We’re on one heck of a ride aren’t we! I hope you have managed to survive the last 7 days of trading. If you’ve come out of Thursday’s crash and yesterday’s rally relatively unscathed then you’ll have done exceptionally well. As I write this, the FTSE is up another 4% after the Japanese Nikkei closed up an incredible 14% and the S&P 500 up around 11%.

Tricky times for investors and traders alike. With the economy roughed up and a recession looking likely, there’s a number of newspaper and magazine articles cropping up with ideas on what stocks to buy in a recession and where the stock market is going next. The trouble with many of these articles is that they are interesting, but often devoid of any real research.

Consensus opinion might say for example that now might be a good time to get into defensive, sectors like tobacco, but consensus opinion is often wrong. Thankfully there are some studies into what sectors perform best during various stages of the economic cycle and from which to devise a market forecast. Assuming we’re either heading into a recession or are already there…

When might we come out of recession? A market forecast from various studies

A recession is officially classed as two consecutive quarters of negative economic growth. Though the ‘R’ word is much feared, the average recession has lasted 11 months, with the frequency and depth of recessions decreasing since the turn of the last century. According to Hussman funds, each recession is unique so it’s hard to so exactly what might happen. Historically ‘mild’ recessions last 10 months, while ‘severe’ depressions last for 16 months on average.

Housing: Apparently, the most severe drop in housing is typically in the months before a recession begins, with a slower pace of decline until the absolute low.

Stock market: On average the stock market peaks about 6 months prior to the start of a recession and begins to decline more aggressively as the contraction begins.

Arguably so far the stock market has behaved as it would during a typically recession. On average the stock market bottoms 6-7 months into a recession, but that’s a big average: sometimes it has taken 18 months for the stock market to bottom after the start of a recession. Note this is the time it takes to bottom (no new lows), it takes a lot longer for it to recover its previous highs. Markets are typically ahead of the economy though and will typically bottom around 5 months prior to the end of the recession itself.

NB all of this is in relation to the US, but with global markets so interconnected, the data may not be too far off.

These are just averages and the actual economic response could be very different.

What sectors to invest in now

The S&P 500 guide to sector investing outlines 5 major phases of an economic cycle. This is made up of three expansion phases and two recession phases.

Expansion Phase I (early part)

Sectors to invest in: Technology, Transport

Expansion Phase II (main thrust)

Sectors to invest in: Basic materials, capital goods, materials.

Expansion Phase III (late boom)

Sectors to invest in: Consumer staples

Recession Phase I (early recession)

Sectors to invest in: Utilities

Recession Phase I (late recession)

Sectors to invest in: Consumer cyclical, Financials.

A note of caution though, it’s hard to know what stage you are at in a recession or boom so this has to represent an idealised scenario. The sector rotation policy outlined above has been found to be accurate, but there is a degree of hindsight in returns. IF we’re in the early recession phase then Utilities could be the best place to invest right now. I imagine historically this is because of their higher dividend payments.

Why we might rally from here

There’s some great research from http://www.cxoadvisory.com on how to time the markets based on economic events. Stock market booms occur with rapid increases in economic growth coupled with low, declining inflation. The typically end with rising inflation which leads to an increase in interest rates. CXO have their own stock market model based on an analysis of all the academic research into stock market behaviour and it has been remarkably accurate. You can view this model and its predictions here: http://www.cxoadvisory.com/status/

The various models are based on things like earnings and inflation. They’re currently predicting the market to flat line until 2009, whereupon it will recover with a price target in excess of 1500 12 months from now. That’s a return of 50% from current levels.

Barry Ritholtz put up a timely piece ahead just as the market made some sort of bottom on Friday. It outlined 10 contrarian indicators that pointed to the likelihood of a rally.

You can read the full list here:


1. Relative Strength Indicator, SPX, 1928-2008

Ever since the beginning of the S&P500, the RSI’s monthly indicator has only dropped below 30 on four occasions: 1929, 1973, 2002, and 2008. All 3 prior instances were very close to lows.

2. SPX Losses

The S&P has given up nearly the entire gain from the 2002-03 period to the October ’07 highs. This is a major correction that, like the many trading rallies in the 1970s, should set the stage for the next leg up. Note that these were not buy and hold rallies, but 6 – 18 month trades.

3. Dow Components and the 200 Day Moving Average

All 30 Dow stocks are below their 200 day moving average — a condition that has only occurred once before — and the last time was right after the 1987 crash.

