Last week we posted an article, during the Tuesday market slide of over 1%, entitled "Has The Correction Started?".  That answer is no.  In fact, since the beginning of 2012 there has only been one week that has seen a decline which was the 2nd week of February when the S&P 500 was down just over 2 points.   Hardly a correction.

With yesterday's late day surge, based on the continuing stock rigging between the Fed and the banks, we have now moved well into extreme ranges for a "buying stampede".  With the volatility index now at some of the lowest levels in the last 5 years - complacency risk in the market is extreme.   This complacency is further complicated by the high levels of bullish sentiment when measured by the number of stocks on bullish "buy" signals as well as the number of stocks trading above their respective 50 day moving averages.  To paraphrase Jimmy McMillan - investment risk remains "to damn high". 

What Was Behind The Surge

Yesterday's market advance has got investors scratching their heads and the media tripping all over themselves.  The announcement by the Federal Reserve following the FOMC meeting was a non-event.  The Fed did not change policy and offered no hints as to future policies. The Fed proffered a slightly better economic assessment, albeit not by much, and a worse inflation assessment.  The dollar rallied, bonds tanked and gold sold off because there were no hints of further quantitative easing programs.

After the FOMC announcement stocks held their gains as the media quickly pointed to the stock rally as an indication that the Fed would continue to do whatever is necessary to keep the market moving in the right direction.  Remember, rising asset prices boost consumer confidence which is still at recessionary levels.  What is interesting is that many "experts" still see QE coming even though the economy is back on its feet.

However, the real reason for the stock spike that occurred going into the final hour of trade on Tuesday was when JP Morgan announced that it would buy back $15B of its shares and hike its dividend.   A "senior Fed official" said the early release of JPM's stress test results was a miscommunication between them and JP Morgan.  Really?  If that was the case then WHY were so many banks ready to make capital-return announcements?  This was a well-orchestrated event and the major players new this well in advance.

However, there is a bigger question that should be asked here since banks are now back, theoretically speaking, into financially strong shape.   Why does the Fed want to keep their interest rate policy at zero until 2014?   If banks are well capitalized now why continue to punish savers by appropriating their funds to give to the big banks and Wall Street.   Furthermore, if banks are in such good shape why is the Fed allowing them to now deplete the capital they just built up?

Here is another problem - the "stress tests" are in reality very flawed because they did not take into account the mark-to-myth assets, mortgages and European exposures, sitting on the books of the major banks.  The banks are far less "well capitalized" than the Fed claims and the problem now becomes that once banks start paying dividends, it's difficult for a regulator to get them to stop without panicking investors.  The seeds for the next crisis have now been sown and the mistakes of the past are once again being repeated with very little backstop for future events.  

Where does all of this leave us, as investors, now?

What Correction?

The action last week, while volatile, kept the markets in a positive advance without correcting any of the current overbought condition.  While the market did come back quickly to turn previous resistance levels, the 2011 market highs, into support, Tuesday's "advance" now requires us to move up areas where we expect future corrections to occur.  While no correction has currently occurred it does not mean that it won't.  The reality is that the longer the market advances without corrective action the larger the correction will likely be.

Corrections, while the media detests them, are a very necessary and "healthy" part of any longer term, positive advance.  Prices can only remain at extremes for a finite period of time before they revert back to, and generally beyond, their mean.   This allows the market to "reset" itself for a continuation of the advance.  In reality, as investors, we welcome corrections so that we can buy assets at "cheaper" levels.  What is required though is patience - and "buying stampede's"  tend to put investor's patience to the test.   This is where investors begin to make "emotional" mistakes that lead to longer term portfolio losses.

We have identified three likely areas where such corrective action would likely occur.  The first level is a retracement and consolidation back to the previous 2011 highs.  A pullback to that level which works off some of the overbought, overly exuberant, condition of the market, will allow for adding additional exposure to equities.   If that first level of support should fail, which is very likely due to the extreme overbought condition I will discuss momentarily, the next logical level of support is the 50 day moving average. 

The 50 day moving average is a moving target that will vary slightly each day depending on daily market movements.   However, as of the time of the this writing, that level is currently just above 1333 on the S&P 500.  Lastly, if the 50 day moving average is broken then the critical level of support become the previous "neckline" from the 2011 "head and shoulders" topping pattern that led to the 20% swoon last summer.  This support level, around the 1260 level, should hold up to any decline this year.   If it doesn't we will have other very important decisions to make at that point as things will likely be going very poorly.  

Note:  Everyone does technical analysis differently.  Trend lines, moving averages, price formations, etc. all lead to good analysis.  However, in order to try and provide a usable analysis for investors to manage portfolio risk we have chosen some very basic analysis that has served us well in the past.

The Rubber Band Effect

As I stated, the market remains overbought, over bullish, and over extended on many measures and corrective actions from extremes are a necessary part of any healthly market.  For the purposes of this discussion we are going to look at the market in terms of standard deviation.  In simplistic terms standard deviation simply measures how much variation, or dispersion, exists from the moving average to the current price.  Putting this in terms of stretching a rubber band - if you stretch a rubber band to 95% of its maximum that would be equivalent to two standard deviations.   If we stretch the rubber band to 99% of its maximum that is three standard deviations (for geeks it is 99.73%).  Currently the market is trading in excess of 3 standard deviations of its 50 day moving average.  In other words, the current market advance is stretched to its maximum. 

As you can see in the chart above during bullish trending markets the market tends to trade between the moving average and 2-standard deviations (blue dashed line) above.  In a bearish trending market it trades between the moving average and 2-standard deviations below.  When the market has reached 3-standard deviations (red dashed line) it has usually preceded a corrective action.  Furthermore, the current advance is very similar to the advance that we saw in 2011 leading up to the market top and 20% correction last summer.

The point here is simply that the economy is still very weak otherwise the Fed would not be leaving the door open for further stimulative action and leaving interest rates near zero.  The markets are being pushed by liquidity pumps which will fade as we continue to move forward.  The markets are extremely ebullient and with the media cheerleaders going "all in" this is generally the first sign to start becoming a profit taker.

As we have been stating since December the markets are on net "buy" signals and in a bullish, positive, trend.  We must honor those trends and remain invested until those trends turn negative.  However, we also want to manage portfolio risk accordingly - take profits, reduce laggards, and add risk based holdings during corrections that put risk and reward more in our favor. 

Remember, investing and managing money is not a competition.  Our job as investors is to protect our capital first and foremost.  We should only "risk" our capital when we are cognizantly aware that the risks, or the potential for loss, is outweighed by the potential for gains.  Today, that is not the case.