A Market of Stocks

By Frank Barbera CMT. July 28, 2009

It has been a really fast moving series of events in the stock market over the last few weeks and the outlook has changed pretty radically in just the last 10 days. I am always monitoring events and important developments in my indicators and on the charts. Back on July 12th, as prices were pressing down toward the 870 area on the S&P, I started noticing a lot of oversold values on my technical gauges which prompted me to point out to newsletter subscribers that a number of short term gauges were getting oversold. On Sunday July 12th, I noted in a report to subscribers that,

“On the analytical front, it is primarily shorter term gauges for the stock market that are showing oversold values at the present time, including Up to Down Volume, RSI and McClellan Oscillator. In the chart below, we show the 14 day (medium term RSI) based on the Cumulative A/D Line which is now down to the +30 area, often symptomatic of market lows. As a consequence, we believe a trading rally to the 910 area, and possibly back up toward the 940 highs could develop over the next few weeks. This rally will probably end up as part of an ongoing medium term correction and once complete, a larger stock market decline could follow a bit later this summer. For now, we are leaning strongly to a bottom case for the near term and expecting prices to reverse higher after some weakness in the early part of this week.”

At the time, I included the chart above which showed the 14 day RSI for my Advance-Decline Ratio getting substantially oversold. As a rule, when markets have been trending up in strong fashion for some time, there is marked tendency for them to become oversold rather quickly on the first material set back. That set back took place on the S&P between June 11th (SPX: 956) and July 10th (SPX: 876) and measured about 8.50%. Since then, I have been seriously impressed by the tenacity of the stock market rally, which not only moved up toward 910 and then 940, but has broken above major price resistance in the 950 to 960 zone. In the chart below, I highlight the breakout above the horizontal resistance, a breakout which was replicated on our cumulative Advance – Decline Ratio. This is especially important since the A/D Ratio tracks the action of the broad masse of stocks. In fact, in the case of the A/D Ratio, not only did the indicator break above the highs of last December and June, but it also successfully broke out above the long standing declining tops line which defined the primary downtrend of the bear market.

Above: SPX (top clip) and Cumulative A/D Ratio

So does this mean that the stock market is in a new bull market? The answer to that question is one of semantics. Defining “Bull” and “Bear” markets is often a very arbitrary game, which some like to reduce to 20% swings. In my view, that is much too simplistic a mindset as is the entire need to assign a label. In my view, it is quite possible that the stock market could rally a lot higher and then ultimately run out of gas and come crashing all the way back down, all while being part of the same bear market cycle. Yet we know that there are those who insist on using labels and would somehow be forced to conclude that a rally in the S&P from 766 to 1100, or 1050, or 1200 “has to be a bull market”. It’s a big rally to be sure, and if you want to call it a mini-bull market, well, then it’s a mini bull market. My point to readers is not to get too hung up on labeling. At the moment the medium term trend is strongly up, and in light of the break out in recent days is likely to persist. That means until we see definitive evidence to the contrary, investors should be playing the market from the long side and looking for low risk opportunities to put money to work.

In addition to the solid breakout on the A/D Ratio I can also point out that the 20 week Rate of Change, a more medium term gauge which tracks momentum, has made new life of rally highs over the last 10 days. In fact, this gauge has surged to the highest levels seen since the kick off of the last cyclical bull market in early 2003. The important take away on this is that it implies that we shall more than likely see continued follow thru to the upside in stock prices for some time to come, likely in Q4 2009. This does not mean that the S&P can’t pull back 3 to 5%, or even experience another 6 to 8% decline. What it does suggest is that the underlying medium term trend will be pointed up for some time to come. That means that during consolidation and corrective moves, investors need to be watching sectors and looking for signs of rotation. Tech stocks for example, have recently moved up at a torrid pace and may be set to give back some of those gains in the weeks ahead. While tech is setting up for a pause, there is no reason that money can’t bleed its way into other sectors, like for example, Healthcare, which is up strongly across the board today.

Other technical gauges which also suggest more upside ahead include the Short Term Ratio of Up-to-Down Volume and the Medium Term ARMS. In the case of the Short Term Ratio of Up to Down Volume, notice that after a powerful surge in early March, the indicator remained at high levels in April and May before dipping down to just below neutral values in June and July. The fact that this gauge bottomed at such a relatively high level is a strong indication of a market that has robust internal dynamics at work, and a market that wants to move higher. We will be watching in the days ahead to see if this gauge manages to closely approach the mid-March peak, as the higher it goes, the more carry over momentum the rally will have. Likewise, the ARMS Index has just plunged to new lows for the entire decline. That is a huge signal that stock prices will be trending higher for some time to come. Very low ARMS Index values are a sign of strength. Over time as prices work ever higher, and the ARMS Index starts to trace out a series of higher lows, then we will start to get warning signals for a potential high. For now, that outcome is likely ‘weeks and weeks’ down the line.

