Our market model signaled an exit on Wednesday just in time to warn of the pending big sell-off on Thursday and Friday. See our top tip this week for actions you should take now.

Market Summary

Investor optimism that the Fed would soon halt interest rate increases has fueled the rise in the DJI and S&P 500 over the last few weeks. That optimism was shattered on Wednesday when the Open Markets Committee raised rates once again and said further increases may be necessary depending on economic conditions. Well, what else would they say? Investors seemed surprised, however, and a sell-off began as they focused on signs that inflation was reappearing. Foremost among these signs was a jump in import prices and gold rising to levels not seen since 1980 when interest rates rose to 21.5%. Adding to concerns was a surprise decline in consumer confidence and continuing high crude oil prices. A rise in bond yields also threatened to attract money away from equities.

For the week, the DJI lost 1.71 percent, the S&P 500 slid 2.62 percent and the NASDAQ Composite Index plummeted 4.24 percent. Despite the decline in the DOW, this was not a distribution week for that index. Distribution was occurring heavily on the NASDAQ though, and two distribution days on Tuesday and then Wednesday brought the distribution day count to 5 in 15 days causing our market model to issue an exit signal. This was a timely signal as the distribution continued and spread to the other indexes on Thursday and was still well above average levels on Friday. In recent weeks we have commented that the tightening Bollinger Bands on the NASDAQ weekly chart could presage a breakout either to the up or downside. The weekly chart now gives us an answer to that question.

This week we are likely to see the NASDAQ test the support level it found in January, which happens to coincide with the 200 day moving average. A further fall below that level could put the index in the 2200 range not seen since last December 30.

There were 20 breakouts this week with most retreating in the face of the strong market headwind. Two did manage to close out of range. Medtox Scientific (MTOX) gapped up and reached an intraday high of 10% above its pivot before closing for a gain of 5.9% and Elan Corp. (ELN) was the sole breakout attempt on Friday gaining 8% above its pivot before closing for a 5.4% gain.

Our top ranked industry this week was Specialty Steel with Food & Dairy products showing the biggest improvement in the rankings.

Market Model Revisited

Since our market model signaled an 'exit' for the NASDAQ this week, its perhaps useful to review some questions about the model and its interpretation and use.

What is the Market Model?

The market model is in fact three different models based on the DJI, NASDAQ Composite and S&P 500 indexes using two assumptions in common:

• That a succession of distribution days in a certain period indicates it is time to consider closing your positions. This gives an exit signal.
• That after a market bottom, a follow-through day is necessary before opening new positions. This gives an enter signal.

The number of distribution days, the period over which they must occur and the timing and strength of the follow-through day differ for each index.

How was the model built?

The model was built in April 2004 using DJI and S&P 500 daily data back to 1950 and NASDAQ Composite data back to its inception 1984. The time periods used were therefore quite long and should be reasonably representative of bull and bear markets. The parameters of the models were derived by optimizing the returns that each index would have given over the study periods by going long in the index when an enter signal was given and going to cash when an exit signal was given. Because the model was built using data from such a long time period, it is not felt necessary to revise it frequently.

What are the values of the parameters?

Each day after the market closes we look at the market movement for the day and assess whether the current signal should change.

If the current signal is 'enter', then we count the number of distribution days for each of the three major indexes over the last few trading sessions. We will issue an 'exit' signal if the number of distribution days exceeds a threshold as follows:

If the current signal is 'Exit', then we look for the day on which the index set its lowest intraday low since the last exit signal was issued and closed above that low. We'll call that 'day 1' of the recovery since it closed above the lowest low. We then look for a follow through day where the index closed at least 1.5% above the close on 'day 1' and volume exceeded the previous day's volume (an accumulation day). That follow through day must occur within a certain minimum and maximum number of days after day 1 as follows:

There is also an additional requirement that the close must be at least 0.05% above its 200 day moving average.

Is the Market Signal used in any of your other models or metrics?

Yes, the market signal was found to be a significant variable, along with many others, in determining the expected gain after breakout. Consequently, it is part of the evaluation process that puts a stock on the TradeWatch Buy at Open list. It is not used currently in the sell model used by the Sell Assistant, although it may become a factor in future as we continue to improve that model.

How should I react to an exit signal?

An exit signal indicates that the index in question is in a confirmed downtrend. Weakness in one index is likely to extend to others. We know thatwhen the market is in a downtrend 3 out of four stocks will follow the market so when an exit signal is given there is considerably more risk associated with each position. Your reaction will therefore depend on your risk tolerance. If you have a low tolerance for risk, then you will close most or all positions - there will always be other opportunities when the market rebounds, which it always does. Otherwise, you should at least do the following:

1. Eliminate margin call exposure
2. Sell all weak holdings
3. Review other holdings and lock in profits where further gains are problematic, such as if a support level had been violated.
4. Be very cautious about taking any new position. Only one out of four stocks will make gains when the market is trending down.

How should I react to an enter signal?

An enter signal means that the market bottom is passed and stocks are now back on an uptrend. It is relatively safe to open new positions, but with all the caution and due diligence you would have used prior to the exit signal.

Is there more information available on your site?

Yes, we've written about the market model on several occasions:

Market Signals
Using Market Signals for ETF Trading
Market Model Refresher
Interpreting Market Signals

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