Stop Doing What Everyone Else Does

A poll was recently conducted on Twitter asking, who was the most helpful trader in 2013? We do not know everyone on the list, but we know most of them. What common trait do the people/firms share that allows them to be helpful in the difficult world of trading and investing? They all have a system that pays attention to what is happening in the markets, which is in stark contrast to the common Wall Street way of investing based on predictions about a highly uncertain future.

Paying Attention Could Have Limited Gold Losses

Do you want an example of investing based on trying to figure out what is going to happen versus paying attention and adjusting? On December 31, we presented the chart below while comparing investing in gold (GLD) based on forecasts to using a simple moving average system to monitor demand for gold relative to stocks. The horizontal lines in the gold chart below show the 2013 forecasts for gold made in late 2012.

Even Warren Buffet Needs Trend Reversals

If Warren Buffet purchases company XYZ because he feels it is undervalued, company XYZ will eventually have to resume an uptrend for Mr. Buffet to make money. The same can be said for bottom-pickers in gold. Moving back to 2014, it appears as if many hedge funds are playing the gold can't go any lower game. They might be right, but if they are, evidence of a turn has to show up. If those who buy gold today are eventually able to sell at significantly higher levels, gold must (emphasis on must) reverse from a downtrend to an uptrend first, as described in this "how to spot trends" article. From Bloomberg:

Hedge funds raised their bullish gold bets to a six-week high, splitting with analysts at Technical Research Advisors LLC and Goldman Sachs Group Inc. who are predicting more declines after last year's rout. Gold tumbled 28 percent in 2013, the first decline in 13 years and the biggest since 1981, after some investors lost faith in the metal as a store of value. "With gold, in the short-term, we're being pulled in multiple directions," said Michael Cuggino, who manages about $10 billion of assets at Permanent Portfolio Family of Funds Inc. in San Francisco. "There were sellers trying to get out in front of the tapering. Physical demand is OK, but not strong. You also have increasing economic activity, which could begin to accelerate inflation."

Market's Pricing Mechanism Still Bullish

What determines the value of a stock or exchange-traded fund (ETF), such as GLD? The aggregate opinion of all investors, which can be summed up with the equation below:

When the result is net bullish, it tells us the desire to buy is greater than the desire to sell. Desire or conviction is based on the perception of future economic outcomes, earnings, geopolitical events, and Fed policy. In the world of equities, we can monitor the equation above with the weekly chart of the S&P 500 below. When the trend is bullish, it tells us the net perception of the future is favorable; when the trend is bearish, the net perception has moved into "we are concerned" territory. The "look" of the chart as of Monday's close still sides with the economic and stock market bulls. If the chart prints a lower high (see A and B), then the odds of future economic and market weakness increase. Notice the term odds was used in the prior sentence, which aligns with one of the tenets of investment success - thinking in probabilities.

For those new to the concepts presented here, this week's stock market outlook video covers navigating the 2010 Flash Crash with observable evidence (no forecasting was required).

Trade Deficit Smallest In Four Years

A few years back, we often heard "America does not make anything any more". The latest trade deficit figures included some bright spots for the economy and manufacturing. From Reuters:

The U.S. trade deficit fell to its lowest level in four years in November as exports hit a record high and weak oil prices restrained import growth, the latest evidence of strengthening economic fundamentals. The Commerce Department said on Tuesday the trade gap fell 12.9 percent to $34.3 billion. That was the smallest deficit since October 2009.

Investors Vote With Their Wallets

The weekly chart below tracks the desire to own stocks (SPY) relative to the desire to short stocks (SH). When the desire to own stocks is greater than the desire to short stocks, it speaks to a state of aggregate economic confidence. As of Monday's close, the ratio has experienced some relatively mild weakness. If the look of the chart morphs into something similar to points C and D below, our concerns about the stock market will increase. For now, the chart is calling for some patience with stocks.

Keep in mind, our analysis above does not involve the use of a Ouija board or palm reading. The changes in the market's risk tolerance are observable. If the bull market slips into a bear market, the ratio above will flip over to a bearish look. The beauty of math, data, and charts is they are free from emotions, opinions, and cloud-inducing bias.

Investment Implications - Long Until Evidence And Data Shift

As noted Monday, the market has shown signs of slowing momentum; something we are keeping an eye on. If the observable evidence and hard data deteriorate in a meaningful way, our market model will call for further incremental reductions in equity exposure. For now, we continue to maintain significant positions in U.S. stocks (VTI), financials (XLF), energy (XLE), small caps (IJR), Europe (FEZ), and global stocks (VT). We will continue to let the market be our guide.