Breakout or Fakeout - How Can We Know For Sure?

The question of the day remains largely the same as it has been for the past four trading sessions: Will a modest breakout to new all-time highs mean that the rally that began on February 4 continue or become just another maddening "breakout fakeout?"

To be honest, only time will tell. However, the business of investing is about staying on the right side of the really big, important move. So, while we can't know what the future will hold - especially in this day and age when the algos can push the S&P 500 SPY up or down 1 percent just for the heck of it - we CAN try to make sure the odds are in our favor before we make a commitment.

So, this morning, we will attempt to do just that by running down our list of important market models to see where they stand in the hopes that perhaps a theme will emerge.

Putting The Odds of Success In Your Favor

To be sure, there are no perfect indicators. There is no holy grail that will get an investor in the market at the bottom every time and out at the top. Not gonna happen. No way, no how. Doesn't matter how many PhD's you put on the project or how much computing power you have. Ms. Market's game simply cannot be mastered with a magic indicator.

However, one CAN attempt to put the odds of being on the right side of the market in their favor by developing a series of unemotional, mathematically-based, market models.

To clarify, we are NOT talking about creating a black box which spits out magical buy and sell signals. No, we are talking about ways to quantify the market's historical drivers and tendencies.

For example, everybody knows that it doesn't pay to "fight the Fed." So, it would seem to make sense to have a model to tell us whether or not the Fed is friendly. Staying in tune with the Fed doesn't work in all environments. But since it does work in most environments, this is an area you want to pay attention to.

Experienced investors also know that it doesn't pay to "fight the tape." So again, the game plan is to build models that indicate when the tape is healthy. The bottom line here is that when the trend and momentum indicators are hitting on all cylinders, stocks tend to go up. As such, if the trend and momentum models are positive, one should give the bulls the benefit of the doubt. And when these indicators are negative, history shows that it is a pretty good idea to get the heck out of the way.

Our Market Environment Model is designed to, as you might suspect, indicate the "state of the market." In simple terms, we want to know what type of animal we are dealing with. You see, experience has taught us that it pays to play the game one way when the bulls are in charge and a completely different way when the bears are holding sway.

So, the first step is to figure out whether the odds favor the bulls, the bears, or something in between. Toward this end, we have created ten indicators/models - each with an area of specialty - that make up our Market Environment Model.

So, without further ado, let's run them down.

What Do The Models Say?

Trend and Breadth Confirm Indicator: The idea here is that when the trend of the stock market (as determined by a simple moving average) and the breadth of the market (the advance/decline line) agree, the message is confirmed. It's a simple concept, but when this indicator is positive, the market has advanced at a rate of 33 percent per year. Current Reading: Positive

Trend Ratings: It is important to understand the time-frame relationships in the market. Therefore, we want to take the pulse of the market on both a short- and intermediate-term basis. We define short-term as 3-days to 3-weeks and the intermediate-term as 3-weeks to 3-months.

As the saying goes, the most bullish thing a market can do is go up. Again, it's a very simple concept, but the trend can be a very good friend if you are on the right side of a big move. Therefore, we want to know whether the trends are positive, negative, or neutral.

Current Reading - Short-Term Trend: Positive
Current Reading - Intermediate-Term Trend: Positive

Cycle Composite: While there is no such thing as a crystal ball, looking at a composite of the one-year, the four-year, and the 10-year cycles can be very enlightening. The key here is that the market will oftentimes move in accordance of its historical cycles. Therefore, we look at the projection of the cycle composite each and every day. Today's Reading: Positive

Volume Relationship: History shows that when "demand volume" is above "supply volume" the S&P 500 index has gained ground at an annual rate of 11.7 percent. And when "supply volume" is above "demand volume," the S&P has lost ground at a rate of -6.1 percent. So, clearly it might be beneficial to pay attention to this relationship. Current Reading: Neutral

Investor Sentiment: There have been volumes written about investor sentiment. But it is important to recognize that this is a very misunderstood area of study. The bottom line is fairly simple though; when sentiment reaches an extreme, it means that investors have already taken action and it might pay to start thinking about going the other way.

Our Sentiment model tells us that the S&P loses ground at the rate of -10.6 percent per year when there is too much optimism, the S&P gains at a rate of 30.9 percent when there is too much pessimism, and manages to gain about 7 percent when the model is neutral. Current Reading: Neutral

Risk Model: This is a model of models designed to tell us the level of risk in the market. When the model is positive (meaning risk is low), the S&P has gained at a rate of 28 percent per year. When the model is neutral, the market has gained at an annual rate of about 8 percent per year. And when the model is negative, stocks lose ground at rate of -24 percent per year. Current Reading: Neutral

Market Mode Model: This model attempts to identify whether the stock market is in a trending mode or a "mean reverting" mode (i.e. a sideways market). When stocks are trending, it would pay to follow trend-oriented indicators. And when the market is in a "mean reverting" mode, it is generally a good idea to utilize a swing-trading approach. Current Reading: Mean Reverting

Economic Model: Although the state of the economy doesn't always drive the stock market, it often does. Therefore, it makes sense to know the relationship between the market and the economy. For example, when the economic model is very positive, stocks gain ground at a rate of 23.7 percent per year. When the model is neutral, stocks advance by 11 percent per year. And when the model is very negative, the S&P has fallen at a rate of -23 percent per year. Current Reading: Moderately Positive

Industry Health Model: Finally, one of the best ways to stay in tune with the market's overall environment is to look at the "technical health" of the 103 sub-industry groups. When most of the groups are trending higher and technically "healthy," the S&P has gained at a rate of more than 30 percent per year. And when this model is negative, stocks lose at a rate of -15 percent per year. Current Reading: Neutral

What's the Message?

Currently, 6 of our 10 models/indicators are positive, 4 are neutral and 0 are negative. Thus, the overall model score is +6. The bottom line... drumroll please... This is a positive reading and tells us to give the bulls the benefit of the doubt.

So, while the algos giveth and the algos taketh away on a hourly basis, the message from our Market Environment Model is that the odds favor higher prices over in the next week or so. Again, there are no guarantees in this game, but if one stays in tune with the message from this type of model, they are likely to stay on the right side of the big, important moves. And THIS is where the really big money in this game is made.

Click Here to Receive the full "Daily State of the Markets" report each morning before the opening bell. Dave's full report includes a list of the current market drivers, trend analysis, key technical levels, six momentum indicators, two early warning indicators, the weekly State of the Market Model, pre-open analysis, and a thought for the day.