Overdue correction needs time to resolve

A relatively sharp decline in global indices (the much-needed respite we have spoken about in this blog, triggered by events in the Middle East) needs some time to find its footing before our trend-following strategies are re-engaged to follow the uptrend.

Nasdaq took the brunt of the selling this week; this was clearly seen in the percentage of stock remaining over their 50-day moving average, which sharply dropped below their low seen during the correction in November.  In addition, Nasdaq relative strength, which has been weakening, saw a sharp drop on Friday. See the charts below:

VIX surged above its 50-day moving average.  A large gap in VIX below its 50-day moving average warned of a possible reversal (which transpired this week). Now, VIX rests well above its 50-day moving average; we will be watching this gauge as a possible clue to resumption of the uptrend:

A sharp decline in the LQD/IEF ratio, our spread of corporate bond prices vs. short-term Treasuries, is a concern worth noting. A flat or uptrending slope in this ratio has been favorable to equities. Although the trend remains up, this indicator warrants watching for a potential trend change.  See the chart below:

Although the uptrend in equities remains intact, we will be watching our indicators for stronger signs of a change in trend. Holding off on adding large long positions (partial entries may be warranted) and maintaining our stops.

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Nasdaq leads the decline; Dow Theory divergence and small cap weakness bear watching

As equities take their first noticeable breather since mid-November, it is noteworthy to observe the relative weakness in the Nasdaq compared with the S&P500. The Nasdaq's swift correction in relative strength (the composite fell 2.39% on the week vs. .76% for SPX) is its most extreme since equities rallied off their September lows.  Some frothiness in technology and a few bad apples in the earnings mix proved enough to shake the bulls from their perch in this sector of the markets.  See the chart below:

Nasdaq breadth indicators swiftly fell to levels achieved at the lows in November. Stocks trading over their 50-day moving average fell over 10% to 70%, nearly matching the level seen at the bottom of the pullback in November's 5% rout.  Although this respite in bullish frothiness was needed, it was met with light volume, a positive reinforcement of the bullish uptrend and perhaps enough to entice some nibblers to buy.  See the chart below:

In fact, we focus on the Nasdaq and its relationship to its former high at 2,859 achieved on Halloween 2007. A decisive break of this high (another 6% to go) will reinforce the bullish trend and coerce other equity indices to follow along.

Moving on to other sectors and styles, we have found some curious changes that bear watching.

The Dow Jones Transportation Index took a hit this week, printing a divergence from the Down Jones Industrials. This is the first significant divergence in Dow Theory seen since the September bottom and bodes watching. There was no single culprit in the transportation index decline, spread across airlines, ground and maritime shipping.

As for style, this week we saw a noteworthy correction in the relative strength of small caps vs. large caps, a larger hit that the one we saw in November. This could be normal profit-taking in the frothier side of the market in favor of more conservative equities. Although the uptrend in small caps vs. large caps remains intact, watch for style rotation as the significant market gains from the March 2009 bottom begin to wear. Small cap outperformance peaked about 18 months before the S&P500 peaked in October 2007. This could suggest the need for large caps to "catch-up" to the performance of small caps before this Bull run is over. See the chart below:




Reviewing our sentiment readings, our Put/Call alert flashed last week came to fruition as the low seen had in the past preceded market declines.  See out chart below (from last week's blog):

Today, this indicator reads neutral-slightly bearish at .79.  VIX similarly printed an extreme reading last week and preceded the pullback as noted in this blog. Today, VIX crossed above its 50-day moving average, eliminating the "risk gap" we have noted before. Based on past market behavior, VIX could see some more upside (and equities some downside) before a modest "November-like" correction is over.

As the uptrend remains intact, we suggest holding off with new buys until some basing is seen. In the November correction, prices took a hit quickly then stabilized; in November, our indicators resolved themselves to the bullish camp rather quickly after the first few days of declining prices. Watching price and our indicators this week will play an important role in assessing the health of the Bull run.

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Market Tour Update

Bullish prices marched forward this week as negative divergences in momentum indicators resolved themselves through the price uptrend. Volume on the uptrend remained modest (it should have been much higher now that the holidays are behind us). Our sentiment indicators this week tried to convince the Bull to tame its advance, but the Bull just charged on with no sign of tripping over the extreme readings that our sentiment indicators continue to flash.

Two indicators currently stretched and signalling caution for longs include VIX (the Volatility Index) and the Put/Call ratio. The latter, in particular, is helpful in identifying price extremes.  For example, when investors and traders are excessively bullish, they will buy more calls vs. puts, therefore deflating the put/call ratio. The theory is that when "everyone" is buying and bullish, there are fewer investors left to keep the rising momentum going. Friday's Put/Call ratio of .58 was last seen on April 15, 2010, one day prior to a 2% pullback in SPX and the start of a11% retreat in the index through May. Timing, however, is tricky with this indicator, and the start of options expiration week this Monday could have skewed Friday's reading a bit.  But this is an indicator nonetheless to keep an eye on. See the chart below:

Our next indicator of note is VIX, which represents volatility in equities and trends lower as equity investors become complacent with a climbing uptrend and join the crowd. Our VIX indicator once again flashed a complacency warning sign; with the index falling significantly below its 50-day moving average (it closed Friday at 15.5). The last time such a gap was seen, the SPX embarked on a trading range with no significant pullback to speak of.  See the chart below:

VIX can remain "complacent" for a long time. VIX was at this current level in Q4 04 and continued to trend lower through Q1 07 (touching single digits at times) as the SPX marched upward into 2008. During this time frame, however, VIX would go through fits and starts just as equities did, as consolidations and single-digit corrections dotted the landscape.  It is interesting to note that at today;s VIX closing level, the indicator almost matches its low formed in April 2010 prior to the aforementioned correction.

