Sell in May and Go Away?
By Frank Barbera CMT. May 1, 2007
Over the last few weeks, money has clearly been flowing back into the equity market with many of the major averages pressing into new high ground. Until yesterday, the most recent advance in averages like the S&P 500 had been fairly relentless with the S&P gaining ground 14 out of the last 19 sessions, during which time it advanced by a hefty 8.80% from the early May closing low. It is time to load up on stocks, or is more caution warranted at this juncture? In our view, the stock market has displayed a high degree of upside momentum over the last few weeks, enough to suggest that the S&P 500 will at worst, ‘hold up’ and remain in a high level range for the next few weeks.
For the S&P, important support over the course of May will develop in the area of the former late February highs at 1460.00. At the same time, on a major trend basis, the S&P looks over-extended, and could soon be nearing a more important cyclical peak, possibly a major bull market high. This tells us that the upside is most likely capped to within a few percentage points as the old highs of April 2000 and September 2000 at 1530 are likely to act as major resistance for the S&P. Since the S&P ended last year at 1430, the upside potential, more likely than not for the stock market in 2007, is probably capped at the 1530 level, implying the S&P will have a hard time gaining more than 7%. Mind you, it is very possible, and indeed likely that over the next few weeks, if the S&P remains in a tight range between 1460 and 1500, that a more important topping pattern could emerge, with the classic downside action in the stock market post May emerging during the early summer months.
In what we would consider to be an ‘optimistic’ view of the equity market, we show in the first chart a rising wedge type top developing on the S&P 500. Under this type of (broad) scenario, prices would hold up over the next few weeks into early June, and then sell off initially back down toward the 1440 to 1450 zone during the course of the summer with July a likely low. From there prices would push up to one more round of new highs into early to mid September, in the process fully retesting the former highs in the 1530 zone. At that juncture, prices would gradually decline into year-end, ending 2007 virtually unchanged for the year, but in the process setting up the prospect of a major bear market in 2008.
As we see it, the relatively high momentum levels seen recently on MACD (as well as decent breadth) act in some fashion to argue this case, as does the still overwhelming evidence of broad scale liquidity. Perhaps we are ‘dead wrong’ and the market will boom through the old highs at 1530, but that would seem to be seriously out of character with the growing evidence of a slowing economy and the ongoing correction in Housing. While we are of the belief that the equity market can disconnect for awhile with underlying reality, there would seem to be a reasonable question as to how long enough even a juiced up stock market can bubble higher amid signs of 1% GDP growth. Again, these are just our opinions, and we wish we had a perfect crystal ball.
A second outcome, which at this point we would rate as a 50/50 dead even choice, is that the rally to new highs over the last few weeks really is concluding the much larger bull market seen over the last few years, and as such is now virtually exhausted. Under this outcome, the high levels of upside momentum seen in recent days will not retain the ability to prop prices up much longer, and after another round of token new highs, the S&P will be set up for a fall.
Under this outcome, the month of May will be spent with the index between 1520 and 1470, with prices under-cutting low end support in early June. Note the very steep rising trendline which we have pulled back to over the last few days. Ladies and Gentlemen, by any standard this is a grey-beard bull, and such steep angles of ascent cannot often be sustained for very long. Thus, we would argue, that while there is no rain falling at the current time, over the next few weeks the clouds will gather and before too long the stocks market skies will darken noticeably. In our view, this alternative, more bearish scenario really has the potential to fit the underlying reality a lot better, which is a steady decent into a consumer led slow down, possibly recession and another big round of liquidity problems coming from both housing and Asia. Most of the stock market looks extended, expensive and vulnerable.
Above: the Medium Term ARMS Index for the S&P 500, getting dangerously low, i.e. fully overbought.
Before moving on to look at some individual sectors, we want to spend a moment and look at some of our favorite gauges. Among these, we would look at the ARMS Index, otherwise known as the TRIN. In our work, we keep our own universe of Advances and Declines, Up Volume and Down Volume for the S&P 500 to avoid all the technical pollution and redundancy that comes from ETF’s (big volume), Preferred’s, Bond Funds, Country Funds et all. Most Bond Funds and Preferreds, which now make up more than 1/3 of the total NYSE listings, follow the Bond Market and NOT the stock market. To get clean data, you need Operating Companies Only, and we tabulate that every day.
Using clean data, we see that the ARMS Index is doing its job, just like it always has. Notice that the big spikes up above readings of 1.30 have invariably accompanied the most important bottoms of the last few years. High ARMS Index readings ABOVE 1.30 (the upper horizontal line) tell us there is real fear in the market, and in order to be a successful investor, you must know when to “Buy the Fear.” Back in Mid-March, fear was definitely building with the ARMS Index spiking rather sharply up to a reading of 1.22 on March 14th. Now, look at what has happened since mid-March where we see the indicator tumbling down across the range to values very close to .80, the lower horizontal line. Typically, the ARMS Index is EARLY in spotting tops, but invariably, low ARMS Index values are a signal to use caution. In the present instance, that signal is amplified as there is a potentially major bearish divergence underway in this gauge. Namely, over the last two months, prices as measured by the S&P 500 have moved to a new high in April (4/25/07 1495.22), above the February high (1459.68 on Feb 20th, 2007) while the ARMS Index has NOT moved to a lower low. Instead, the ARMS Index made its extreme low back on February 21st at .7401, and is now holding ABOVE those levels with a recent higher low at .8133 on April 26th. This means that the maximum bullish buying power was seen back in late Feb at the .7401 value, and that while buying power of late has been strong, it has not been as robust as that seen in February and thus, has failed to drive the ARMS Index down to an equal or lower low. The fact that Buying Power is exhausting at less robust levels then seen in late Feb, tells us that we could be within a week or two of a final high in prices, and within a few weeks of the next serious downside reversal.
