"Remember the old 70-20-10 rule of thumb - 70% of a stocks movement is due to the averages, 20% to the sector and 10 % to the individual stock." Most investors have probably read it a dozen times in the past 5 years.
Let me add an important piece that the statement left out and rephrase the above rule of thumb: "About 70% of any stock's movement is caused by the positive condition of the underlying fundamentals of the stock market, because the stock market cannot move up if the underlying fundamentals are in a negative or down trending condition."
After a recent posting on the correlation of stock market movements, relative to Inflowing Liquidity levels, I received about a dozen emails complaining that Liquidity Inflows were worthless because Liquidity levels were "Not a Leading Indicator".
Of course not ... Liquidity Inflows level in the stock market are NOT a Leading Indicator, rather they are a necessary, underlying fundamental condition that is needed for any rally condition in the stock market.
Some investors think that the newest and best "Leading Indicators" are the Holy Grail, and nothing else is more important. The fact is that, by their nature, Leading Indicators are early attempts to read the direction of a trend change before it has actually happened. That means that all the market supportive elements are not in place yet, and the hope is that they will all turn positive.
Realize, that the odds of an (early) Leading Indicator being correct on a signal by itself, has a direct correlation with the condition of the underlying fundamentals that support the signal. The greater the number of negative fundamental market conditions that exists at the time of a Leading Indicator signal, the greater the odds that the Leading Indicator will fail, whipsaw the investor, and produce a loss.
We have Leading Indicator Models for the stock market, but with each signal we carefully look at the Underlying Conditions in the market at the same time. In this posting, we will look at what some of these underlying conditions are.
In the chart below, you will see 4 underlying market conditions that are needed for a Leading Indicator signal to be successful and not fail. It is only the positive, and strong levels of these underlying conditions that gives the stock market the propulsion to be able to trend higher and not fail to the downside.
When any inverstor's Leading Indicator signal is positive and the underlying fundamental conditions are like the ones seen below, then their Leading Indicator signal will fail to the downside. See the chart below:
Underlying conditions don't have to be Leading Indicators, they are not supposed to be. Instead, they are more like the ocean's tide. The old saying is that a rising tide raises all boats. A falling tide does the opposite.
Let's re-look at the Long Term Liquidity chart for the period between May 2004 and October 2005.
I relabeled the chart in terms of the ocean's tide.
Explanation: When a positive trend line breaks to the downside on Liquidity inflows, then it can be said that the tide is starting to go out. When that happens, money is leaving the stock market and like a boat, it will sink to a lower level. When the Liquidity moves into a Contraction level, then the boat is in such shallow water, that it will likely hit bottom or reef.
After awhile, the Liquidity tide will start to reverse with the tide coming in. This is signaled by the resistance line breaking to the upside. At this point, stocks start to get lifted up. And, when the Liquidity reaches an Expansion territory level, then there is a strong swelling in the ocean that carries all boats (stocks) up.
The point here, is that if a Leading Indicator gave a signal that was contrary to this underlying fundamental, then the Leading Indicator's signal would have failed to the downside.
The moral of the story: Be sure to follow and know what the underlying fundamental conditions are saying when you get a Buy or Sell Signal.
