November was an action-packed month for the global equities markets. The US market started the month in a rally which was under pressure. For the first week of trading the bulls could not quell the bearish pressure, and technically, the rally ended on November 8, 2007, just 10-weeks after the August 29, 2007 follow-through day of confirmation. The three primary catalysts that ignited the market's correction were: heightened subprime/credit woes, tepid third quarter corporate earnings, and the threat of waning economic growth. The correction was steep, erasing the benchmark S&P 500 Index's gains for the year, and sending each of the major averages below support of their respective 50-day and 200-day moving averages. In the middle of the month, the selling reached what many chart readers would call egregiously "oversold" conditions, which set the stage for a technical "bounce." However, each new rally attempt was quickly crushed until investors returned from Thanksgiving. Then the major averages enjoyed their best 1-week gains since March, and the market managed to produce a follow-through day.

Stocks slid during the first half of the month as fear gripped the Street due to the enormous write-downs (Wall Street's latest euphemism for an old fashioned ''loss'') in financial issues and the poor action in retail stocks. For those that do not fully understand the intricacies of this problem, allow us to explain: Many major financial institutions enjoyed sizable gains by writing loans and extending credit during the first half of this decade. The environment was ripe due to the monstrous real-estate bubble that was in effect coupled with the Federal Reserve's overnight lending rate at or near lows not seen since World War II. However, when most people were not looking, these favorable conditions began changing during the summer of 2005, when nearly every real estate stock topped.  At that time, the Fed was in the nascent stages of a series of rate hikes to combat inflation. This helped to eventually cause a disconcertingly large number of subprime loans to default (subprime woes), which meant that a certain group of financial institutions would quickly become strapped for cash.  Many could not continue extending credit with the same favorable terms as before (credit crunch).

During the summer of 2007 the subprime losses began to surface as a considerable problem for many financial firms. To further complicate this uncomfortable scenario, these losses could not be easily quantified, since no one knows for certain how much of these loans will go unpaid. To put help illustrate this point, the current consensus is that the vast majority of these "write-downs" are projected to cost the financial community approximately $400 billion. Out of that $400 billion, the banks and brokerage firms that made those loans own about half of that debt. That figure, at face value, appears to be an uncomfortably large number. Put in other terms, the actual amount is "not that much" for the overall economy, since it is roughly equal to one bad day for the major averages. The crux of the problem lies in the fact that typically banks lend $10 for every $1 taken in. This means that the financial companies that currently own this debt may be forced to "write-down" a disturbingly large $2 trillion!  The subprime and credit meltdown caused several of the country's largest investment banks to suffer multi-billion dollar losses which caused a few of them to replace their CEO's. This simply means that businesses and consumers have less access to the credit that might otherwise help fuel economic growth. Normally, when uncertainty reigns supreme, investors' appetite for risk materially declines, which adversely affects institutional sponsorship, a vital component for a successful rally.    

A second negative factor that dragged stocks lower in the first half of the month was lackluster earnings data. The average company in the S&P 500 posted an average -2% drop in profits in the third-quarter. This was the first earnings related decline in several years, which caused many to worry that the economy is headed for a recession. However, excluding financial firms and so-called consumer discretionary companies, earnings swelled +8.2%, exceeding analysts' forecasts for a +7.5% gain on that basis. The lackluster earnings data from the third quarter has clearly played a pivotal role in the market's weakness from the middle of October to the middle of November.

What does all this mean for the market? Six weeks ago, on October 11, 2007, the major averages negatively reversed from new all-time highs.  This was the first early indication or "technical signal" that lower prices would follow. CANSLIM.net readers were made aware of this on October 11, 2007, in the Market Commentary section of that day's CANSLIM.net After Market Update (read here). The report said, "It was extremely worrisome to see each of the major averages negatively reverse. A negative reversal occurs when a stock (or in this case - the market averages) opens up the session heading higher but then reverses and ultimately closes lower. Reversals are often considered more severe if the stock's initial gains lift it to a new high, but it then reverses and closes for a loss on heavier than average volume and ends near the session's utmost lows. Negative reversals can occur on a daily, weekly and monthly chart. On Thursday, it occurred on a daily and weekly time-frame. In general, the longer the time frame involved, the more concern is prompted by the severity of the reversal. Volume is directly correlated with the severity as well, and this was the highest volume down day since the major averages bottomed out in mid-August...It may be premature to call for a correction, but earnings season will play a key part in determining the way things in the market will go. Instead of listening to the talking heads and various opinions and guesses about what will happen, disciplined investors who follow CANSLIM.net's daily reports will continue to be reminded to trade based on what we actually see happening - not based on what someone thinks will happen!  Now it would be prudent to note that the market's tenor has shown us a change." In the weeks that followed, the daily reports continued to study price and volume for signs on what was actually happening.