Above: Short Term Ratio of Up to Down Volume

Above: Medium Term ARMS Index

As a result, a good approach to entering a market like this is generally to seek out industries and individual companies that sell at good values and may be temporarily out of favor. I tried to make a case to an unpopular sector last week in the Managed Care article, and so far those stocks have responded exceptionally well. In my daily efforts I constantly screen the entire market for stocks and funds that are oversold and out of favor. I do not automatically put money in those stocks, but I use the screen as a list of items that I can begin to monitor. Over the last few days for example, a good portion of the Defense sector has been sold down fairly hard. Now, would I go out and buy these stocks? Not necessarily. The Radar Screen scan for oversold values on the stocks is just part of the analysis. It throws a spotlight on individual issues, and on occasion on whole sectors that may be momentarily out of favor. To this end, one needs to check up on the news, perhaps listen in on a conference call or two to get a sense if the decline is temporary, if some larger issue is at work that could extend the decline, or hold back a recovery rally. Sometimes there are legitimate reasons to steer well clear of depressed issues as they are depressed for good reason. However, usually when a group is oversold it does give a potential buyer the benefit of a well defined exit point, and from a risk-reward point of view, having a well established stop loss right from the word go is what making money is all about. Sure, a fair portion of the time you are going to get stopped out and lose money. Like Baseball, in the stock market nobody gets a hit every time at bat. In the stock market you can make very good money being right half the time if you manage your losses with rigorous risk control.

Above: an example of a sector that showed up on a recent RSI Scan. Aerospace issues like NOC, LMT, ATK, BA are on the low end of the range, this sets up a situation that for speculative investors is possibly an opportunity to take a close look.

Investors should never assume that just because a market index has “gone up a lot” that the opportunities to make money have passed them by. A number of occasions, if you put in some time scanning individual stock charts and sector charts, good ideas can be found even in a market that has gone up a substantial amount. In other words, stock market advances are seldom uniform, and within the disparity between groups can be significant opportunities. Another recent example of this kind of idea can be found in a strange comparison between Airline Stocks and Auto Stocks. Now why in the world would anyone compare these two disparate sectors? Strangely enough, they are not as disparate as they may seem at first blush. For example, both sectors are highly sensitive to an improving or weakening economy; they are both deeply cyclical. The chart below shows the US Auto Group alongside the US Airline group for the better part of the last decade or two. A fair portion of the time these two sectors are directionally aligned.

Above: Ford Motor (bold) and AMR (thin line) – big discrepancy for two deeply cyclical names?

Now, let's look at the recent snap shot using AMR as a proxy for the Airlines and Ford as a proxy for the Auto’s, as GM is not presently trading. Notice the huge recovery in Ford shares, which seems predicated on (a) a lower cost of financing as spreads have narrowed, Ford is highly leveraged on its balance sheet and (b) a rising sense of optimism that the worst of the recession is over. So far, the AMR stock price has not moved up one iota on the potential for an improving economy. Pretty strange dichotomy if you ask me. Look around the market, and we see Hotel stocks well up and off the lows; why not the Airlines? Now, of course, we know that the Airlines are bleeding money, and the financial outlook at the moment looks grim. Yet, very often in strong cyclical rallies each group will “take turns” as market leader and the rotational trade may eventually swing around and allow the market to take a more positive view. Is this speculative? You bet it is. But the point is that within every market, there are always opportunities that can be found, and within each potential opportunity, the most important consideration is the idea of setting up a risk control discipline.

For traders, it is essential to know precisely where you are going to get out of a trade, even before you put on the position. Another important element is to look carefully at the potential set-up. Is there improving group strength? Is the stock in question showing improved relative strength? Is the stock or sector showing an oversold value, and if so, is the positive divergence? In the case of the Airlines right now I show you a snap shot of the Relative Strength Ratio versus the S&P 500. Over the last few days it is just perceptively beginning to break above its declining trend line with a double bottom forming over the last few months. On the RSI, there is positive divergence on the right side of the Double bottom. Even with all this it is still possible to lose money, but some of the key elements needed for success in a speculative trade could be present. This is a sign that investors should dig deeper, and bore in with their own analysis with a heavy emphasis on assessing risk-reward.

Above: Relative Strength Ratio of Airline stocks versus S&P, with RSI on R/S Ratio showing positive divergence.

Other sectors that have come off the highs include Education and Training Services, Steel and Industrial Metals, Conglomerates, Fertlizer and Agricultural Chemicals, Scientific and Technical Instruments, Water Utilities, Metal Fabrication, Farm Products, Appliances, Healthcare Information Services, and Restaurants.

As always, No recommendations of any kind. I just wanted to encourage investors who may be feeling a bit left behind, -- don’t give up! Iif you use discipline and patience, you can still find interesting opportunities in the current equity market. There will most certainly be any number of corrections and consolidations along the way, and as prices do pull back, inexorably this will open up even more opportunities for investors who are paying close attention to what is now fast becoming more a market of stocks, than a stock market.

That’s all for now,

Frank Barbera

© 2009 Frank Barbera

Contact Information

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