What's the Story Behind our Asset Allocation Model's Message?

We know from trying to play the balance game between our emotions and statistical analysis (which is nothing more than seeing what history has provided in the past when similar conditions existed) that every time we have the readings we're currently receiving from our Asset Allocation Model, the stock market is playing havoc with our emotions.  It is ALWAYS telling us to NOT trust the message, that the machine is out of balance, out of whack, and that something special is occurring that makes today "different."

Sometimes it is "different," and in the rare case that is the situation, we have our Market Trend Analyzer (that we mentioned in yesterday's post), which acts as a "safety valve" for those serious declines that the combination of Investor Psychology, Monetary Conditions, and Stock Market Valuation don't predict. 

The discipline doesn't get any better than when it shows all of the components in their optimal buying zone, as they are showing today.  But market bottoms and corrections have a way of testing your resolve.  The strongest "bullish" signal typically happens at the point when the most stocks are getting hammered, and quite often, you see a residual process as the evolution works its way through the bottoming formation.  As we've been mentioning, we believe August 8th was the peak in bearish momentum, and the action since has been the evolution as the bullish forces gradually come into play.

We're not sure WHY, but for some reason when investors have so much fear that the VXO has been pushed above that level of 44, it seems that the dam breaks and gushes so much fear it passes the point of no return.  Traders panic, and investors tag along.  They sell with no regard for price.  But that does not usually end the perception that the bear market or correction has ended.  The residual fear when the public investor reads the paper the next day, or sees his/her portfolio's statement at the end of the month, rushes them to "cash out."  Often, the left shoulder of the bottoming reverse "head-and-shoulders" pattern will occur simultaneously with the peak fear as measured by the VXO, and then the public selling generates that "lower low" a few weeks or even a few months later.  Looking at the chart below, the similarity between today's market and the correction that we saw last year extends even to the internal action of the stock market, which you can see in our oscillators that measure the number of advancing and declining stocks.

Click on the image above to view a larger chart.

Yet, the danger with my "cute" rhyme is that the above thought - that this correction gives you a pattern to trade - encourages investors to wait on that final "right shoulder."  Risk aversion and "doubt" are in all of our heads.  We just need a little assurance that the problems and worries of today will be resolved, and when it seems as if there is no solution, the waiting stifles new investment and sometimes the right should does not occure and the procrastination means that these investors remain in cash.

But as we've mentioned before, we believe that as the decisions of the Super Committee come to light, sunnier days should return.

Don Hays

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