Market Summary

NASDAQ Market model signals 'exit'

The NASDAQ suffered its third weekly loss in succession this week and on Thursday registered its fifth distribution day in eleven sessions causing our market model to signal an 'exit'. The DJI and S&P 500 suffered their first loss in eight weeks. All three indexes pulled back on lighter weekly volume indicating that this is a consolidation in response to the large gains made, particularly by large-cap stocks, over the past 2 1/2 months.

Our market model backtests well (see below) but it has not performed well over the last two months. Since issuing its first exit signal for the NASDAQ on March 13 when it closed at 2350.57, the index has risen 8.8%. The other major indexes have fared even better with gains of 11.9% for the DJI and 10.0% for the SPX.Will it be any different this time? We cannot tell, but the markets are certainly due to take a breather. Here are some facts to consider that might color your point of view.

• Funds continue to flow into institutions, albeit at a slower rate, and are split fairly evenly between domestic and foreign funds. Including ETF activity, equity funds reported net cash inflows totaling $3.235 billion in the week ended 5/23/07 with Domestic funds reporting net inflows of $1.435 billion and Non-domestic funds reporting net inflows of $1.800 billion; (AMG Data Services).
• Short interest has been rising since mid-2006 as it did before the market peak in 2000. While short interest provides a floor under the market as the shorts cover, eventually the bearish sentiment wins out. See this Bloomberg chart.
• Statistically speaking the mantra “Sell in May and go away” has held true for the S&P 500 since 1950.
• The Bollinger Bands around the weekly NASDAQ chart have tightened considerably. This usually presages a breakout to the upside or downside, although the direction of the move cannot be determined from the chart.

We wish all our newsletter subscribers a happy and safe memorial Weekend. Remember the markets are closed on Monday.

There were no new features added this week.

How the Market Model Works.

Market signals are generated by our Market Model based on distribution days and follow through days. A distribution day is one where the index closes down on higher volume than the previous day and follow through day is an accumulation day that occurs within a range of days (see below) after a market bottom. Note that our definition of a distribution day is clear cut and simple. This explains why our distribution day count on the NASDAQ this week climbed to five while a prominent investment daily only has the count at 3.

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.

There is more information on how we built the model here.

How the Model worked in 2006

The model successfully avoided the large correction that began in May when it issued a sell signal on May 10. However, the requirement that a follow-through day can only occur if the index is above its 200 day moving average, meant that an enter signal was only issued on September 13, well after the market bottom. this significantly reduced the overall return and the model ended up breaking about even. The following chart shows the entry and exit points for 2006 and the returns for the index and the returns achieved if using the enter and exit signals. The 200 dma is also shown so you can see how the enter signal was delayed.

Model Performance Over 5 Years

Over the past five years the model has outperformed the NASDAQ Index by a factor of almost three:

Investment Advisors Using our Service

TradeRight Securities, located in a suburb of Chicago, is a full services investment management company and broker/dealer. They have been a subscriber, and user, of BreakoutWatch.com for some time now. They practice CANTATA and use Breakoutwatch.com as a “research analyst”. You can learn more about TradeRight Securities at: www.traderightsecurities.com. If you’re interested in speaking to a representative, simply call them toll-free at 1-800-308-3938 or e-mail gdragel@traderightsecurities.com.

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