The market analysis framework is primarily driven by the following principles:
- Don’t fight the Fed
- Don’t fight the Market
- Don’t fight the Tape
Don’t fight the Fed
When monetary policy is easy, slowly its effect will be felt in asset prices for extended period of time. Major bull runs in stock prices (including housing or any other speculative assets in vogue at that time) are often preceded with extremely easy monetary policy. On the other hand, when monetary policy is tightened, slowly stock prices often exhibit chaotic behaviour before eventual down trend in line with slow down in business cycle.
The are mainly two variables in which the Fed can influence money supply: (i) target of Fed funds rate and (ii) the size of the Fed’s balance sheet. It is only since the great financial crisis of 2008 that the Fed is actively using the second variable. In principle, easy monetary policy is characterized by lower target of Fed funds rate and expansion of the Fed’s balance sheet.
For more information, read the Monetary Conditions Guide.
Don’t fight the Market
The Dow Theory stated that there are primary trend, secondary trend, and minor trend in the stock market. Once a trend is in place, it tends to continue until evidence to the contrary is established. Thus, we are advised to go with the trend.
We can assess stock market trend by looking at price indexes, such as SP500, which are usually constructed as capitalization-weighted average of a group of stocks. Thus, these indexes are disproportionately affected by high cap stocks. For the purpose of identifying primary trend, price indexes are highly noisy since any small changes in their constituent stock prices affect the index.
In view of these two limitations, I prefer to look at longer term market breadth statistics, such as new 52 weeks highs and new 52 weeks lows to assess direction of primary trend in the stock market in general. By looking at market breadth statistics, all stocks are treated equally. This is desirable because in major bull run, all stocks should participate. When confidence is high and cash is plentiful, investors are adventurous enough to invest in even non-blue-chip stocks. By looking at new highs and new lows, we only count significant movement in stock prices. Noise in stock prices get filtered out. As a result, we will get a less-biased and less-noisy statistic to assess primary trend in the stock market.
For more information, read the Primary Market Breadth Guide.
Don’t fight the Tape
The objective here is to detect continuation, exhaustion, or reversal in the broad market by looking at price actions of individual stocks more closely, at 1 month time frame.
Basically, I categorize stocks into three main categories: up trending stocks, down trending stocks, and consolidation stocks within one month time frame. Then, I will look at last day price action to see whether the stock rise significantly on high volume (accumulated), fell significantly (distributed), or did not move much but still have high volume nevertheless.
From these, I can see whether there are many stocks which are being acquired from consolidations, many leading stocks being dumped, many depressed stocks no longer being sold, etc for the past few weeks. From this forest few of the market, I can objectively define whether the market is strong, weak, or in range-bound state. In addition, I can also objectively define more timely continuation, exhaustions, or reversal in the broad market by looking at individual stocks in aggregate in addition to looking at chart of broad market indices.
For more information, read the Market Breadth Pattern Guide. You may also want to read the following post about “Using Market Breadth Statistics to Differentiate Counter Trend Move vs Trend Change”.
Relative Valuation of Stocks and Bonds
In addition to the above three components, occasionally, I look into relative valuation of stock market to bond market to see whether one is generally more expensive than the other. The idea is to see possible shift in asset allocation among institutional funds who invest among the two asset classes. It is difficult though to build a proven market timing tool based on this concept.
Horizon of Relevance
The three concepts explained above are complementaries. Monetary conditions help to anticipate long term outlooks of “inflationay-prove” risky asset prices, such as equities and properties. Primary market breadth aligned us in medium term trends in the broad market. Market breadth patterns anticipate as well as align us to short term fluctuations in the broad market.
|Concepts||Horizon of Relevance||Explanations|
|Monetary Conditions||Long Term||One business cycle (around 4 years)|
|Primary Market Breadth||Medium Term||6 months – 1 year|
|Market Breadth Patterns||Short Term||1 week – 1 month|