Let the Sunshine In…
By Frank Barbera CMT. March 20, 2007
What a difference a few days can make. Last week, when we penned these commentaries, the S&P was plunging toward a retest of its lows with strong support clearly pegged in the 1360 zone. We wrote at the time that,
“Against this backdrop, a medium term low of some degree should form with prices rising in coming days to establish a “failing” right shoulder high. The momentary relief of a stock market rally says nothing about larger problems, and is the reflex action of crowd psychology gone a few steps ‘too far’ right out of the gate. In the case of the S&P 500, the 20 week or 100 day lower band closed today at a reading of 1360.50, and that area should be major support if tested tomorrow."
As it happened, the sell off did indeed continue into the next trading session where prices fell to a reading of 1363.98 at which point, they began to reverse sharply higher. Since putting in that important short term low, the stock market has been solidly back in rally mode, with the S&P 500 rising four out of the last five sessions and ending today back above 1400 with a close of 1410.94 (a gain of nearly 50 S&P points since last week's intra-day low). Has our outlook changed? To this point, not one bit. We continue to view this advance with the broad stock market as very likely akin to the ‘eye of the storm,’ wherein the sun can shine brightly for a brief period of time. In our view, the stock market rally now underway should still most likely be viewed as a ‘right shoulder’ rally which would still be targeting prices above 1425 to 1430, and as high as 1450. Thus, for the time being at least, both the US and Global Capital markets have regained their footing. This thesis is also supported by the fact that the Japanese Yen has sold off against the Dollar, representing at least a partial stabilization in the unwinding of the Yen-Carry Trade. With liquidity trends stabilizing, we have also seen a healthy recovery in commodity prices with the Precious Metals stabilizing as seen with Gold back above $650, Silver back above $13.00 and Platinum back above $1200.
Another question that needs to be addressed, in all fairness, relates to the bullish possibility that what we have just seen is a correction and nothing more, and that in the weeks to come, the rally could continue and make new, even higher 52 week highs. In our view, we will remain from “Missouri” on that one, and insist that if the market is going to re-vitalize a damaged bull trend, it will have to “show us” by pushing into new high ground and staying there for several weeks.
This is not an impossible outcome, but is less likely given the severity of the recent decline and the fact that it is a high probability that more housing and economic pain lies directly ahead. As a result, the correct approach to the stock market going forward will be one that focuses on relatively short term trends for “traders” and stock/sector selection for more medium term investors. In the final analysis, where stock market “tops” are concerned, prices have not “completed” a top until there is a top visible on the charts, and a top from which prices have broken down. To this point, the farthest on point for this market would be that a top is under construction. True bearishness cannot spring from the wellhead until a top is constructed and prices have actually broken down. In the real McCoy, the actual construction of a top is usually measured in weeks, by a series of rapid fire back and forth swings, with prices ultimately breaking down in violent fashion. For the S&P a ‘would be’ topping formation would need to see a few important elements. First of all, it is important to note that the 100 day moving average (or 20 week MA shown last week) is now flattening out. This is a big change from the strongly advancing moving average seen during Q3 and Q4 2006. With the flattening out of the middle band, we will also see the lower band begin to flatten out in the weeks ahead, and over time, the upper and lower bands will likely begin to “pinch in,” converging toward one another. A powerful top, would ultimately break down (Point A) below the recent lows in the 1360 area, and in the process downside penetrate a declining 100 day lower band. In the world of technical analysis, moving down to a rising lower band, and moving down through a declining lower band are two entirely different animals.
What was seen last week, while scary, had the protective overlay of a rising 100 day lower band; in other words, support rising underneath the market that could “catch” the market as it fell. In real “bear turns,” this is normally a ‘one off’ event. Put another way, the first crack at this band, prices always hold and usually recover nicely (what we are seeing now). The second crack at the lower band, and the whole edifice begins to topple over with a mess of much larger proportions gets underway.
At present, we have time to judge and make sense of what will come next, and for now we do not want to pre-judge the stock market too harshly. We remain acutely aware of the fact that in recent years the great credit bubble has ballooned to such epic proportions that, if a real unwinding were allowed to take place at this late date, the consequences would most likely be both a capital market crash and an economic crash of epic proportions. Michael Panzner's “Financial Armageddon” (excellent read) springs to life with a speed of frightening proportions. For the “powers that be,” all bears need to remember that every effort will be made to avoid this unwinding, and to prevent the US Humpty-Dumpty from falling off the proverbial wall. In this sense, if a Fed-engineered “re-inflation” has any real chance, then keeping the stock market buoyant amid the Real Estate/Housing Correction is vital, and with the housing slump accelerating, now would be the right time to start pulling out all the stops where the stock market is concerned. Since not one of us can know what lies ahead, the best we can do is watch closely and try to evaluate where things presently stand.