4. Cash Allocation

Investors current allocation to Cash is well above its 21 year mean and are at the highest levels since ’02, ’98 and ’90 lows.

5. 90/10 days

This week has seen three 90% downside days, reflecting massive liquidations.They can only continue for so long. As noted above, we believe in scaling into long positions. We would become more aggressive buyers after the first 90% upside day. This has historically created a good entry for a 1 to 3 to 6 month holding period.

6. Percentage NYSE over 200 Day MA

The percentage of stocks trading over their 200 day moving average is at multi year lows.

7. Gold vs SPX

The cost of an ounce of Gold is now greater than the S&P500; This last occurred in the early phase of the 1982- 2000 bull market – around 1984.

8. VIX Moving Average

The VIX (also known as the Fear Index) hit a multi-year high of 70.90, reflecting extreme levels of emotion in the markets. We like to look at this on a 50 day moving average:

VIX Deviation From 50-Day Moving Average

Readings above 15 over the last 10 years have produced significant rallies. The present reading on this indicator is 26!

1998 Reading Market Up + 27 % (3 Months Later) and + 36 % (6 Months Later)

2001 Reading Market Up + 22 % (3 Months Later) and + 22 % (6 Months Later)

2002 Reading Market Up + 14 % (3 Months Later) and + 19% (6 Months Later)

If history bears out this should be a good buying opportunity with a 3 to 6 month horizon.

9. S&P500 is down 47% from its peak level one year ago.

Transports are down 38%. These are relatively rare degrees of loss, and suggest a near term upside move.

Some more bullish indicators:

According to SentimenTrader’s (www.sentimentrader.com) Smart money/ Dumb money indicator, even before yesterday’s rally, the smart money were buying strongly and the dumb money was panic selling. Typically readings like this are good buy signals on a 3-6 months time horizon. The last time they reached these levels was March of this year. Ok the rally only lasted a couple month months, but there was still some oomph in the market at a time that people were expecting further falls.

Last week the S&P 500 decline 7% to a new low. According to Sentimetrader, this has only happened three times previously. In 1929 the return 6 days later was +25%, in 1931, the return 5 days later was 22%, in 2001, the return 8 days later was 14%. If the past is anything to go by, there could be further gains to come.

Some bearish indicators:

Unfortunately in the same study mentioned above, the returns following the initial rally were generally flat so after an initial spurt we could flat line for a bit.

www.thewizard.com, www.marketclub.com and Click the market’s Gravity charts all timed the down move exceptionally well. I’ve reviewed each of these in a previous edition of What Really profits. All of these are still bearish on the daily and weekly charts, which might not be a great sign.

My Trades

After making a number of small trades unsuccessfully trying to find the bottom on the S&P 500 last week, I finally got it right on Friday. I really liked the vicious bounce on the US market open and coupled with the contrarian indicators I was getting from various sources, I plucked up the courage to enter one more long trade. This time I felt more confident with the technical bounce finally indicating there might be some buyers around to back up the panic indicators that I’ve outlined above. So this time I went long the S&P 500 and the Dow. I bought the S&P 500 tracking ETF, SPY at 89.35 and the Dow tracking ETF DIA at 84.32. The damn things went against me straight away, but my stops weren’t triggered. I decided to hold over the weekend and last night I was very happy to say the least. Quite probably my best ever trades. Unfortunately the weekly net gains were reduced by my earlier unsuccessful attempts at finding the bottom, but still I was rather pleased with myself for once.

The Wizard has caught the forex moves very well these last few weeks, with most of the currency pairs showing a good profit. The futures filter did well on the downside, but has given back some of those gains with yesterday’s rally. Still the shorts on oil and natural gas made me a paper profit of $20,000! If only I can find somewhere that will take my excel spreadsheet as legal tender.

This week’s hot trading buttons

The week’s planned economic announcements will continue to play second fiddle to the shocks and surprises that await us all. There are important announcements from the UK to start the week with CPI on Today. Wednesday brings a raft of US data with US PPI and retail sales. Bernanke is also due to speak on in the late afternoon.

Trading Wisdom

One of my favourite daily reads is http://www.thedailymash.co.uk. It’s offered some light relief over the past few weeks with its made up articles and inane commentary. I thought you might like a little light relief this week. Some of their thoughts on the cost of bailing out the banks:

“It would actually have been cheaper to launch an intergalactic space mission to search for the planet Krypton, find Superman, bring him back and get him to fly round and round the Earth until it started rotating the other way, thereby turning back time and opening up the wholesale money markets again.”