Market Outlook: Is It Time to Prepare for the Worst?

With 2014 off to a lackluster start, investors need to consider whether they should take action to avoid a likely sell-off.

A Pullback is Not a Sell Signal

On the first trading day of the year, SPDR S&P 500 (NYSE: SPY) fell 0.96% and extended its loss with a small decline on Friday. For the week, SPY fell 0.51%. The two-day sell-off at the end of the week was not a very significant event, but in a search for new indicators, some commentators are trying to compress the January Barometer into an ever shorter time frame.

The January Barometer claims that the market will end the year up if the S&P 500 moves up in January. A lower close for the index in January is bearish for the full year.

Several years ago, a widely admired technical analyst, Louise Yamada, CMT, revealed she had found a way to improve the January Barometer. She told The New York Times that when there is a gain in the first five trading days of January and a further climb through the end of the month, "there is a 94% chance of the market being up for the year." That quickly became compressed into an indicator that follows the first five days of January to forecast the trend of the market for the year.

This week, I saw a study showing that the first day of the trading year could also be used to identify the year's trend. If the first day of the year is up, the stock market moves higher for the full year 82% of the time. 

Annual data for the S&P 500 index goes back to 1928, and in 62 of the 86 years since then, 72% of the time, stocks have closed up for the year. Given the strong bullish bias in the stock market, the January Barometer, in any variation, provides little tradable information.

Rather than trying to use January to develop a forecast for the year ahead, traders should consider what they will do when a pullback occurs. The past two years have been relatively mild from a volatility perspective. In both 2012 and 2013, there were only two pullbacks of 5% or more. The last pullback of 10% ended in June 2012. There is no doubt we are due for a pullback.

SPY Market Outlook Chart

Traders need to consider what they will do when prices pull back. The question is whether or not it is worth taking action. If a $20 stock, for example, falls to $19 (a 5% pullback) or $18 (a 10% pullback) before recovering, is selling to avoid the loss the best course of action?

There are some traders who want to avoid all losses, but that is not possible. Until the pullback happens, it is best only to plan. Taking preemptive action carries the risk of lost opportunities. Planning to sell when the pullback shifts to a bear market is probably the most prudent plan for many traders. There is no sign that will happen anytime soon, and until it does, we remain in a bull market.

Gold Miners Outperform Gold

SPDR Gold Shares (NYSE: GLD) opened the year with a gain of 1.85% last week. Miners also participated in the rally. Market Vectors Gold Miners ETF (NYSE: GDX) ended the week up 2.73% and Market Vectors Junior Gold Miners ETF (NYSE: GDXJ) gained 6.28%. The participation of mining stocks confirms the short-term bullish outlook for gold.

Last week's gains highlight an important risk factor traders should understand. More leverage does not always lead to significantly larger gains. Direxion Daily Gold Miners Bull 3X Shares (NYSE: NUGT) gained 7.57% last week, not much more than the gain delivered by GDXJ. However, NUGT has more than twice as much risk as GDXJ when risk is measured by historic volatility.

The 100-day historic volatility of NUGT is 128, while the same measure is only 52 for GDXJ. For comparison, the 100-day historic volatility of SPY is 10. Traders need to understand how much risk they are accepting in pursuit of returns.

GDXJ is also offering a buy signal on the DeMark Sequential indicator.

GDXJ Market Outlook Chart

This indicator begins with a setup that is completed when the price closes lower than it was four days ago for nine consecutive days. Once the setup is completed, the countdown begins, and the countdown increases by one each day that the close is lower than it was two days ago. When the countdown reaches 13, a buy signal will be triggered on a higher close.

Sequential is designed to spot potential turning points. The idea is that after a downtrend lasting more than a month (the nine-day setup period followed by the 13-day countdown requires at least 22 days and usually more), a reversal is probable. However, unlike most indicators, DeMark Sequential can reset and complete a new setup before giving a buy signal, which makes the signals more reliable.

Sequential signals do not work 100% of the time, but they are widely followed by professionals. This could indicate gold has found a short-term bottom and miners are a buy for the short term. Additional confirmation is needed before gold and gold miners should be considered buys by long-term investors.

This Week's News

In addition to some potentially market-moving news from the Federal Reserve and the jobs report, earnings season kicks off this week.

Market Outlook News

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