In last week's article, I noted that the financials were an important sector with the Bank Index (BKX) needing to hold support between 109 and 109.50 and the XBD — Broker-Dealer Index needed to hold in the 219 to 220 zone. In both cases those levels held with the BKX bottoming on 3/14/07 at 109.09 and the XBD bottomed on 3/14/07 at 220.67. Interestingly, even though the S&P has rallied substantially off the lows from last week, to this point, the advance in both the banks and brokers (especially the brokers) has been understated. I would note that the XBD is still quite oversold and would appear to have more recovery rally ahead. In this vein, this would argue that as an indicator all by itself, the overall stock market also has more ground to recover.
But what about some of the other sectors? Where could new leadership emerge? In my view, there are several area’s we are watching where leadership is expected to emerge. The first, and closest to my heart, is the precious metals stocks, where high underlying commodity prices and downside pressure on energy costs should combine to produce a very favorable environment in the months ahead. Outside the purview of these articles, all investors should keep a sharp eye on the mining shares.
Aside from precious metals, I also have a very favorable disposition toward energy from the last few years, and continue to believe that the conventional “group think” on energy put out by Wall Street is completely misguided. The argument as I heard it repeated to me in a conference last week, is that one should downplay the ‘apparent’ low valuations in the energy sector as these are low P/E’s predicated upon late cycle earnings. The argument here is that while the stocks look cheap, earnings for this cycle have already peaked and thus, will begin to fall, forcing up P/E multiples.
While a portion of this argument may be valid, in my view, the fact that most analysts on Wall Street are showing lower 2008 EPS forecasts is largely predicated on soft energy prices with most estimates pegging crude under $50. As I have outlined in prior articles, the odds are actually quite high that prices will remain firm above $60 as excess inventories have now drawn down to such an extent that we are now looking at the prospect of the first quarterly decline in stockpiles in nearly a decade. In this vein, a large trading range for crude oil between $55 and $70 looks very likely, and that implies that energy shares of all sorts may yet surprise on the upside. With the energy space, there are a number of interesting areas, but none more compelling than the case for Energy Service/Drilling Companies. Fundamentally, day rates for these companies have exploded in recent years, the result of years of under-investment wherein new rigs were constructed at a very low rates. Even now, as the building of new rigs has increased substantially, the aging of the drilling fleet means that more rigs will be coming offline in the years ahead, then starting up. With new sources of energy increasingly difficult to find, and the visage of ‘Global Peak Oil’ showing ever more evidence of solidifying as seen by the sequential output declines recorded in a number of the worlds key oil fields, all in all, the case for the Drillers looks rock solid.
Indeed, on a technical basis, I would note that in looking at the past twenty years, for most of the 1980’s and 1990’s the Oil Service/Drilling stocks radically under-performed the US Stock Market as shown by a long decline in the Relative Strength Ratio. Yet since 1999, that Ratio has been trending higher, and over the last two years has broken out above a long term, nearly 20 year base. In my view, this breakout has now been followed by an orderly pull back to the break out point, a classic technical indication for a group that continues to “turn” the corner. In addition, a modest look back at the chart shows profound indications that we have just seen yet another major low. On the next chart, I plot the relative strength ratio of the oil service sector relative to the S&P 500 with its 50 day and 200 day moving averages (top clip). On the lower clip, I plot the Medium Term MACD for the R/S Ratio which clearly shows a bullish divergence attended the “double bottom” lows of last October 2006 (point A) and Jan 2007 (point B). Note that while Point B saw the sector fall to a new low in relative performance, the downside momentum behind that new low in relative performance dried up, with prices subsequently reversing sharply higher and MACD crossing back above the neutral ‘zero’ line at 1.00.
Over the last two weeks, the OSX Index of Oil Service companies held up spectacularly well during the market sell off with the OSX bottoming intra-day at 192.04 on 3/05/07, only .65 cents below its 2/20/07 low of 192.04. For all intents and purposes, the index held perfectly at the February 20th lows, something also no other stock index succeeded in doing. What’s more, as the stock market has begun to recover its recent losses, these stocks were practically the first group to retrace the entire decline and already made new higher highs.
