Saturday, June 11, 2011

Assessing the trend

What a difference May (and June) make!  Swiftly, the S&P500 has corrected about 7% from its April high. Many indicators are extremely oversold, and several of our negative (red) trend-following readings have gone to neutral, suggesting that the sell-off may be nearing a point of inflexion.

We follow "major" trends in several main asset categories. Most of those readings first turned over (flashed warning signs) in early May.  One of our most reliable indicators is a ratio of the S&P500 vs. the 30-Year US Treasury Bond price, denoting the relative favor of stocks vs. bonds. Using this indicator. our trend-following system would have gotten the investor out of equities and into bonds in the first week of May. Note the chart below and the green (buy) and red (sell) signal lines.























There are no glaring warning signs that this correction is nothing more than a normal setback. However, we all know that a trend change can continue as a trend change and then become the new trend! In market conditions whereby selling feels relentless, there comes a time when bears cover shorts and value-seekers place bids on the market.  A few of our indicators suggest that such a bounce may be on the near horizon.

Put/Call ratio at 1.18 is at bullish (contrary) levels, and its 13-day moving average sits at the highest point of the year at 1.06. This typically precedes some sort of bounce in equities.  VIX, our fear factor reading, has risen but clearly not as much as with other pullbacks. In fact, VIX tends to remain in the 25 and below area during bull market pullbacks, only to sprout into the 40's and higher when we are at the cusp of bear-market conditions.  Stocks trading over their 50-day moving averages are sitting at low levels last seen in the 2010 summer setback following the "flash crash." While these various indicators sit at extremes, we would look for signs of capitulation (aggressive selling) with an intraday recovery to mark the start of a bounce.

One test we anticipate this week is whether the Nasdaq and the S&P500 can hold support at their 200-day moving averages, only 15 points lower than Friday's close for the Nasdaq, and 18 points for the S&P500. Given Friday's swoon of 41 points and 18 points for the Nasdaq and S&P500, respectively, one would expect the market forces to potentially test these nearby levels sometime on Monday. Clarity around price performance at this important bull/bear dividing line will aid in our overall assessment of the market trend going forward.

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Saturday, May 21, 2011

Markets at the crossroads

Is this current setback in the equities a normal consolidation in an uptrend, or does it foreshadow more serious weakness ahead?  In addition, are there indications that might suggest the start of a topping process in stocks?

On a weekly basis, we review 23 charts depicting various trend-following and sentiment indicators. Here are some noteworthy observations that suggest a neutral (if not modestly bullish) stance on equities.

Stocks comprising the S&P500 trading over their 50-day moving averages (known as “bullish percentage”), a proxy for a healthy uptrend, have declined from a peak of 95% in October 2010 to 67% today. Based on our historic back testing of the bullish percentage indicator, a level of 55% or higher has sustained a bullish trend. But the waning participation of many equities (commodities, materials, energy and financials are most to blame) raises caution. Volume has been lackluster, both on up-days and down-days, a neutral indicator.

Similarly to waning bullish percentage, a measure of price momentum has diverged from the uptrend in the indices since peaking in October. The Relative Strength Index (RSI) of the S&P500 reached overbought peaking levels in Q4 2010 as the S&P500 gained. But as the S&P500 reached a higher high in late April, RSI sat a a lower level than when the S&P500 hit its earlier peak in February, a classic sign of "divergence" and a warning to bulls.  The Nasdaq exhibits a similar weak showing.

Chart of the S&P500 noting weakening RSI
We have had four of these stock market pullbacks since November 2010. During the pullback in March, when the S&P500 swooned about 7%, bullish percentage fell to 42%, and one of our closely-followed indicators, the New York Stock Exchange Summation Index (measuring cumulative advances vs. declines) poked briefly into bearish territory. The question is whether other indicators that held strong during the previous setbacks in March and November are now turning negative. Let's take a tour and see what (if anything) is different this time.
 
Starting with the positives, the Nasdaq has begun to outperform the S&P500. Historically, such outperformance has been a leading indicator of strength for equities. We saw the Nasdaq underperform since January 2011 through the March correction, only to outperform since mid-March. See below:  
 
Nasdaq vs. the S&P500 shows outperformance
On the flip side, strength in financial stocks has also been an important support for the broader indices. It is hard to argue that financial companies are not an important driver to sustain and expand growth in the economy. Financials have underperformed vs. the S&P500 since peaking in April 2010, and they continue to underperform now as they did in March, hitting new lows in relative strength.  Despite this underperformance, however, our relative strength indicator (RSI) is diverging positively and showing some signs of strength. When RSI diverges (heads in a different direction) than price, we pay attention as this may suggest a change in trend. See the chart below:
   
XLF (Financials) vs. the S&P500 shows positive divergence
There are several market indicators we follow as proxies for global economic conditions and sentiment toward global growth. One of those indicators is a ratio of copper prices to the 30-year Treasury bond. In the best of growth worlds, this ratio would climb as copper prices rise and bond prices decline (while interest rates rise), a bullish economic scenario.  This indicator peaked in February and is now sitting at support marked by peaks in April and November 2010. We measure RSI with this index too, and it tells a slightly positive story as RSI failed to reach a lower low (it diverged) as the index fell to a lower low.
 
