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Line in the sand

Nervy Nikkei

The tendency of equities to do well in April and then struggle from May onwards is, of course, just that: a tendency. There is no reason whatsoever why we cannot suffer weakness beginning earlier or indeed not suffer it at all. Although the S&P did suffer a sell-off beginning in May last year, it was a minor shakeout, which saw the market shed 7.5 per cent. In my book, a correction is a drop of at least 10 per cent. While we avoided this in 2013, I doubt we will be so lucky this year.

Tech's modest sell-off

Admittedly, the downside so far has been pretty trivial, in the scheme of things. This is even true in the worst-affected indices, such as our own FTSE 250 or the tech-heavy Nasdaq 100. The 7.9 per cent decline in this index has spooked many traders and prompted comparisons with the bursting of the technology bubble back in 2000. Some perspective is called for here, though. The Nasdaq has seen 13 drops of this size or greater since March 2009. It suffered two of more than 10 per cent in 2012, without damaging the larger uptrend.

Melty mid-caps

So, why do I feel more nervous today than I did back in late 2012, say? Both fundamentally and technically, the set-up was much more favourable 18 months ago. The Federal Reserve had lately unveiled its third round of quantitative easing, the indices’ momentum readings left plenty of scope for upside, as did valuations. Today, QE is being gradually wound down, while momentum readings and valuations are much more stretched. The first point is the most important. Printed money trumps pretty much everything else, at least in the short run.

Given Wall Street’s current vulnerability and the likelihood of several rough years to come, I need to have a clear plan about when to turn outright bearish. Many of the gurus out there already have, particularly those who rely on methods such as Fibonacci projections, Gann angles or sunspots. As a humble follower of the trend, my approach is to assume we are still in an uptrend until we have confirmation that it has turned. There is no need for any magic or finesse here: the simpler we keep it the better.

S&P's key level

I have previously shown (bit.ly/1t3KmCh) how investors can dodge the worst of bear markets by simply switching into cash as soon as the S&P 500 ends a month below its 10-month exponential moving average, which currently sits at 1769. Does this mean a bear market has definitely started once the index posts a monthly close below this line? Of course it does not. It is, however, a perfectly reasonable - and objective - way in which to define a larger downtrend. For now, we are in a short-term downtrend within a long-term uptrend. There is still no evidence of a top.