Outside of these two indicators, the patient is healthy. At the end of the day, PRICE is the key indicator and that remains positive and yet extended (we track the delta between price and a few of its moving averages, a gap which has underscored the market's extension).  Market breadth remains strong.  As for resistance, note that the Nasdaq Composite is about 20 points away from meeting up with its 2007 high. Breaking through this resistance level will lend credibility to the prospect of a longer-term bull market.  US equities have begun to outpace Pacific-rim markets, and bonds continue to feel the effect of allocations shifting toward stocks.  Some emerging markets (i.e. India) are beginning to feel the heat of food price inflation, as several central banks have been raising interest rates, in part to cool QE2-induced cashflow from sparking bubbles in those emerging markets. We may be seeing the start of such a trend. We look at the Pacitic Rim markets (ex-Japan) and have noted their recent underperformance vs. SPX.  See the chart below:

As for sectors, Financials and Technology, two sectors we would like to see as leaders in the market, have resumed their relative strength uptrends. Small Caps continue to outshine large caps, and growth continues to beat value.

One of the most disconcerting decisions to make at this juncture is whether to continue to join the crowd and buy stocks. The big doubt in the back of one's mind is whether one is buying at a top. When uptrends gain significant momentum (think back at the 2003-2007 time frame), those who stayed the course, averaging into the market with partial buys along the way, and boosting long positions more aggressively in market pullbacks, were rewarded.

One needs to be mindful of the risks inherent in a strategy this time. Macro-economic conditions underscore the risk: The US is recovering at a slower pace today than it did following the 2001 recession largely due to the absence of growth from housing and stubbornly-high unemployment. The risk of national and local debt levels continue to hang over us as a dark cloud. And inflation seems to want to break out of its cage after being tame for so long (some food price indicators are harkening back to the leap in rice inflation in 2008). Oil price is another concern; will the price of gasoline pushing toward $4 per gallon trip this nascent recovery?  In late 2007, as West Texas Intermediate Crude surpassed $90 per barrel (where it sits today), the SPX started to stumble (most likely as mortgage fears surfaced, but perhaps in part spurred by the fear of $4.00 per gallon gasoline).  See the chart below:

As we keep abreast of the stage of the recovery and the economic cycle, we can't ignore those sectors that have underperformed and perhaps will "have their day." Consumer Staples, Healthcare, Financials and Utilities have underperformed as Materials, Energy, Technology and Consumer Discretionaries have led.  Will potential sector rotation (laggards turning into leaders) provide some guidance as a way to participate in the uptrend? Reviewing our relative strength indicators, Technology and Financials (noting their recent strength), tempered with some weightings in Consumer Staples and Healthcare (shunning Utilities due to interest rate risk) might be a prudent way to approach this market.

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A Respite For The Uptrend?

Technical analysis pundits have been sounding the alarm of excessive optimism and divergence in the equity indices, clamoring for some sort of pullback. So often, analysts can easily fall into the trap of "too many indicators" studied in "too short a timeframe," generating frequent trades that, at the end of the day, were no more profitable than taking a longer-term position consistent with the intermediate term trend.

Our "trend-following" approach to equities rests on following a simple system tracking the S&P500 (SPX) against a Relative Strength Indicator (RSI) and its moving average, and a moving average of SPX price. This simple system has captured the major intermediate-term trends despite the fears of overbought markets and divergences we speak of here. 

Even though following (and sticking with) the major trend is the key to investment success, the trend ocassionally sees corrections which represent equity drawdowns in our trend-following approach. Staying consistent with the major trend, but hedging with futures or options when the outlook gets dicey, is an ideal strategy.

Our Market Tour indicators help us gauge the reward/risk of the market at any time, and the propensity for a short-term correction in the major trend (our higher-level RSI/Moving average study noted above keeps us on the right side of the market nonetheless). As for our Market Tour indicators, here is a summary of the positives and negatives. After reviewing these indicators, a higher level of caution is warranted with regards to long equity positions.

Positives (regrettable for Bulls, not too many):

1. Clear uptrend sustained in weekly and daily charts of major indices. Recently, selloffs earlier in the day have often recovered by the end of trading.
2. Nasdaq relative strength beats SPX (technology has often led uptrends and we look for this sector to lead the sustained advance in equities).

