Forward Looking Outlook

By Frank Barbera CMT. August 15, 2006

Stocks closed sharply higher on Tuesday sparked by a better than expected reading in Core PPI, which in turn holds out hope that the Federal Reserve may be closer to the end of its interest rate hiking cycle. Of course over the last few weeks, stocks have moved up and down like �an elevator with a lunatic at the controls’ as virtually every piece of conflicting data has sent stocks soaring and then plunging back to earth.

Tomorrow, the market will be focused on the CPI report, where the core rate will once again be the focus. For CPI aficionados, the real impact in tomorrow’s CPI report will probably come from the oversized Owners Equivalent Rent component, which measures an obtuse variant of housing market rents. In a perverse twist of fate, Owners Equivalent Rent tends to run counter to the primary trend of the housing market, moving down when housing prices rose in recent years, and now, moving up as housing prices begin to weaken. What a crazy world we live in when this component is virtually alone in its assessment of the housing market, and where the Federal Reserve has placed itself in the awkward position of not being able to ignore this data lest they lose more of their inflation fighting credibility and put the US Dollar at risk.

As a result, the markets are likely to have more issues to contend with regarding the forward looking outlook on inflation and the real trend in Fed policy. In my view, a key indicator to be watching over the next few weeks will be the action in the NASDAQ Composite, which--as seen last week--has been losing relative strength versus the S&P 500 for some time.

In the chart above, we see the Relative Strength Ratio of the NASDAQ versus the S&P over the last few years in the bottom clip, with the ratio breaking to multi-year lows over the last few weeks. Technology stocks, while long viewed as growth stocks, are really better classified as growth cyclical as they tend to be very sensitive to a strengthening or weakening economy. Of late, I wonder whether or not the relative weakness in tech is front running a broader economic downturn in late 2006, early 2007. In my view, the answer is quite possibly YES.

When reviewing some of the many technical gauges available for the NASDAQ there are a number of potentially disturbing signals manifesting themselves on the daily charts. To begin with, for many years I have maintained a Medium Term Up-to-Down Volume Oscillator for the NASDAQ exchange which is normally oversold below —200, and overbought above +200. Readings near zero are neutral and normally, after a strong move in one direction, the oscillator will “correct” toward zero. Usually, it is during this correction that you can tell a great deal about what is taking place in a given market. In a strong market, the oscillator will often correct down toward zero with prices actually giving back very little of their preceding gains. Conversely, in a weak market, we see deep oversold readings at the outset, followed by a movement back up toward neutral in the oscillator with prices actually recording very little “on balance” price recovery. This second scenario is what seems to be playing out on the NASDAQ chart right now, wherein we see a very deep oversold reading was generated on the Up-to-Down Volume Gauge of -353.59 on June 13th. Back then with the oscillator at —353.59, the NASDAQ Composite closed at a short term low on June 13th of 2072.47.

Since then, the oscillator has moved back to neutral with a reading on Monday of +3.67 with the NASDAQ Composite ending yesterday at a reading of 2069.24. Here’s the point: From the low in the oscillator below —300 in mid June to yesterday with the oscillator at zero, the NASDAQ Composite had at that point LOST ground, falling from 2072.47 to 2069.24. That is simply horrible behavior, and in my experience is absolutely a warning that the market will at some high head lower in earnest. Now some of you may be reading this and saying, “but Frank, look at the NASDAQ today, it’s way up, up 39.26 index points to a reading of 2108.95, -- so see….it has now gained ground since 2108 is above 2072.47." My response: OK, true enough, with today’s gain the NASDAQ is positive, but “net, net” we are talking about a gain of just 36 meager NASDAQ points or a mere 1.73% on a recovery in the oscillator from —353.59 to today’s preliminary value of +20.56. That is still horrible! To illustrate how sick a market we are talking about here — at least potentially — let’s flash back to the major NASDAQ top seen in March 2000 when I exited long positions in Technology stocks.

Back then (see above), my Up-to-Down Volume Oscillator moved in a very similar fashion with the initial bout of NASDAQ weakness depressing the oscillator to a deep oversold low of -443.20 on April 14th, 2000 with the NASDAQ Composite closing that day at 3,321.27. From that low, the Up-to-Down Volume gauge then recovered over the next 47 days to a June 21st reading of +58.10 with the NASDAQ Composite closing June 21st at 3,936.84. Back then, we saw a gain of 615.57 NASDAQ points or 18.53% on exactly the same move in the oscillator which, by the way, has now been advancing off the June 13th low for 43 trading days thru today’s close. See any similarities anyone?

