What Can Be Learned When The Algos Are In Charge?

The goal of this report, which can oftentimes be classified as a meandering morning market missive, is to identify the primary drivers of the stock market. To be sure, there are certainly times when the drivers of the action are actually quite easy to identify. And then there are days like Tuesday, where there was nothing terribly obvious to the naked eye.

While the end result didn't appear to be meaningful (the DJIA and S&P 500 indices each lost 0.2 percent, the NASDAQ actually eeked out a slight gain), sometimes how the action unfolds on an intraday basis can speak volumes about what is actually happening in the market.

Algos Back At It

After one of the least volatile days of the year on Monday, the bottom line is the algos got back to work on Tuesday. Although there wasn't much in the way of economic inputs to consider (the NFIB Small Business index came in below expectations), the boys and their computer toys did get some "taper" headlines to work with after the market opened.

In what was clearly an all-algo-all-the-time affair, stocks were pushed and pulled in both directions based on whatever came out of a Fed governor's mouth. Never mind the fact that most of what passed for "news" yesterday was anything but, the algos were armed and ready to react - and move the S&P 5 or 6 points each time within a matter of minutes.

First Up, Richard Fisher

The first to hit the wires with comments was Dallas Fed President Richard Fisher, who, is set to become a voting member of the FOMC next year.

As usual, Mr. Fisher suggested that the Fed can only do so much and should step away soon. Fisher reminded the audience that the QE program cannot continue forever. In addition, the Dallas Fed President raised concerns about the size of the Fed's balance sheet and the challenges it poses, adding that QE "becomes riskier by the day."

Although Mr. Fisher's views are widely known, the algos apparently got the headline they were searching for (at the speed of light) and stocks moved down in a straight line.

Now Batting: Dennis Lockhart

Next up was Atlanta Fed President Dennis Lockhart. Not surprisingly, the generally hawkish Mr. Lockhart told the press that he "would not take [the taper] off the table at this time" and that the FOMC could very well begin pulling back on it's $85 billion a month bond buying program in December.

Lockhart also said the recent Nonfarm Payroll report data was encouraging, but not "decisive" evidence of a sustainable improvement in the labor market. Mr. Lockhart added that he wanted to see inflation accelerate toward the Fed's 2% goal before beginning to taper.

And yes, the algos noticed Lockhart's comments about the potential for a "Dectaper" - and not in a good way.

And Finally, There Was Kocherlakota

Then there was Minnesota Fed President Narayana Kocherlakota. Kocherlakota first said market speculation about tapering is "puzzling" in the light of the current economic challenges. In other words, he didn't understand why folks are concerned about the Fed "tapering" when the economy isn't exactly hitting on all cylinders.

On that note, Kocherlakota added that tapering now would produce a drag on an already slow economy. And finally, he repeated his recent call to cut the Fed's unemployment threshold to 5.5% (from 6.5%) and reiterated his feeling that the Fed must be ready to do more to stimulate economic growth. A dove indeed.

As you might have guessed, the algos once again reacted - this time to the upside.

What's The Takeaway?

So what, if anything, should investors take away from a day like Tuesday?

The first point is to understand that after the bulls have enjoyed a decent move higher, the market tends to consolidate for a spell. During these sideways, range-bound periods, buyers tend to "stand aside." In short, everybody knows stocks have run and become overbought in the process. As such, anyone looking to add exposure will likely hold off until some sort of pullback occurs.

The key is that this leaves the market vulnerable to selling pressure - and also to algo-driven activity such as was seen yesterday. Remember, the goal of an "ignition algo" is to start a trend that other algos will then jump on to. And the bottom line is this is what appears to be transpiring now.

The best course of action then is to hang tight and watch carefully for signs that the "consolidation" phase may be morphing into something worse. On that score, the key level to watch would be 1740 on the S&P 500 cash. Above this level means that the consolidation continues. Below it, well... maybe not so much.

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Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of Fed Policy
      2. The Outlook for Economic Growth

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Neutral
(Chart below is S&P 500 daily over past 1 month) Intermediate-Term Trend: Positive
(Chart below is S&P 500 daily over past 6 months) Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 12 months)

The State of the Tape

The Early Warning Indicators

The State of the Market Environment

Weekly State of the Market Model Reading: Positive

Thought For The Day...

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Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

• Near-Term Support Zone(s) for S&P 500: 1760-40
  
• Near-Term Resistance Zone(s): 1775

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

• Trend and Breadth Confirmation Indicator: Moderately Positive
  
• Price Thrust Indicator: Moderately Positive
  
• Volume Thrust Indicator: Negative
  
• Breadth Thrust Indicator: Negative
  
• Bull/Bear Volume Relationship: Moderately Positive
  
• Technical Health of 100 Industry Groups: Moderately Positive

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

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Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
StateoftheMarkets.com

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

Positions in stocks mentioned: none

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The opinions and forecasts expressed are those of David Moenning, founder of StateoftheMarkets.com and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of TopStockPortfolios and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.