Copper vs. Bonds: growth story still intact, but softer
 
 
Alongside weakness in copper prices and commodities, perhaps also suggesting a softening in economic growth expectations, we have seen a pickup in Treasury bond prices. Long-term Treasuries have gained about 6% since the beginning of April and just briefly surpassed their peak hit during the March correction. RSI has been positively diverging  as price established a double-bottom and held long-term support. Rates, inversely, have been falling.  See the chart below:
 
Treasuries gain as risk-aversion increases and economic growth softens
Another indicator is the ratio of Corporate Bond prices to the medium-term Treasury bond (represented by the Exchange-Traded Funds, or ETF's, "LQD" and "IEF"). Corporate bond relative strength tends to correlate positively with the S&P500. We look for turns in the relative strength ratio of LQD/IEF to provide warning signs of turns in the S&P500. When corporate bonds decline vs. Treasuries, that tends to indicate a rise in interest rate spreads in risky vs. "risk-free" debt and tends to be a negative leading indicator for equities. Currently this indicator barely favors bonds over stocks (let's call it neutral), but it has been erratic lately and is not displaying as weak a reading  as it did in March.  See below:
 
Corporate bonds vs. Treasuries indicator is neutral
The "risk-on" trade which favors equities also is captured by the relative strength of small caps versus large caps, and the relative strength of growth vs. value stocks. Both of these indicators remain bullish, although small caps have begun to challenge their uptrend line drawn from the March 2009 lows:
 
Small Caps relative strength rests precariously on their uptrend line
To wrap up, our indicators generally suggest that this correction is a normal pullback in an uptrend. At the Annual Symposium of the Market Technican's Association, held in New York earlier this month, the market forecast panel largely remained bullish (with a 17,000 Dow target a few years out being cited). The short term seems to be plagued perhaps in part due to the "sell in May and go away" warning, and/or early fears of the end of QE2. Also, several events have come to the surface and are likely causing some retreat in the "risk-on" trade. IPO's have been in the headlines again (and talk of an IPO bubble). Sovereign debt is also grabbing center stage (as the good news from positive Q1 earnings reports are now history). There are erratic signs of economic growth, housing prices continue to fall, and the national debt isn't going away anytime soon. 
 
We are seeing signs of asset allocation into more defensive equities (healthcare, staples, utilities), at the expense of commodities, financials and industrials. In the chart below we have plotted the relative strength of various sectors vs. the S&P500. The defensive sectors have led since late February:

Sector Leaders and Laggards:














































To turn more defensive (if not bearish), we will look for a decisive break in the the S&P500 uptrend with a close below 1300.  To turn bullish, a large-volume leap in equities with outperformance in growth stocks (not to mention firmness in financials) would be encouraging. At this time, we are inclined to add to equities and ETF's exhibiting relative outperformance, with a preference for larger-cap, dividend-paying names, establish shorts in underperforming groups (some emerging markets have exhibited noteworthy weakness), and maintain a modest allocation to bonds.   

The Baseline Analytics Market Tour is updated periodically as warranted by developments in the financial markets.
 

Monday, May 9, 2011

Waiting for the uptrend to reassert itself

Enough short-term damage has been done to equities to instill a "wait-and-see" attitude toward either short or long positions. Seemingly good economic and political news events are not sending equities decisively higher (a bearish development). Looking at the chart of the S&P500, it appears that last week's swoon has met the conditions of a reasonable correction in an uptrend. However, with the decline off the opening highs on Friday, and a newly-negative MACD (printed below the price chart), we are at a standstill between the bulls and the bears:
























Gauging our various indicators, major indices held support and rested just above their RSI 50 lines. However, as we have noted here in the past, the reversal in our corporate vs. government bond ratio (LQD/IEF), and weakness in copper prices, foretell concerns about a softer economic recovery:

Copper/US Gov't Bond ratio breaks trendline support:



















Corporate vs. Medium-Term Government Bond Ratio favors bonds over stocks:





















Historically, these two indicators cited above have led market turns in the equity markets. For now, we will heed their advice and remain cautious unless and until a convincing rally in equities (on higher volume, imagine that!) and a reversal in these two indicators occurs.

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

Monday, May 2, 2011

Kinks in the Uptrend

Two "kinks" in the strong uptrend have surfaced that warrant attention.

One of our market trend confirming indicators is the ratio of copper prices to the long-term US Treasury Bond. A rising ratio suggests optimism for economic growth, given the significant role that copper plays in the world economy. A decline in this ratio suggests economic weakness (weaker copper prices and stronger bonds cause the ratio to fall faster).

In the chart below, you will see that the copper/bond ratio has settled back to long-term trendline support. Note that setbacks have preceded declines in the S&P500. In fact, this ratio, which broke through resistance marked by highs in 2006, 2007 and 2008, has settled back to that support line (former resistance), and bodes watching:


















A second curious kink in the uptrend is the appearance of divergence in the S&P500. We like to see RSI (the Relative Strength Index) turn higher and make new peaks alongside new peaks in the equity index.  as the chart below demonstrates (see the red circle in the RSI section at the top of the chart), RSI on a weekly basis (more meaningful that a daily chart) has been trending downward as the S&P500 index has been climbing:


Other indicators generally support the uptrend. With the strong surge that equities have experienced, however, these two kinks in the uptrend potentially foreshadow a breather for the uptrend. The emergence of additional negative indicators will signal more cause for concern.