In addition to the Up-to-Down Volume Oscillator, I also see a number of potential negatives building in the charts of other key NASDAQ gauges. On the next chart, we see the NASDAQ Composite on the top clip and Cumulative Money Flow gauge on the lower clip. Note that the downside violation of the long rising 200 day moving average was confirmed by an equivalent breakdown in Money Flow. At the present time, NASDAQ is barely above the 200 day lower band which stands as the last vestige of major support at 2040.00. For the Money Flow, any break outside its equivalent 200 day lower band over the next few weeks would be extremely bearish and too date, the upside recovery in this gauge looks quite belabored.

Finally, I am also going to be watching the action on the NASDAQ 10 day ARMS Index (below) over the balance of the next two weeks. Over the last few years, readings on this gauge below .75 have often either accompanied, or preceded reasonably important short term tops.

With this indicator currently near .91, it is not quite down to the kind of reading that could be a rally killer implying that the NASDAQ could press a little higher over the next few days toward 2150.00. With that said, as we approach late August, low readings on this gauge below .75 could be another major signal to be extra careful with Technology stocks. In my view, if the NASDAQ does roll over in coming weeks, it will not be a good sign for the broader S&P 500 and the DJIA. In both cases, while those indices continue to hold above major medium term support levels, the action of the last few months continues to look like distribution taking place and the construction of large topping formations. For the S&P 500, which is also still within the context of a rising short term trend, the next resistance is 1290.00 to 1295.00 which could be tested and approached over the next few days. On the downside, any close below 1260, then 1235 and finally 1220 would be a “three strikes and your out” scenario for the S&P with a close below 1220, nothing less than a major breakdown.

While the major averages continue to look suspect, there remain areas within the market that look bullish including both Oil and Gold. In the case of Gold, the physical price appears to be reaching a solid equilibrium level in the low $600s and could begin to strengthen into late August. At the present time, the positive relative strength shown by Gold Stocks points to the conclusion that the bullion is very close to another important low (note the XAU closed up 1.48 today (1.07%) with the HUI up 5.11 (1.57%) while Gold was lower by nearly $6.50). That’s good relative action on behalf of the mining stocks which have �come in’ over the last few days. In the energy sector, the Natural Gas stocks are sporting a bullish pattern as well with the widely watched XNG Index poised to break out of a multi-month high level consolidation pattern into new all time high ground.

At the present time, many hourly gauges for the Natural Gas stocks are seriously oversold suggesting that the group could rally in the relatively near term. For the XNG, any close above 445.00 in coming days would be very bullish and would suggest that a new medium term uptrend is well underway. Within the Energy sector, probably the most �bombed out” segment are the Oil Service stocks and drillers. Talk about overdue for a rally, these stocks have moved lower coming into today’s session for the balance of the last eight days.

In my work, I maintain a number of charts on the Oil Service group, all of which show a technically bullish oversold condition. Starting with my Medium Term Advance/Decline Ratio (below), we note that the maximum oversold condition was seen back on June 20th with a fully oversold reading of .72 (below the benchmark at .80). Since then, indices like the OSX and ETF’s like the OIH have been slipping to lower price lows accompanied by positive divergences (higher, less negative lows) on this indicator.

In addition to the Advance-Decline Ratio, my Medium Term Up-to-Down Volume Ratio for Oil Service stocks is also at levels that are extremely oversold on a historical basis. On the next chart, we go back nearly 17 years to 1988 and notice that, for the most part, readings below +90 on this gauge have been associated with important bottoms. Last night, this oscillator closed at +88 and has also not been confirming lower price lows in the OSX seen in late July, and has held up well (not going down much) during the decline of the last two weeks. Consequently, I believe the Oil Service Index is about to turn higher on a medium term basis (OSX closed today +3.15 at 195.45) and could, in coming months, also move to new all time highs.

For stock investors, the current market environment is highly challenging with sector analysis a very key element to generating solid total returns. Going forward, it appears that Gold, Oil, Natural Gas and Oil Service are getting back into gear and could soon begin to reassert their leadership role within the stock market. With regard to the major averages, at the moment the jury is still out, and any stall by the latest rally effort in coming days could yield a very negative verdict if the market internals fail to pick up in a material manner.

Frank Barbera

Contact Information

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