Negatives (more than our usual tally):

1. Divergence in momentum indicators (the buying strength is waning).
2. Low VIX marks complacency and is worthy of watching for a sudden shift in equity direction.
3. Advance/Declines (NYSE McClellan Oscillator indicator -- NYMO) flashed a minor warning sign (NYMO fell below its 13 and 34-day moving averages on Friday).
4. Financials felt a bout of underperformance this past week as foreclosure debates persist and the overhead risk of bad mortgage debt remains.
5. Decline in CRB (gold included) as the dollar strengthens. The US dollar and equities have largely moved inversely during the rally from 2009; a change in trend can spell trouble for equities. Gold may be leading the way to a decline in stocks (gold and stocks have moved largely in tandem), as GLD fell about 4% last week. An upward bias in US interest rates and continued Euro risks fostered by sovereign debt concerns have helped the greenback firm.
6. Slight decline in corporate bond prices vs. Treasuries. Traditionally, a spread in bond prices above Treasuries has been positive for stocks.
7. A decline in small caps vs. large caps on the week, denoting a bounce in the "risk-off" trade.  

In addition, we follow an "economic strength" indicator as defined by the relative price performance of copper (our proxy for industrial materials and therefore industrial growth) and US Treasuries. When the trend of this ratio rises, we are in a favorable growth, if not a potentially inflationary period. This trend has been positive since March 2009, along with equities. A minor risk (suggesting a pullback potential) has been noted as this ratio is bumping up against resistance around the 3.50 area seen in 2006, 2007 and 2008. Each time it hit this level in the past, a correction of 15%-30% occurred.  See the chart below:

In conclusion, once again we sit at a potential turning point in equities. Friday's mixed employment report provided a bit of a wake-up call to the bullish enthusiasm that has graced equities since early December. There is no telling from the momentum and trend indicators we watch, as to what magnitude of a trend change we might see. The markets are way overdue for a consolidation or a correction. We feel that these indicators beg for caution and continued hedging of long positions for the time being.

Click here for our Market Tour on StockCharts.com.

Bob Palmerton - January 9, 2011

Topping indicators spell caution for bulls

Each week, our Market Tour reviews select indices, sectors, sentiment and volatility readings, and intermarket relationships, in order to gauge the reward-to-risk of all asset classes. There is no doubt that bullish momentum and the Street's need to participate in the uptrend has driven equities to the higher-end of our comfort zone. As traders and investors, we look for reward-to-risk opportunities with a minimal 3:1 reward/risk profile. This is determined largely by technical analysis factors, taking into consideration support and resistance and momentum indicators.

At this juncture of the rally in equities, an expected pause (if not correction) causes us to lighten up on long positions and establish contrary (short) positions in equities. One of our strategies has been to write covered calls on profitable long positions, expecting either to pocket the premiums as the long positions weaken, or have such long positions called away (leaving some money on the table). In reviewing this past week's action, we intend to continue this strategy.

Technical Analysts will see that the S&P500 (SPX) has recovered a bit over 62% of its decline since the peak in 2007 (61.8% is a classic technical indicator retracement benchmark). This may be a ripe time for a pullback in equities.  In addition, SPX has seen a negative divergence in RSI (a lower high as price climbed to a higher high), and MACD has printed a negative cross-over (see chart below). Although at the end of the day, PRICE is the important indicator, such momentum statistics are cause for pause and caution.

The Nasdaq displays a slightly weaker position vs. SPX, with more pronounced weakness in RSI and a negative MACD cross-over. Nasdaq underperformed SPX last week.  See chart below:

Although the price trends in equities remain up, we have denoted our comments on our market tour mostly neutral (rather than bullish) given the extent of the rally and the negative momentum indicators.

Here is a list of other positives and negatives as we review sentiment and intermarket relationships:

Positives:

1. McClellan Oscillator statistics remain positive.  The indicator remains above its moving averages (13 and 34-day) as the Summation Index remains above 400 and above its 20-day exponential moving average.
2. Relative strength is improving in Financial stocks.
3. Continued strength in commodities.
4. Outperformance of corporate bonds vs. treasuries.
5. Continued strength in small caps and growth stocks.

Negatives:

1. A downtrend in relative strength in Consumer Discretionary stocks while Staples remain firm (a relative strength bottoming pattern for Staples appears to be emerging).
2. A potential negative for equities was strength in 30-year Treasuries last week. A short-term bottom for treasuries could precede a setback for stocks, as these asset classes have correlated inversely.
3. From an Elliott Wave perspective, SPX apears to have completed the final 5th wave of an impulsive rally, which would suggest a correction forthcoming (its retracement of nearly 2/3 of the decline since its peak in 2007 is an additional concern for bulls).

Neutral:

1. VIX and Put/Call have turned neutral. Although it is interesting to note that VIX has risen along with equities, suggesting a bit higher risk premium and potential volatility in equities.

Based on these observations, we are not embracing a bullish stance as the crowd has, but will sit on the neutral side with some hedged postiions in shorts to take advantage of an ancitipated pullback as we commence the New Year.

Click here for the latest Market Tour on StockCharts.com.

Bob Palmerton - January 2, 2011