There is a message in this awesome relative strength, and the message can only be that large institutional managers see value in the sector. With the excellent relative action seen in the past two weeks, the index has now succeeded in pushing the Relative Strength Ratio Line versus the S&P up and through its medium term declining trendline, again, a very positive early indication. Within the drilling group, there are many excellent names including Schlumberger (SLB), Global Santa Fe (GSF), TransOcean (RIG), Diamond Offshore (DO), and Grant Prideco (GRP) to name but a few. We are also seeing M&A activity within the sector, with the buyout announced yesterday of Todco by Hercules Offshore. In my view, this shows that CEO’s within the space understand the value at hand and are looking to enhance their leverage to rising day rates and strong demand.
Yet another Energy sector that has come through the recent selling squall within global markets in great shape is the ultra-high flying Uranium sector. In what can only be described as a stunning turn of events, on March 1st, Energy Resources of Australia (ERA) announced that its very major Ranger Mine, was shut down as a result of heavy monsoonal rains that had drenched the roads in the township of Jabiru near Darwin Australia. Energy Resources is one of the world's larger Uranium U308 Producers, accounting all by itself for 11% of worldwide Uranium production. While not as devastating an event as the Cigar Lake flooding which befell Cameco Ltd (CCJ) last November, this nevertheless looks to cut back badly needed supplies to a very tight market.
Above: Monthly prices of U308 Uranium
Source: Cameco Corp.
The predictable result has been yet another surge in U308 prices to above $90 per pound, which means U308 is now up more than 1185% from its late 2000 low. While I would be the first to admit that the chart above looks dangerously over-extended and ripe for a sharp pull back, the dynamics of this market are quite unusual with a number of analysts who understand the market, dubious of anything more than a near term decline. Perhaps, once the rainy season clears, and some of the production taken off line begins to return, prices will ease returning to levels in the $60 to $70 range. Thus, the uranium space is not without its potential risks, and those who tread in these waters need to understand that a pull back could develop at any time. However, the much larger global demand for nuclear power looking out over the next decade and beyond strongly argues that this sector is now in a secular bull market and an environment where prices corrections may not pack a lasting punch. In this vein, I really like the action in the uranium mining stocks which still appear to be in highly robust up-trends.
While uranium stocks have already had a huge advance, they could arguably still have a long way to go before reaching a more important high. For the time being, the odds are fairly strong that at least a few more weeks of consolidation will be needed in order to ‘reset’ the sector and prime it for its next advance. However, if the next few weeks deliver just ‘more consolidation’ and no definitive signs of a downside reversal, then we could be looking at yet another vigorous move higher, as the recent liquidity panic has already produced oversold values in this group. Again, not for the faint of heart, some key leaders to watch closely within the sector are Denison Mining (DML) on the Toronto Stock Exchange, Fronteer Development (FRG-TC), Strathmore Minerals (STM-VC) and UEX Corp (UEX-TC). For new comers to this space, a definite ‘go slow’ approach is required, but if prices for U308 continue to hold up, these stocks could catch on fire once again, producing as they have in recent years, nothing short of spectacular results. In this vein, a dollar cost averaging approach aimed at some of the more liquid names may not be a bad idea, as this would allow investors to catch some of the benefit of an additional rise, while reserving some capital to buy at lower prices in the event a long overdue correction suddenly materializes.
Anyway you slice it, the chart of the Uranium Producers remains in a powerful uptrend with prices above the 50 and 200 day moving averages.
Above: the 14 day RSI for the Uranium Group which recently pulled back to oversold values near 40. In bull market, the 80/40 Rule applies
For some of the up and coming leaders, key support levels to watch closely are as follows: For Denison Mining (DML), C$12.00 is strong support with C$14.50 as resistance. Any move above C$14.50 would be bullish while weakness below C$12.00 would look like something of an initial chart breakdown. For Fronteer Development (FRG) we see a very similar pattern, with similar prices, wherein there is strong support at C$12.25-$12.00, and resistance at $C15. Any sustained move above C$15 would be bullish, while a break below C$12.00 would be a relatively close stop-loss exit point. These are not intended as specific stock recommendations but as helpful parameters for those interested in following some of the leading names in this space.
At the close, the S&P 500 finished higher by 8.88 index points to close at 1410.94, with the DJIA up 61.93 index points to finish at 12,288.10. For the NASDAQ Composite, Tuesday saw the index gain 13.80 index points or .58% to end at 2408.21, while the Russell 2000 Index ended at 793.60, up 6.55 index points. The 10 Year Treasury Bond closed at a yield of 4.55% with nearby April Gold ending higher at a close of $659.30, up nearly $5.00. Crude Oil edged higher finishing at $56.73, a gain of .14.
That’s all for now,
© 2007 Frank Barbera