Above: S&P 500 (top clip) and GST Daily Cumulative A/D Ratio (bottom)
Among the many signs of technical deterioration that we will be watching for, weakness in cumulative breadth gauges would be high on the list. To date, the Daily A/D Ratio for the S&P 500 has been in a strong uptrend and as of this writing remains above a rising 20 day average and a rising 50 day average. In order to get more bearish on the stock market, we would need to see the 20 day average cross below the 50 day average which would tell us that the majority of stocks is no longer participating in the advance. This has NOT happened yet, and is one reason that we are holding off on getting too negative.
The other area that is also still holding up at least reasonably well is the number of 52 week New Highs on the NYSE. In our work, we track the NET number of New Highs, and while this gauge does appear to be failing and making lower highs below the February highs, to date, the deterioration in the New High list is only modest, and not enough to move us into the more bearish camp. As a result, the overall stock market can be expected to do very little, up or down in our view over the next few weeks, over which time we will get more insight into how well, or how poorly, the medium term trend of the market is fairing.
Above: the NYSE Net New Highs
Turning to various sectors, we have long been big fans of the Energy Group, and in particular the Oil Drillers. What’s more, we also believe that Crude Oil prices are headed much higher into the Summer Driving season, as present gasoline stockpiles are drawing down at an alarming rate, and will soon force refiners to draw down crude supplies. Worldwide, Crude Oil stockpiles have been falling and OPEC has done a credible job in cutting back production. With all of this in mind, we nevertheless see some reason for caution within the Energy patch which has had a huge advance since we talked about the sector at length within a day or so of the January low.
At this point, our technical work on the Oil Service Stocks and Oil Drillers looks distinctly near term overbought. As can be seen in the chart below, after a nearly 25% advance off the late January lows, the Medium Term ARMS Index for the Oil Service Index is now back down to its lower horizontal line, representing a fully overbought condition.
This does NOT mean that the bull market is over for Energy Service stocks, far from it. What it does mean in all probability is that the Oil Service stocks are due for a period of consolidation, which should last at least a few more weeks. For the medium term investor sitting on big profits in this sector, which by the way outpaced all other sectors in April, a consolidation means perhaps cutting back a bit on open longs, or for more tolerant investors, simply holding existing purchases. For new money, contemplating a purchase of Oil Service shares at these elevated levels, a lot more care is needed and in that vein, our advice would be to hold off and wait for more evidence that consolidation is running its course. At this point, I would rate this sector, which is one of my “non-Gold” favorites as a HOLD, until we see a five to ten week consolidation nearing completion. Other evidence suggesting a multi-week consolidation is in order comes from the Medium Term A/D Ratio and the Rydex Oil Service Sentiment Gauge, both of which are near the historic high end of the range. Again, for those sitting on a comfortable margin or profit there is no need for action, but for those looking to invest with new money, we would take a ‘go slow’ approach at this particular juncture. Within the Oil Service group, we continue to like Schlumberger (SLB), Global Santa Fe (GSF), TransOcean Offshore (RIG), Pioneer Drilling (PDC) and Nabors Industries (NBR). In the case of NBR, a gas driller, the degree of over-extension is less severe (and that includes other names like BJS, GRP, and GW also involved heavily with NatGas), and these could still surprise a bit more on the upside.
Above: GST Oil Service Index 1997 to present and Below: the Medium Term A/D Ratio for Oil Service stocks, back up to fully overbought values following the deeply oversold (low) values seen in late January.
Above: The GST Rydex Medium Term Sentiment Model for Oil Service Stocks — at the high end of the range, a caution sign implying that the group will need to move sideways for a period of some time, likely a few weeks, before moving into a position to begin a new advance.
Finally, when it comes to potentially low risk “oversold” situations, we note that Uranium Group has taken a substantial shellacking over the last few days. At the present time, this sector is substantially oversold enough to warrant some bidding, as the long-term uptrend looks quite entrenched. In our view, the best way to approach a high flying market like Uranium is to buy the relative strength leaders and enter positions using spaced out incremental buying on weakness. With leaders like Denison Mining (DML-TSE,DNN-AMEX) down 4.10%, Palladin Resources (PDN-TSE) down 2.10%, UEX Corp down 4.67% (UEX-TSE) and Strathmore Minerals (STM-VC) down 7.82% just today, we see the current dip on Uranium related shares as an unequivocal buying opportunity and a prelude to the next leg up.
Above: Compressed Hourly RSI for Denison Mining shows the stock now heavily oversold — highly indicative of the entire Uranium sector.
At the close, the DJIA ended higher closing at a new all time high, gaining 73.06 index points to end at a reading of 13135.97. The S&P 500 also rose, closing at 1486.30 to end Tuesday with a gain of +3.93 index points or .27%. Among the secondary indices, the NASDAQ Composite closed higher by 6.02 index points, ending at 2531.11 for a gain of .24% with the Russell 2000 Index ending at 816.25, up 1.68 or .21%. On Tuesday, nearby Gold ended lower by $5.60 at $677.50 with Crude Oil also weakening by $1.31 to finish at $64.40. The 10 Year Treasury closed at a yield of 4.64%.
That’s all for now,
© 2007 Frank Barbera