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Can Seasonality and Cash on the Sidelines Lift Stocks?

Nov 18, 2011
Simon Maierhofer

The daily grind can wear you out and cloud investors’ judgment about the market’s direction. Never mind about the short-term; in investing as in sports, it’s the final score (long-term outlook) that counts. Everything else is fluff.

The S&P has lost well over 100 points within a matter of days and sliced through important technical support. Is there any reason for stocks to rally or will the bottom fall out (again)? Here's what the facts say:

Money Flows

The last time I looked at money flows was before the end of QE2 in May 2011. The May 20 issue of the ETF Profit Strategy Newsletter plotted the S&P 500 against two forms of cash flow (investable cash and mutual fund cash levels – see chart below) and offered the following assessment:

“The numbers allow for only one logical conclusion. Without the generous monetary policy there is very little new cash left to drive stock prices higher. Without that cash fix, the market will crash like an addict forced to go cold turkey.”

Today we ask again, where will the money come from to drive stocks higher?

>> click here to view chart

                                           

The Investment Company Institute (ICI), which tracks mutual fund in/outflows reports that investors have yanked more than $21 billion out of domestic equity mutual funds since October 5.

Charles Biderman, CEO of TrimTabs, another company that tracks fund flows, observed that since September individual investors have taken out about $800 million a day from equity, mutual and pension funds.

Since July, public companies are spending about $2 billion every day to shrink the trading flow to shares on balance. Where did they get this money from? Since 2009 companies have sold about $3 trillion in bonds and about 800 billion of new shares. Companies are currently the only buyers of stocks as individuals remain net sellers.

Money Flows Confirms Bad Timing

A look at money flows confirms the generally bad timing of individual investors. On October 4, the S&P bottomed at 1,075. The S&P (SNP: ^GSPC), Dow (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC), Russell 2000 (Chicago Options: ^RUT) and most other major indexes are up 20% or more while the VIX (Chicago Options: ^VIX) dropped as much as 50%.

Many investors who endured the grueling summer sell off just to throw in the towel in September or October did not get to participate in this move. To no surprise, the media declared a new bear market just as stocks bottom out:

Oct. 3: “Think the economy is bad? You haven’t seen anything” – CNBC
Oct. 4: “S&P enters bear market territory” – Reuters
Oct. 4: “S&P falls to the bears” - TheStreet

Quite to the contrary, the October 2 ETF Profit Strategy update predicted a looming 20% rally and outlined exactly how this pivotal bottom was to occur: “The ideal market bottom would see the S&P dip below 1,088 intraday, followed by a strong recovery and a close above 1,088.”

Good News – Bad News

The rally from the October lows is good news. The buy-and hold investors who had the stomach to toughen out the 20% summer loss are back at respectable positions while short sellers who missed the sell off get a second chance to join the fun.

Based on the most recent sentiment readings though, investors don’t feel like selling stocks. Investors Intelligence just reported the highest reading of bullish investment advisors and newsletter writing colleagues since July 26.

Surprise, just as investors were getting excited again, the S&P broke through a “bullish” triangle. What happens when corporations stop buying (perhaps due to falling earnings) or worse, start selling? Where will the cash come from?

Long-term Bearish Forces

It doesn’t take much imagination to put together a quick list of bearish developments. Here are my top four:

- Retiring baby boomers: Starting this year, more than 10,000 baby boomers a day will turn 65. Thanks to the lost decade, most retirement dreams are under-funded. The ones that were sufficiently funded a few years ago now suffer from low-interest rate fatigue.

The generous spending of baby boomers drove the 1980’s and 90’s bull. The required frugality of retiring baby boomers will be a drag on economically sensitive sectors such as consumer discretionary (NYSEArca: XLY), technology (NYSEArca: XLK) and retail (NYSEArca: XRT).

- US Deficit: Government spending now accounts for 36.44% of GDP. A budget conscious government is bad for business.

- The euro zone: The euro crisis is not an issue of confidence, it’s structural. It would take a book to address all of Europe’s issues but the essence is this: Many euro countries have more debt than they can service. Unless they can get their hands on an extra couple trillion dollars, governments will default.

- A giant head-and shoulders pattern: The S&P is working on a massive, bearish multi-decade head-and shoulders or M-pattern (the cash flow chart above shows the important trend lines). Trend line resistance for the right shoulder (or the right side of the M) at 1,372 was sandwiched between two Fibonacci resistance levels at 1,369 and 1,382.

The April 3 ETF Profit Strategy update said the following about this resistance cluster: “In terms of resistance levels, the 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions.”

Simple Conclusion

There are only two reasons why stocks could temporarily rally:

1) Seasonality
2) Flash-in-the-pan type news from Europe

As mentioned earlier, there are plenty of reasons for stocks to drop, possibly even drop like a rock.

The trick to profiting from lower prices is proper risk management. The right time to sell long positions is either when the up side target is reached (that was at 1,275) or when support is broken (that was at 1,215).

If you sell and go short right after support is broken and place a protective stop-loss just a few points above support, you limit your risk to almost zero while prying open your profit potential.

Such key support mentioned over the past six months include S&P 1,325 (July 27 – S&P dropped 16% within the next ten trading days) and for those who missed 1,325, 1,298 provided a second chance (July 29 – S&P dropped 15% within the next eight trading days).

The S&P is now well below 1,275 and 1,215, where the ETF Profit Strategy Newsletter recommended to go short. Are stocks getting ready to bounce or is it still early enough to go short?

The ETF Profit Strategy Newsletter identifies the short-term support level likely to elicit a bounce and the best time to go short. In addition to short-term entry points, the newsletter also provides a mid and long-term forecast.

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