By Ryan J. Puplava CMT, July 6, 2009
Green, Yellow, and Red. Those are the colors of an American traffic light. Green means go. Yellow means caution because the red light is about to appear. Stop if you can do so safely. Red means Stop. Currently, the markets are signaling a yellow light which again, means caution. It means take a step back and review your homework. Are your hypotheses proving correct in this market environment?
If you’re bearish on the global market, what do you have to say for expansionary manufacturing readings from China, India, Turkey, and Sweden? The Indian government is expecting growth of 7.75% this year and China is expecting 9.0% growth in 4Q. Retail sales are up 6% over the past eight months in Australia and 9.1% in Korea over the past four months. Korea’s trade surplus continues to grow.
If you’re bullish on the American market, what do you have to say about the consumer sentiment and job report last week as they ticked down? What about all of the secondary economic indicators that haven’t turned positive yet like unemployment, retail sales, and consumer credit?
With all of the economic opinions I’m reading right now it’s no surprise to me just how varied they are. We’ve come to a point in which the market must reflect on its gains and search for the next catalyst to take us higher or correct downwards. The market is signaling a yellow light as momentum and breadth have waned. Caution should be the modus operandi in a portfolio with adequate hedges. It is at times like this without any catalyst to push the market in a given direction that I turn towards market technicals.
The spring rally in stocks has ended. It went out with a bang in early June with a break above the 200-day moving average in the S&P 500 and the Dow Jones Industrial Average. The spring rally is marked as the 3rd biggest rally in the past 100 years.
I say it has ended based on three signs: momentum, breadth, and a lower high. The question now is whether we’re in for a correction or a running correction (sideways) market; but first let us take a look at those three signs mentioned above in review.
Momentum has two parts and is defined as the change in price of a security or index multiplied by the trading volume. May and June has shown a loss in momentum for the major indices with the rate of change turning negative mid June. Volume peaked around May 7th as the summer has resumed its characteristically low volume behavior.
A lack of momentum is a signal and a warning of change. Momentum hasn’t changed to a negative mode yet, but it has changed and the momentum that was supporting the bullish rally has gone.
Breadth is another category that looks at the health of the stock market by telling us how many stocks are participating in a particular market move. It takes a look at how many stocks are above their moving averages, how many are hitting new 52-week highs and lows, and the number of advancing and declining stocks in a day. Let us see how the markets are fairing.
The percentage of stocks above their 50-day moving average is below. When 70% or more of the NYSE stocks are trading above their 50-day moving average it is considered an overbought market. A reversal and peak signals a short-term sale.
Below is a chart of the NYSE composite index with volume, advances to declines, up versus down volume, and the 52-week highs and lows. Using an area chart only the greatest net value, whether up or down, is charted for emphasis. We can see in the NYSE up versus down volume that the value is pinching. We haven’t seen any decisively up or down days because volume has been so light. June 15th and June 22nd were significant down days that showed distribution and notable selling pressure.
According to Dow Theory, a trend is assumed to be in effect until it gives a definite signal it has reversed. A failure swing is the first sign of a trend reversal. A failure swing is when price fails to make a new high (bearish) or it fails to make a new low (bullish). We have a failure swing in the market as of last week for the market indices.
Well that takes care of momentum, breadth, and a lower high. Clearly, we can see that the market is in a precarious position and is showing us a yellow caution light. Let us then discuss possible corrections and sideways markets. As a side note, I do mean correction because I think there is enough evidence that we have started a cyclical bull market within a secular bear market. I believe this because of the upturn in the U.S. leading economic indicators (which is not just due to an increase in money supply), central banks continue to pour liquidity, the treasury market has been a haven for equities to park with the 10-year back at the 3.5% yield range, long-term market technical indicators are positive, and the market isn’t deleveraging as defensive sectors outperform the market in this recent sell-off.
Back to possible corrections here... one of the patterns that has been highlighted quite often recently in many wrap-ups is a possible Head & Shoulder (H&S) pattern. Why do people see H&S patterns all the time? It has the typical characteristics of a Dow-Theory reversal when higher highs (lower lows) are interrupted by lower highs (higher lows). The only problem here is that a H&S pattern only becomes an H&S pattern when the neckline is broken and not before. Once the neckline is broken a price target can be calculated taking the distance from the top (bottom) of the market to the neckline and subtracted (added) from it. As a side note, a complex H&S pattern has multiple shoulders. Here is the current S&P 500 index and the possible H&S pattern that many are pointing out:
We don’t have enough of a corrective pattern yet to decide if this is a zigzag, flat, triangle, or combination of any of those three, so there’s no need to go over those types of corrections. The only thing I can be sure of is that we are now in a sideways trending market, working off a lot of the overbought readings this powerful rally has created. We don’t have the conviction from the market based on technicals until the previous support and neckline are broken to the downside or a new higher high is created. Quite simply, this market isn’t trending. We have the first sign that it “could” be trending with a failure swing, but this hasn’t been confirmed by a lower low (which would also confirm a H&S pattern).
When markets are trading sideways it’s best to be cautious if you’re an investor, and nimble if you’re a trader. As an investor, piling on new longs when the market isn’t telling you to do so is reckless. At the same time, going to cash and piling on the shorts to go bearish on the market is also reckless. A better long or short (if you’re bearish) strategy is to raise some cash and increase your hedges. You can do so very effectively in the short-term through the use of index ETFs and index options to hedge a portion of your portfolio.
As a trader, this is your time to outperform the market: buying at support and selling at resistance with sufficient risk management using stops. Your risk and return boundaries are known and you can set stops and limits at appropriate support and resistance lines.
Alcoa will start the earnings season off on Wednesday. Whether you believe estimates are too low or too high for this quarter, you may have already placed your bets. We saw in the last quarter that analysts were too bearish and stock prices performed well with earnings surprises in addition to “less bad” economic reports. It’s possible that analysts may still be too bearish and we get a few surprises this season.
Right now, defensive sectors are taking the lead as portfolios have shifted from beta and alpha to healthcare, consumer staples, utilities, and telecom services. Bonds have rallied with the 10-year Treasury note yield down to 3.5%. The dollar has been rallying ever so slightly since June 2nd in a flight to safety.
My personal feelings are that the market may go through a testing phase to see if this cyclical bull market is for real. It’s possible that if a H&S top is formed, the S&P 500 moves towards 810, turns up, and we form a much larger H&S bottom (with November 2008 as the left shoulder, March as the bottom, and this testing phase as the right shoulder) similar to the 2002-2003 market bottom. I won’t know until this market traffic light turns from yellow to red with a break below 880 on the S&P 500.
© 2009 Ryan Puplava