Yet More Bull—Mega Style

I’m not ashamed to admit I often fantasize about technical analysis. I realize that may seem strange and/or nerdy, but for years I’ve been drawn to it like a moth to a flame. I dream one day I’ll find a magical technical-analysis silver bullet—worthy of Nobel Prizes and admiring throngs.

The problem is, in reality, there is no such thing as a silver bullet for investing success. As such, I’m determined to keep long-term investors from succumbing to the chart. Over three years ago, I cautioned against basing investment decisions solely on technical indicators, and I’m back to reiterate that warning.

Why now? Well, the NYSE Bullish Percent (NYSE BP) indicator recently gave what many technical adherents deem a serious warning signal. On November 9, the chart reversed from a column of Xs (good) to a column of Os (bad)—the result of a material decrease in the number of NYSE stocks giving “point and figure” buy signals. Since then, many of the indicator’s followers have warned about more downside in a higher-risk environment.

But I doubt it. Far be it from me to imply looking at technical indicators is bad. However, where people go awry is in interpreting. First, most technical charts are widely known, so to get a leg up, they must be interpreted differently (and correctly) from the herd. If the herd sees a chart and runs for the hills, blindly following them likely isn’t the best move.

Then, relying on charts alone won’t help you. Why? Stocks aren’t serially correlated. Price movement alone isn’t predictive. It’s best to take a deeper look, weigh fundamentals, and draw an informed conclusion.

And sure enough, in assessing prevailing fundamental market drivers—economic, sentiment and political—in addition to this year’s NYSE BP activity, I form a different interpretation. I think there’s more bull market ahead. Corporate earnings are at all-time highs and growing. In 2013, the US will have a gridlocked government, which mitigates legislative risk. Emerging Markets appear poised to reaccelerate. Businesses are investing. Trade barriers are falling globally. Yes, there are always market risks, but today’s are widely known and likely won’t trump current strong fundamentals.

Hence, in my view, the indicator’s reversal isn’t a sign to cash out, buy protective puts or anything of the sort. It’s indicating something else: A change in leadership consistent with the current bull-market phase, which favors big companies. The biggest of the big—“mega caps.”

It may seem a stretch to interpret any chart as a “buy big” signal. But consider how the NYSE BP is constructed—as you should know how any chart is constructed before taking action. It’s equal-weighted versus cap-weighted. Size doesn’t matter. The index’s smallest company counts just the same as the biggest company when plotting the chart. And in the NYSE, there are about 2,800 listed stocks, most of which aren’t mega cap. As small goes, so goes the index.

And for most of this year, bigger firms have outperformed smaller stocks. That could be a sign of seasoned investors, eyeing slowing earnings in a maturing bull market, moving from small, economically sensitive firms to the companies with more stable earnings growth. They seek companies with geographically diverse revenue streams, strong brand names, high market share, healthy balance sheets and more stable earnings—all classic characteristics of the world’s biggest companies.

In a time when investors want to funnel money into a small universe of the biggest stocks, the larger universe of smaller-cap stocks will suffer. And with most of its constituents struggling, the NYSE BP will inevitably flash an ominous signal, as will other various indicators like oscillators, advance/decline indicators and such—however, they won’t tell you the handful of mega caps are likely more than picking up the slack.

Here, I’d be remiss not to mention many mega-cap stocks look pretty darn strong currently on a “point and figure” basis, and their relative strength is positive versus the broad market. Granted, like all charts, this is backward-looking—it’s based on recent price movement—but in this case, I like backward-looking. It provides further evidence of a shift to mega. And forward-looking fundamentals tell me mega’s lead should widen over the remainder of this bull market as more investors forsake small for big.

That last sentence is the key: Charts can identify past trends, but fundamental analysis gives us more to understand whether they’re likely to continue. Here’s the age-old problem with technical analysis: A chart doesn’t explain why it’s doing what it’s doing. Pretty much every chart junkie admits this, yet many err in believing the “why” doesn’t matter. It does. Very much. Especially if you want to maximize the chance you’re on the right side of the market.

With technical analysis, just as with fundamental analysis, a unique interpretation is essential if you want an advantage—and fundamentals are essential to unique interpretation. Otherwise, you’re susceptible to every charting head-fake known to humankind. And in all my technical analysis studies I have yet to find a chart free of potential head-fakes for the interpreter. As I pointed out over three years ago, the NYSE BP is chock full of them.

Time and again, these indicators deliver “ominous” signals that alone tell investors nothing about where the market is headed, how quickly it will get there, or how long the direction will last. Furthermore, ignoring fundamentals before acting on a chart will only ensure you do the same as everyone else following the chart. How is that unique? How will that give you a leg up?

I believe only a keen understanding of fundamental market drivers can help the chart-obsessed (like me) avoid all-too-common pitfalls and view their charts differently than others to know what those others don’t know.

So, my cheerful charting chums, what to make of the recent “ominous” NYSE Bullish Percent signal? Decide for yourself how to interpret it, keeping fundamentals tippy-top of mind. Also keep in mind the market hasn’t collapsed since that November 9 reversal to Os. Actually, for what it’s worth, global stocks are up around 3.0%* since then.

From my perspective, all things considered, the signals point to yet more bull ahead, with mega caps leading the charge.

*Source: Bloomberg Finance, LP.