Tail Wagging the Dog?

• Posted by Derek
• on August 6th, 2010

“I measure what’s going on, and I adapt to it.  I try to get my ego out of the way.  The market is smarter than I am, so I bend.”  Martin Zweig

Anyone reading my posts knows I place huge emphasis on relative strength. Not chart indicator RSI, but the comparison of one stock vs. the universe of stocks.  As mentioned here, my philosophy towards identifying edge is that a) drift in correlation precedes b) relative strength/weakness precedes c) absolute price movement precedes d) fundamental news.

That means I generally believe that large moves begin internally and work outward, with the “market of stocks” developing a bullish or bearish pattern before the index follows.  My preference is to find subtle shifts in a stock and/or sector, and enter as this relative strength takes hold within a day of the absolute price movement.  In most cases, a move by a batch of individual stocks is a precursor to a market move.

I do have to remind myself on occasion that, by definition, the other side of relative strength is relative weakness.  And while I feel most comfortable acting when the strength begins internally, it’s important to realize that what I see as relative weakness can be relative strength in reverse.  For example, how do we define a DJIA +100, NASDAQ -2 day? Instinctively, I think this means the broader market is weak. But maybe the truth is that the DJIA is strong, and NASDAQ is biding its time before catching up with the new lead dog.

This is precisely where we are today.  If one considers the news flow this week, and looks at the pattern in the S&P 500, it is hard to make a bearish case.  We had positive breadth last week leading leading into a Monday rally, followed by 3 days of hugging the highs against a backdrop of concern over the jobs number.  Textbook strength, in fact.  But I sit here and dwell on the fact that the Russell 2000 has lagged, and that gives me great concern that we’re floating with one engine.

In those 3 days of consolidation, I thought we’d see the big index flat to down while the broader market rallied. That has clearly not been the case, as the DJIA is flat and Russell is down 1%.  The % of stocks trading above their 10 wk average has fallen but not plunged from 70% to 67%.  While my concern grows, the big index has been able to digest its gains without any damage…a sign in itself.  I’ve never forgotten late 1994, when my focus on the persistent weakness in tech stocks left me clueless to the powerful move unfolding in large cap growth stocks like JNJ.  Tech stocks eventually regained their leadership role, but the inability of their relative weakness to drag down the rest of the market was a sign of strength and eventually doubters had their faces ripped off.

Point is, anything can happen. Small caps have led for years, maybe large cap is ready to take over. Maybe high quality is finally ready to take over. I don’t know, but from my vantage point a massive move lies ahead following this tightness, and I need to be prepared for whatever comes along.  Short setups haven’t followed through, long setups mostly have.  I am open to the possibility that the $SPX could pull a Priceline and just ramp from a paused uptrend.  Not my preference, and I’ll be way underexposed if that happens.  But it’s on my radar…I know that this compression will lead to a move far greater than most expect, so having a flexible plan will get me where I need to be positioned quickly enough.

The key to market success is to make a ton when opportunities are clear, and hold on to it when they are not.  When I can convince myself of equally strong arguments in the same sitting, it’s a sign that my psyche is not committed.  The best recipe is a humble confidence allowing patience and risk management to coexist…I’ll have that combo when internals and the index sync back up.  This 3 day tightness has created enough tinder to take the next move WAY outside the range we’ve been lulled into expecting.  I join the typical technician answer…get the Russell up above 665 and we’re off to the races, hold below 650 and we may be in trouble.  It’s rare that I find potential for an outsized move with such obvious lines in the sand, but this week’s action is setting the table for something big.  Seriously, we’re halfway between the 2007 highs and 2009 lows…there will be plenty of time join the winners.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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