Charts courtesy www.stockcharts.com

 

PICTURED: The benchmark S&P 500 Index fell -10.78% in just over six week following its October 11th negative reversal. It remains under its 50-day and 200-day moving average (DMA) lines.

History shows us that it is best to avoid making new buys before a proper follow-through day emerges. A proper follow-through day can emerge after Day 3 of a new rally attempt.  Then, at least one of the major averages needs to rally at least +1.7% on higher volume than the prior session. In addition, remember that some of the strongest follow-through days in the past decade emerged approximately 7 weeks after the correction began. The simple reason why it is best for a correction to last several weeks is to give stocks adequate time to build new bases. That does not mean every follow-through day takes 7 weeks to develop, but the average duration of a correction is something we should remain cognizant of. As of this writing, none of the major averages has yet to produce a follow through day. However, in a somewhat surprising turn of events, the paper changed their assessment of the healthy action demonstrated by the major averages on Wednesday, November 28, 2007. For the first time in history, the paper's editors decided to use their proprietary indexes to indicate a follow-through day confirming a new rally attempt after pointing out that several of their proprietary indices did not undercut their lows from the post-Thanksgiving rally attempt, which by definition, means that their rally attempts remained intact. Therefore, Wednesday's healthy action was reclassified (after the fact) as a follow-through day, which means that the market is now in a new confirmed rally.  This suggests that the market environment has changed, and market conditions are again conducive for accumulating and profiting in stocks. However, it is very important to note that not all follow-through days lead to successful sustained rally attempts. 

The major averages that most investors follow daily to track the market (DJIA, S&P 500, and Nasdaq Composite) have yet to produce a sound follow-through day. Confirming gains from the major averages would be a reassuring sign of healthy market action.  Leadership also needs to expand in the days that follow. Friday November 30, 2007 was Day 4 of the new rally attempt for the major averages, which means that the ideal window for a new follow-through day to emerge is now open. Ultimately, only time will tell if a sustained rally is going to materialize, determining whether or not the follow-through day from the paper's proprietary indices will serve as a helpful early indicator. Conversely, if the bears show up and this latest rally attempt fails and undercuts the last lows, then the bounce will be nothing more than a follow-through day that did not lead to a successful new rally.

"Equally important, one would like to see a new batch of leadership emerge to confirm and strengthen this current rally."

Another important fact to note is that time is on your side. History tells us that the ideal time to accumulate stocks is during the first 13 weeks after a new rally begins. Some investors fall into the common trap of trading too often, just to feel that they are not "missing out".  But during a correction it is important to raise cash and keep an active watch list. Only after the market confirms a new rally, one can proceed with new buying efforts cautiously. Investors now have been alerted to an early confirmation for what may become a year-end rally.  The most ideal stocks to choose from will a new batch of emerging strong leaders, or prior leaders showing the greatest resilience which are triggering new technical buy signals.

It is very possible that stocks might meander during the next ten days in anticipation of the next Federal Reserve meeting. Remember that the market moved sideways for a few weeks after the last August 29, 2007 follow-through day emerged, and then the market really kicked into gear when the Fed cut rates on September 18, 2007. The Fed cut rates by a quarter point during their October 31, 2007 meeting and signaled that further rate hikes would not follow. Within days, each of the major averages entered a correction and skidded approximately -10% before the new rally attempt was confirmed. This horrid action caused Ben Bernanke and company to change their rhetoric ahead of their December meeting. Bernanke and other Fed officials said persistently tight credit conditions, the housing slump, and high energy prices will probably create some "headwinds for the consumer in the months ahead," and the central bank will have to be "exceptionally alert and flexible." These comments echoed those of Fed Vice Chairman Donald Kohn earlier in the week which led many to believe that a rate cut is in the cards soon. Many investors are looking for the Fed to lower rates to help reinvigorate economic growth.

Going forward, it would be very encouraging to see one of the major averages produce a sound follow-through day. Equally important, one would like to see a new batch of leadership emerge to confirm and strengthen this current rally. Thus far, 2007 has been a challenging year for growth investors. (See Ken Gruneisen's "Investing for the New Millennium" column in this issues of CANSLIM.net News for more insight into why 2007 has been so challenging.)  It is very important to remain patient and disciplined to avoid giving back hard earned gains. As always, keep your loses small and never argue with the tape!