An Elephant and Three Blindfolded Wise Men

Let's start today's post about where stock prices are headed by retelling an old Indian fable:

Three wise men were blindfolded and led one at a time into a room where an elephant stood. Each was asked to discern what was in the room without removing his blindfold. The first, upon touching the elephant's trunk, concluded a "snake" was in the room. The second, upon contacting a leg, concluded a "tree" was in the room. The third, upon grasping the tail, concluded a "rope" was in the room. All were surprised to discover the elephant once their blindfolds were removed.

We thought it might be fun to illustrate just what the modern equivalent of those three wise men "see" as they attempt to describe what's going on in the stock market with the charts that we've developed over the last several years to analyze stock prices, as described in a recent article from the Reuters news agency.

Odds of a pullback are increasing, with the market in slightly overbought territory, said Bruce Zaro, chief technical strategist at Delta Global Asset Management in Boston.

"I do suspect the closing of the earnings season will lead to at least a pause and possibly a pullback," Zaro said. The S&P 500 could shave 3 to 5 percent between now and early April, he said.

It would seem that Bruce Zaro is a blindfolded wise man who feels the market's potential for mean reversion, such as might happen if volatility in stock prices could be described by statistically normal distribution that might be observed in something that looks like a control chart:

Here, having the most recent data be below the mean trend would suggest a rising market as stocks would be "underbought", while being above the mean trend would suggest that stock prices are "overbought" and are increasingly likely to either stall out or fall in the future.

In this chart, which picks up the major trend that has existed in the U.S. stock market since the QE 2.0 bubble popped in late July 2011, we see that stock prices are in what Bruce Zaro describes as "slightly overbought territory". The 3-5% "shave" he predicts by the end of March would represent a little over a one-standard deviation decline in stock prices, which would be a move from the central black trend line to the light-gray dashed line immediately below it.

Next, let's see what another blindfolded wise man discerns as he examines the stock market:

At the same time, other analysts say, the market has not shown significant signs of slowing, including a break below 15- and 30-day moving averages.

Such moves would be needed to show that momentum is slowing or that the market is at risk of a correction, said Todd Salamone, director of research for Schaeffer's Investment Research in Cincinnati, Ohio. The S&P 500's 14-day moving average is at 1,511 while the 30-day is at 1,494. The index closed Friday at 1,519.

Todd Salamone is what we would describe as a "momentum" guy. Unlike a practitioner of momentum trading, which is really a kind of crowd-following/crowd-anticipating investment strategy, Salamone believes in the physical force of inertia, which is a way of saying that once stock prices get onto a particular trajectory, they'll stay on it!

All you have to do to see that prediction on our chart above is to draw an imaginary line from a point at the bottom of the most recent short-term trend up through the most recent data point for stock prices. And then on out as far as you dare dream. Kind of like Chuck Prince's dance party investment strategy, because what can possibly go wrong so long as you don't see stock prices suddenly dip below the moving line average shown on the chart?...

Let's get one last take on the current state of the stock market from the Reuters article:

The S&P 500 has been trading near five-year highs, and it notched its highest level since November 2007 this week. But the gains have pushed the benchmark index almost as far as it is likely to go in the near term, with strong resistance hovering around 1,525 and 1,540, one analyst said.

As a result, the index is set to move sideways, said Dave Chojnacki, market technician at Street One Financial in Huntington Valley, Pennsylvania. "We just don't have the volume or the catalyst right now" to go above those levels, he said.

Dave Chojnacki is described as a market technician, which means he is a practitioner of technical analysis. Here's how Investopedia explains that black art:

Technical analysts believe that the historical performance of stocks and markets are indications of future performance.

In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, the technical analyst's decision would be based on the patterns or activity of people going into each store.

In essence, what he is saying as he senses the stock market today is that because investors have never gone shopping for stocks much above the 1,525 and 1,540 level for the S&P 500 before, they're resistant to go shop for them above that level now.

But then, he goes on to say something actually interesting - he loosely perceives that some sort of physics might be involved, as he doesn't find any forces that might drive stock prices higher as he surveys the market's current environment.

The two comments together would seem to describe how stock prices might behave given the lack of upward room to move that is indicated by the current changes in the growth rates of stock prices and dividends per share driving them as the gap between them narrows in our chart below, if only the analyst knew of the relationship between the two!:

The only perspective that's missing from the Reuters article is the consideration of a steep decline for stock prices once we get past the near term. We guess they couldn't find a fourth wise man to blindfold before going to press....