By Frank Barbera CMT. July 7, 2009
Over the last few months, markets have enjoyed a strong recovery on the hope that an economic recovery would take shape. For much of this time period, markets have been content to observe economic data which has improved moderately, or in some cases, simply failed to get much worse. This so-called, ‘second derivative’ phenomenon is something we have written about regularly, and written about as far back as December 2nd of 2008. In that article, we focused on the ISM Purchasing Managers Index and an oscillator we created using that gauge stating:
“Assuming that the entire first quarter is below –15.00, and possibly April (heading into tax season—always a slow time of year) we could see this ISM gauge residing below –15.00 in May, possibly even June of 2008. However, it is most unlikely that it will reside below –15.00 much longer then May/June 2008 which would match the longest ‘sub –15.00’ readings on record. That means that a “recovery” of some sort is very likely to begin taking shape during the second half of 2009, and that recovery will probably last at least 12 months on a statistical basis, as way too many economic gauges are at the stock market equivalent of “deeply oversold.”
At this time it appears that going forward, instead of the data simply not getting any worse, the markets will increasingly demand to see tangible improvement, proof that things are in fact getting better. As it happens, to date there is virtually no evidence that a material change for the better is underway. As a result, markets have entered correction mode which was predictable given the huge overshoot on the upside seen in recent weeks. In my view, the odds are high that on the corporate front, the rally of the last few months has been about “hope” for improved results, and has been largely predicated on huge cost cutting steps implemented throughout the corporate world. In the weeks ahead we may see a market that softens further as it becomes clear the tangible proof the markets want to see in both earnings and economic figures is not immediately at hand. Still, cost cutting within corporate America has been exceptionally deep, and as we get later in the year, easier EPS comparisons with a terrible Q3 and Q4 2008 could once again lift stocks to moderately higher highs. As we see it, the problem at that point is then most likely going to be a lack of ‘top-line’ growth. This is where the “New Normal” kicks in, as this economic recession is not cyclical, but in this case is most likely a structural contraction. As consumers save more, consumer expenditures decline, and as long as unemployment remains very high (likely), final demand is likely to be very tepid. That means top line growth, ex-cost cutting, is likely to be poor in 2010, and in my view that could easily give rise to a second bear market decline as P/E multiples adjust lower.
Over the last few weeks I have spent a fair amount of time in these pages looking back at prior sharp rallies and their ensuing corrective patterns. Based on that analysis I continue to believe that the S&P 500 could dip toward the 850 area, and possibly as low as the 800 to 820 zone. While the down trend could be highly erratic and saw tooth in nature (lots of stop and start rallies and declines) in general, we are seeing a big switch right now toward defensive issues and away from high beta. Over the last few days Recession Retailers have been outperforming Discretionary Retailers, High Grade Corporate Bonds have outperformed High Yield Junk Bonds, Consumer Staples have outperformed Consumer Discretionary, as Bond yields have declined while the Dollar has strengthened at the margin. This is all a classic setting for a correction to unfold, and it is amazing how the crowd psychology has slowly morphed from euphoric a few weeks back to more cautious over the last few days.
Above: the Relative Strength Ratio of Consumer Discretionary to Consumer Staples has turned down sharply in recent days, indicating a changing market psychology in favor of low beta, defensive assets.
Within the US one of the big bear rally leaders was the NASDAQ, and that market remains an important focus for us over the next few weeks. At present we still do not see any substantive oversold values on either the S&P or NASDAQ, but we do see a market that is making progress toward generating oversold values in the days just ahead. As of last night's close, the NASDAQ 21 day Advance-Decline Oscillator ended at –65.64 and that is closing in on the –100 to –150 oversold zone. At the same time, our Medium Term Money Flow Oscillator ended at +10.47 as of Monday, July 6th, and that is only down to a neutral value.
Above: NASDAQ Composite with 21 day Advance-Decline Oscillator
Above: NASDAQ Composite with Medium Term Money Flow Oscillator
Above: NASDAQ Composite with Medium to Longer Range Summation Index
Similarly, the medium to longer range Summation Index for NASDAQ remains in a downtrend below its moving average signal line, and still well above the horizontal zero line. In my view it would not be too surprising to see the Summation Index unwind further, and ultimately, get a bit closer to the zero line before the NASDAQ completes a medium term correction low. As a result we still don’t see a low in the indices, and continue to watch key levels for each of the three widely watched stock market averages. In the case of the S&P 500, the 878 to 880 level is key support in the near term, and any move below that would probably imply a fast sell off down to the 840 to 850 zone. For the NASDAQ Composite, 1755-1770, the area of the June 23rd low, and the May 6th and May 20th highs is key support, and a move below that zone should usher in a further sell off toward the 1670 to 1680 area. For the DJIA, the 8200 to 8220 zone is very important support, with that support close to being broken as the market moves into the last hour of the trading day on Tuesday.
Other indications that more backing and filling lie ahead can be found in the arena of Junk Bonds, which in the last few months staged one of their largest rallies ever. Unfortunately, that advance has left the GST Junk Bond Index at very overbought levels with the junk funds now only in the early phases of rolling over. In the weeks ahead, I would expect a substantial ‘give back’ in this arena as well, which as the RSI moves down toward oversold values could once again set up a medium term low.
Above: GST Junk Bond Index very overbought and rolling over, a sign of changing market psychology and a move back to defensive assets and away from Beta.
Above: Shanghai Composite Index with Medium Term RSI.
Another market which has been at the vanguard of recovery fervor has been the Chinese Shanghai Composite, which amazingly at its recent peak was up more then 1,000 points in the last four months. Yet, last night's close appears to be the end of the line for Shanghai, which appears very over-extended and ripe for a major fall. In my view, any close below 3062 on the Shanghai Index which ended at 3089 last night would be bearish and would confirm that an important short to medium term peak is likely in place. Again this suggests that the global pendulum of risk-reward, fear and greed is starting to swing back toward a defensive mindset after having taken a huge bounce toward optimism over the last few months. For stock market investors right now is a good time to be sitting with high levels of cash, and allowing the market to shake themselves out with an eye toward potentially re-entering the equity markets a few weeks down the line.
That’s all for now,
© 2009 Frank Barbera