Monday, April 25, 2011

Earnings lend support to the ongoing uptrend

Positive earnings reports (approximately 70% of earnings announcements have beat estimates) continue to support the uptrend, supported by generally positive economic statistics. The upcoming test will be whether the S&P500 can decisively break through the 1340 level where peaks in February and April marked short-term tops:


The Nasdaq closed a mere 41 points from its 2007 high and likewise is closing in on the potential of a breakthrough of resistance:

In fact, Nasdaq relative weakness (vs. the S&P500) that we have noted here in the past has been resolving itself, thanks in part to strong tech sector earnings. We like to see the Nasdaq showing leadership to help support a positive environment for equities:


As for financials, the same old story of underperformance continues to flash a warning sign:


VIX too has reared its ugly head of complacency as the index has reached a low (under 15) not seen since July 2007. See the chart below:

We view this low level of volatility (as noted in VIX) as an opportunity to hedge long positions with inexpensive puts. There's no sense shorting a strong market like this, as growing participation from retail investors and the "follow the herd" mentality has damaged the shorts while this uptrend continues.

Click here for the latest market tour on Stockcharts.com.



Sunday, April 17, 2011

Reaching higher

Since its peak in February, the S&P500 has traversed a rather healthy consolidation, despite a correction of nearly 7% on higher volume in mid-March while the earthquake in Japan heightened market fears. A recovery and new basing pattern suggests resilience on the part of the bulls (we may even see some technicians call a "head and shoulder's bottom" as noted on the chart below). I will refrain from such a conclusion as I have seen many such formations turn into continued consolidating patterns prior to a breakout (or breakdown).  Regardless, it appears that the S&P500 would rather rally toward a new high (soon) than breakdown.


























We are seeing continued resilience in the Nasdaq and strength in small caps and growth stocks, further indicators of health in the market. As a trend-follower, our strategy remains "with" the trend but not leveraged on the bullish side for the reasons noted next.

Vix has taken a plunge into the sea of complacency. This is an opportunity to buy cheap puts to protect longs, or cheap calls to participate in a potential breakout to new highs.  See the chart below, as Vix has fallen to a new short-term low near 15.




















Two further cautionary signals include the outperformance of Staples vs. Discretionary stocks, and continued weakness in financials.  As the chart below shows, Staples took a relatively large leap vs. Discretionaries and bears watching for the potential resumption of the "risk-off" trade. 













As for financials, their underperformance vs. the S&P500 is approaching the lows seen in December 2010. The positive light on this relative weakness is that financials as a sector have fallen into a trading range (see the grey line in the chart below) rather than a distinct downtrend.  Financials underperformance is not alone, as materials have also taken a backseat to strength in Staples and, to a lesser extent, utilities.
















Long-term US Treasuries saw a bounce last week and may have formed a short-term (double) bottom. See the chart below:


















Sector rotation into more conservative plays (staples, utilities, bonds), low Vix readings and the "sell in May and go away" mindset may be pushing the smart money to the "risk-off" side of the ledger, after reviewing our various Market Tour indicators. An upside break in the major averages on higher volume is needed to reduce our cautious stance and lighten up on our long positions.

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

Sunday, April 10, 2011

Trend-following indicators remain positive for equities

Despite minor setbacks for the S&P500 and for the Nasdaq last week, our trend-following systems and indicators continue to support long positions in equities.  

Several new bullish developments that emerged last week include the following:
  • A surge in relative strength of Asian equity markets vs. the S&P500 (Hong Kong, Taiwan and China were particularly strong on the week). This reverses the trend that has been in place since October, when the S&P500 led Asian equities. See the chart below:













  • Steepening of the yield curve. Not a good omen for inflationary expectations, but positive nonetheless at this juncture for equities.
  • A rally in corporate bonds vs. treasuries as seen in our LQD (corporate bond ETF) /IEF (medium-term treasury bond ETF) ratio.
  • Continued uptrend in small caps relative strength vs. large caps.
  • Likewise, strength in growth vs. value is favorable for equities.
  • The New York Stock Exchange McClellan Oscillator, an indicator of advances versus declines, strengthened last week and continues to flash a bullish signal for equities:

















Bearish indicators include the following:

  • Gains in US indices on weaker volume (note however that Friday's sell-off was on lighter volume).
  • Continued weakness in financials vs. the S&P500.
  • Gains in relative strength of Staples vs. Discretionary stocks.
  • A decline in VIX as complacency picks up and Investor's Intelligence sports continues toppy bullish sentiment readings:


















Our trend-following indicators continue to support equities as earnings season is upon us and seasonal risk (the "sell in May" mantra) begins to emerge.  With volatility (VIX) once again at low readings, a long equity portfolio with index put protection may be a sensible strategy as we head through April and into May.

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