Stock Market Analysis
How to eat an elephant

Stock market analysis is necessary. You must recognize the environment where your investments live if your goal is to out-perform the market.

If you limit yourself to newsletters, blogs or broadcasts, you will get a lot of opinion (some of it very good) and a lot of noise. It is easy to find an opinion to support whatever view you favor. With a basic understanding of the market, you have a way to evaluate the opinions you hear. Even better, you can reach your own conclusions once you have some market analysis tools.

But the market, even the market of stocks and bonds, is an elephant.

How to eat an elephant? One bite at a time – break the analysis into a set of manageable tasks.

Approaches to Stock Market Analysis

The following approaches will provide the stock market analysis tools you need:

• Dow Theory
• Market Breadth
• Stock Market Cycles
• Investor Sentiment – Stock Market Sentiment
• Economic Indicators and Financial Indicators
• Fundamental Valuation of the Market

Dow Theory

The Dow Theory was derived from editorials by Charles Dow - editor of the Wall Street Journal until 1902. One basic assumption is that everything that can be known about the market is reflected through the price. Further, the market will trend up, trend down or move in a lateral fashion as a function of primary waves, secondary waves and market ripples.

Therefore, studying the price action and volume of the market as a whole can guide your investment decisions. Any technical analysis system would fall into this category.

Dow theory is probably the most common form of stock market analysis

Market Breadth

While the Dow Theory considers the market as a whole when timing the market, market breadth considers the individual components of the market. In other words, examining the price/volume action of stocks in the market will provide insight into the market direction. Examples of market breadth indicators would be:

• Percentage of stocks above their 200 SMA (Worden)
• McClellan Oscillator and Summation Index
• Bullish Percent Positive (Point & Figure)
• Arms Index

Stock Market Cycles

A market cycle differs from the Dow Theory in that the cycles are more consistent than waves and ripples in their length. Stock market cycles are similar in the sense that price is a function of the summation of all cycles just as price would be a sum of the waves and ripples. Both the Dow Theory and Stock Market Cycles allow for unexpected events. Examples of market cycle systems would be:

• Kondratieff Waves
• Martin Armstrong’s Economic Confidence Model
• J M Hurst Cyclic Analysis
• MESA (John Ehlers)
• Seasonal Cycles

Investor Sentiment

Market sentiment systems are contrarian in nature. They rest on the idea that at extremes of sentiment, the crowd is usually wrong. Knowing when sentiment has reached an extreme can be a difficulty with any sentiment-based system. How long the extreme will last is also an issue. The following are often used as a basis of sentiment:

• VIX & VIXN (Option volatility)
• AAII Sentiment Survey
• Commitment of Traders

Economic Indicators

Economic and financial indicators often have great market impact and volatility. They tend to lead or lag the market. It pays be aware of the most influential indicators.

Some well-known examples:

• Yield Curve
• Employment
• Inventory levels
• Consumer Price Index

Fundamental Evaluation of the Market

Because individual companies are valued using both dividend and PE models, markets are valued. This is much like the market breadth concept. A valuation of the market is created using the valuations of all the companies comprising the market.

Market PE is the most common market valuation.

The usefulness of this number is that the performance of the market is often predictable based on the PE of the market. A market PE rising from a PE considered historically low is also generally a market that is rising in price.

Consider the market studies showing that low PE stocks outperform high PE stocks. In similar fashion, a market with a low PE will often outperform a market with a high PE.

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