Purple Crayon: Fourth Quarter Forecast

Jeff Macke

Every once in a while I find it useful to print up some graphs, take out a purple Mr. Sharpie (or crayon), lay down a flat edge and draw some trendlines. The process is intentionally, willfully, simple: Connect the lowest or highest price points on a graph and look for a trend. For trading purposes, the more times the chart "tics" on the trend, the more viable it is.

Pretty much every trader on earth uses charts to some degree, whether they admit it or not. The reason is that charts work. Not every time or for every trade, but as an incremental data point in the investing process. Even for fundamental players, entry price matters. Most investors prefer to buy stocks "on support," or trendlines. Doing so means you likely have company getting long at those key levels. In a supply and demand based world it's good to have other people buying along side you when you want prices to move higher.

Which brings us to the point of this segment: The charts for the 3 major US market indexes are flashing warning signs. After plunging in August, the S&P500, Nasdaq, and Dow Jones Industrial Average (DJIA) are all consolidating and making slightly lower highs. In the world of charts, this is a bad thing. It suggests fewer people and dollars are willing to buy stocks here. The Big Book of Charting (which I just invented) says that consolidation patterns resolve themselves in the direction of the prior trend. In this case that would mean lower.

How much lower? As I said on Friday, I'm seeing big round numbers in our future. An S&P bottom at or about 1,000 seems almost too obvious here. More harrowing still, Dow 10,000 isn't too far below and has an almost magnetic allure to stocks. Dow 10k is a dark joke to those of us who remember the first time we went through the level, way back in the 1990's. "Dow 10,000" hats were literally handed out on the floor of the NYSE. Those caps have since been broken out about 13 times and counting in the decade-and-a-half since. Mr. Market loves dark irony.

Charts aren't everything. There are bullish cases to be made here, even for those who don't see the same things I do in a price graph. That said, the Purple Crayon, though obviously simplistic, has worked for me in the past and continues to do so. The Crayon got me out of the long-side in May of this year, which proved to be pretty decent timing. That may have been blind luck, but I'll take any kind of luck I can get.

Before I'm accused of fear-mongering or talking my book let me say this: I'd rather be positive. I really would. It feels nicer and makes pundits more popular. My only problem is I'm a lousy liar and pretending to be bullish here would be disingenuous. But I'm not short via puts, bearish ETFs, or in any other way. Shorting is hard and I wouldn't want to be seen as even implicitly suggesting people short stocks. These days I go bearish by going to cash in my portfolio. This is where I went in May and, with some exceptions, it's where I'm keeping my most of my investment assets now. I'm a little more than 80% in cash.

Right or wrong I call it the way I see it. I want to know how you're playing it. Keep the conversation going in the comment section below.

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