Bears and Bulls

By Frank Barbera CMT. July 25, 2006

After closing sharply higher on Monday, stocks continued their advance edging higher by another 7.97 index points on the S&P, which closed at a reading of 1268.88. For the NASDAQ, Tuesday saw the tech heavy index also post modest advances with a closing gain of 12.06 index points to close at 2073.90.

Despite the gains of the last day or two, overall stock prices have moved essentially sideways since late May when the S&P first tumbled toward 1256.00. During that period of time, despite the build up of deep oversold technical conditions on several occasions, stocks have had a hard time kick-starting a sustainable rally wherein upside follow-through has been all but absent. At the same time, a steady current of underlying deterioration has taken place with the broad Advance-Decline Line moving steadily lower. Over the last few days, just prior to the strong rally on Monday, the A/D Line had broken to a series of fresh 52-week New Lows. At present, the A/D Line remains in a downtrend positioned well below its long term, now declining, 200-day moving average and below the major lows seen in late April and late October 2005 (arrow highlights the recent breakdown).

Above: The Daily A/D Line for 1500 NYSE and NASDAQ Operating Companies

1500 NYSE and NASDAQ Operating Companies Breaking Down?

Does this mean that the stock market has entered a cyclical bear market? To this point, the fairest statement of all is most likely that “the jury is still out.” When reviewing the charts of the major averages there is still some evidence left arguing that the uptrend of the last few years remains in place. For example, if we look at the longer range charts of the S&P 500 and DJIA, it is pretty clear that with the bottom last Friday holding above 1220 on the S&P and 10,700 on the DJIA, the “market” is still maintaining itself within the confines of a medium term, rising parallel trend channel.

With that said, it would be no understatement to suggest that virtually “everything” hangs in the balance as to whether or not the major averages can build into a momentum rally coming off the recent lows. Should the averages rally for a few weeks and then loose momentum and roll over, odds will be high that the next move down will leave little doubt as to whether or not a bear market is in force. Over the balance of the last few months, I have been of the opinion that the bull market correction camp had it right and that the end of Fed tightening would spell relief for the beleaguered stock market. At this point, I am no longer so sure as a growing number of sectors appear to be topping with others such as Housing and Technology in bear market environments. In the case of the Homebuilding stocks, the decline from last year's high is now nearly 50%, a bear market condition if ever one were seen.

Above: GST Homebuilding Index — down 50% in 12 months.

Is a Housing Collapse on the Way?

In my view, the fact that very cyclical groups such as Housing and Tech and now Basic Materials (Non-Ferrous Metals, Base Metals, Steel et al), are rolling over points to the beginning of a broadly based economic slow down. Is it possible that the Fed has already gone one rate hike too far? In my view, that could well be the message emanating from these weakening long term charts. If so, a slow down in the months ahead leading to recession could open up a veritable Pandora's box as the US has never gone into recession in such poor structural condition with debt loads very high and savings rates near all time lows. Worse still, the US has a huge current account deficit that requires more than 2 billion a day in foreign capital to fund our daily needs. If the economy slows down, will foreign capital still see the US as a good place to invest?

Given the extraordinary debt levels, the odds are high that slowing growth will be accompanied by a resumption in the Dollar bear market, which in turn could put upward pressure on long term interest rates, amplifying and reinforcing the recessionary trend. In this environment, it will not be easy to make money as demand could slow, and with it pricing power for many different industries.

One area that has had a great deal of pricing power and continues to look very attractive on a secular basis is Energy. Over the last few years, Energy stocks have gone a long way to supplying the “E” for Earnings that goes into the S&P 500 Price to Earnings Ratio. But could Oil be near a peak? While I completely agree with the thesis of the Hubbert Curve and the concept of “Peak Oil,” at present the two most important factors underpinning high Oil prices are (1) the perception of future supply shortages (Peak Oil), and (2) geopolitical tension — which has certainly ratcheted up a great deal in recent days. Nevertheless, unless the geopolitical arena continues to escalate the cycle of war and violence in the Middle East, a slow down in global demand — a global recession -- could temporarily intervene to bring Energy prices back down to earth. In my view, a serious recession is probably the only thing that bring down Energy prices for a moderate period of time.

Looking at the chart of Crude Oil, a bear could argue that Crude Oil has just completed a 5 Wave Advance on the long term chart, with the Weekly RSI failing to confirm the series of higher price highs seen in recent weeks. To prove a bearish case on Crude Oil, the nearby contract would need to close below the rising medium term trendline which will come in at the $75 dollar level using the CSI Perpetual contract, and at around the $70 level using the nearby CME August Contract. Until these levels are convincingly violated, it would be a speculative call to be suggesting an important top in Crude.

However, what is interesting is that while Crude Oil is rising on less momentum, so too are the Oil Stocks. As can be seen on the daily chart of the Amex Oil Index (and other similar large cap Energy Indices), there are some ominous technical divergences taking shape using long term momentum gauges like MACD and the recent string of new highs. In the case of the XOI, we have now seen four lower highs on MACD against a pattern of four higher highs in price — technically, a potentially bearish set up. At present, like the S&P, the XOI price levels are still “holding” within a larger upward trending pattern, but this will need to be watched very closely in the weeks immediately ahead as any serious downside reversal in Energy stocks would be very detrimental to the stock market averages going forward.

For those who count themselves to be ardent Energy Bulls, perhaps the lowest risk idea of the moment might be found in the area of Natural Gas, where presently Natural Gas prices are selling at only around 59% of their Crude equivalent value. That means that Natural Gas is “cheap” relative to Oil, a fact we can attest to using our spread indicator which is currently showing Natural Gas to be undervalued relative to Crude Oil. With summer A/C demand surging to record levels amid an enormous ongoing heat wave, and hurricane season getting set to begin, perhaps the Natural Gas shares could be among the lowest risk ideas for making good returns in the stock market in the weeks ahead.

Above: Crude Oil (top) Natural Gas (middle) and Bottom: Crude Oil versus its 200 day average compared to Natural Gas and its 200 day average. Presently, the spread is north of 40% which has correlated well to important bottoms in Natural Gas, (see vertical lines).

Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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