safety net of bonds, especially US government bonds.  In bull markets, investors are willing to risk their investment capital in stocks due to the chance of making greater returns. So if this ratio is rising, you would expect a bull market in stocks and of course, the opposite when the ratio is falling.

Below is a 20-year look back on “risk on/risk off” in the upper pane of the chart.  The lower pane shows just the price of the SP500 index. Having them stacked on top of each other it allows you to follow how stocks move in comparison to the ratio.  What is hopefully very obvious is how the ratio acted during the prior 2 major market corrections of 2000 and 2008.  During each of those stock market peaks, the ratio high exceeded 14, bearish divergence (ratio was falling while SP500 price was rising) was evident and a nice topping pattern was formed as the ratio rolled over (changed direction from one of rising to falling).  Fast forward to a look at the ratio today you see the EXACT SAME SETUP. The key going forward is if this is truly a market reversal and it picks up steam as it did in the past two occasions, once the horizontal red support line is breached, stock prices could be in for a major beating.  While I want very much to pull the plug in anticipation of this occurring, I am going to find some patience somewhere and insure I get confirmation before jumping the gun. So far this correction has only been 5% and exiting all long equities positions over a 5% correction makes no sense.  Normally a 5% correction would be considered a very normal ebb and flow within the context of price movement.  In fact, I would consider it just noise.

Excuse the brevity of this post but I need to spend some serious time looking for that patience (where o where did I put it?). If this correction picks up steam I will present some other indicators in future posts I use to compile the “weight of the evidence” providing me “the” confirmation signal to step aside. Until then, we need to accept that corrections are a major part all bull markets and respect the fact the current market is bullish.

I can see clearly now

When you mention the word acuity most people think of the definition of “sharpness of vision” or “the visual ability to resolve fine detail”. To me, on the other hand, I think of the lighting and controller company, AYI.  The company’s stock has performed impressively, tremendously outperforming the index by more than 40% over the last 15 months (most of that occurring in the first 6 months).

As you can see in the chart below, the stock topped out around $145/share in March of last year and has been consolidating since then. What developed during this consolidation period was a very nice, cup and handle pattern that had the $145 share price as the top of the cup, acting as strong resistance.  You can see that each time it attempted to move higher, the bears rejected it handily pushing prices lower. But what happened last week is a textbook bullish move that should make investors salivate.  Price gapped up above the $145 price on big volume, flipping the prior resistance now to support.  In addition, the RSI momentum indicator is firmly in the bullish range, the MACD histogram is positive and all 3 moving averages are bullishly stacked.

With the continued weakness of the general stock market, this stock is (and probably continue) treading water waiting to move higher when the overall selling pressure subsides.   An ideal entry point would be a back test and hold above the $145 level. The beauty of this entry is the risk/reward ratio is very compelling considering a stop loss would be placed just under the $145 level letting you know the bulls have relented and given controls back to the bears. 

Anyone watching the action in the Middle Kingdom stocks lately?

While we weren’t watching, the Chinese stock market ETF, FXI, has been quietly rising alongside and mirroring the rise in US equities.  This past week it broke above an important resistance line that goes back more than 3 ½ years.  You are probably wondering what makes this so interesting because as you can see in the very bottom pane of the chart the SP500/FXI ratio, Chinese stocks have not outperformed the US market but instead has just kept pace and been moving in lockstep. What makes this move in China so significant is it has been done with the backdrop of one of the most impressive rallies in the dollar we have seen since 2008.  Virtually all other foreign equities and non-dollar denominated assets have struggled mightily during this same period yet China stocks have been rising. 

From a chart standpoint and in addition to the breakout, price is well above the 30-week moving average, the MACD histogram is both rising and above the zero line and the RSI is above its mid-line and has been nicely respecting the range of movement one would expect during a strong bull move.  In spite of all the bullish arguments I just can’t get on the bandwagon right here. I realize I may regret this decision but the negative divergence (lower highs on the RSI while price has created higher highs in an overbought condition) is screaming at me.  You can see what happened the negative divergence raised its ugly head in Dec 2012-Feb 2013, the ETF fell ~20%. I have come to learn that unless the weight of the evidence is compellingly positive, it is best to move on to the next opportunity.  You may end up missing out on a few good ones but investments are like public transit, if you miss your bus, just be patient as the next one will be by in 20 minutes or so.

Watching for bottoms

One of the most desirable investments from a risk reward standpoint are those stocks which have fallen precipitously and then finds a bottom.  The attractiveness is obvious because the downside is small and the upside can be huge (depending upon how far it has fallen).  An example of why I like these setups can be seen in ULTA below.  The company announced some bad news in late 2013 and the market took the stock out to the woodshed pushing price down 38% from its high.  Following the low, the stock consolidated for about 8 months before it once again found its mojo and gapped higher. From that breakout it has come all the way back and made new highs gaining more than 60% in four months.  There are, of course, no guarantees on stocks that have had a big fall but if you are patient and get a confirmed change in direction their allure cannot be mistaken.

I do regular screens for these types of setups and am finding a number of nice looking opportunities, some ready right now and some not quite ready (energy sector). Two of the more attractive ones are below.

Fossil, FOSL, a watch and accessory store has fallen 38% from its last high in November of 2013. After bottoming in October, rather than consolidating as I would expect, it has started to move higher and appears to have put in a new uptrend reversal creating higher highs and higher lows. The RSI momentum indicator is bullishly aligned and in December we got a golden cross on the moving averages.  Following a path like ULTA above, a share price recovery back to prior highs would provide a nice, 20% gain from Friday’s closing price

This week’s second idea is Invensense, INVN, a tech company located right here in my backyard. They make gyroscopic sensors that go into tablets, cell phones and a technology that has a ton of current and future uses. From its high in mid-2014 the stock had lost almost 50% of its value when it bottomed in October of last year.   It has since formed a nice double bottom and has broken out above a major prior resistance level clearing the way for a move higher. One of the most attractive parts of this chart is the gap just above. I expect the stock to rise quickly rise and fill the gap. Above that is additional resistance it will need to overcome in the 22.5 area. If that is successful, I expect a retest of old highs to be in store. If so, that would be a very nice 50% upside from here.

The Bulls are in control

As you can see in the 1-year chart below small cap stocks (IWM) have been ping-ponging between support and resistance (consolidating) while the broader market has gone on to make new all-time highs. This divergence had technicians on alert and concerned because we know that small caps typically lead the rest of the market into both new bull and bear markets.  If the small caps could not follow with the rest of the market it was possible, if they broke down out of consolidation, they would be signaling the end of the current bull and start of a new bear. This is exactly why we track the small cap index with great interest hoping it would provide some hint as to what may be ahead.

Less than two weeks before we ring the final bell for 2014 it appears as if we have gotten our signal as small cap stocks have come roaring back, breaking out of consolidation and on to new all-time highs as you can see in the long-term chart below. With the momentum oscillators unwound but still bullishly configured it is looking eerily similar to the early part of 2013 when small caps excelled. Not only are price and momentum aligned but they have broken their downtrend and started to outperform the broader index (as we would hope to see) as can be seen in the second to bottom relative strength pane.

Of course false breakouts are always a possibility but if this turns out to be the real deal, we may be in for the start of a new equity upleg with the small caps leading the charge into the first half of 2015.  Now this is what I call a New Year’s rockin’ Eve.