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The TIP/TLT price relative serves as a good proxy for inflationary fears or expectations. TIP is the iShares TIPS Bond (TIP), which is based on the US Treasury's inflation indexed bonds. TLT is the iShares 20+ Year Treasury Fund (TLT), which is not hedged against inflation.

Bonds loathe inflation and would decline in the face of increasing inflationary expectations. The TIP/TLT price relative takes this one step further by measuring the performance of inflation-hedged bonds against non-hedged bonds. This price relative rises when inflation expectations rise and falls when inflation expectations decline.

Looking at the TIP/TLT price relative for 2004, there are two distinct moves: an advance from mid March to mid May and a decline from mid May to mid August. The decline is still underway as the upper blue trendline has yet to be challenged and the price relative remains well below the late July high. As long as this downtrend continues, inflation remains at bay and bonds are unlikely to remain strong as inflation is not a concern.

Also, notice that there is a good and inverse correlation between the TIP/TLT price relative and the actual performance of TLT. When inflationary expectations rose from mid March to mid May, TLT declined from 91.48 to 80.51. When inflationary expectations subsided from mid May to mid August, TLT advanced from 80.51 to 87.

We can't know the full potential of this rally, but there is abundant evidence that we have a solid bottom, and that we are seeing a rally that has at least the potential to move back to the top of the trading range.

First, there are positive divergences on indicators in every time frame. A positive divergence is where price makes a lower low but indicators make a higher low. The dark red lines on the bottom three panels of the chart highlight the positive divergences. These indicators, by the way, summarize the status of the PMO (Price Momentum Oscillator) for each of the stocks in the S&P 500 Index.

Next, we can see prices breaking above a short-term declining tops line, and there is an important PMO buy signal, generated when the PMO crossed above its 10-EMA.

Finally, Percentage PMOs Rising shows a strong initial impulse with a surge to almost 90%.

It is not impossible for the rally to move prices higher than the March top, but, as with the two previous lows this year, the PMO bottom associated with the recent low was too shallow. It would have been better if it had dropped to around -2.0, creating a fairly solid oversold condition.

Overall, this is a pretty good looking chart, but the top of the trading range could easily be the limit of the rally.

This past week showed stocks higher; their largest weekly gain in nearly 10 months. And, it did so within the context of sharply higher oil prices. By and large, this has set the tone for stocks to potentially move to new highsor so we are to believe. In fact, there is always that probability; however, we accord it a very small one at that.

That said , we are specifically looking at the bond-stock asset rotation for clues towards the best relative performance. Our and our proxy is the Lehman 20+ yr Bond Fund vs. S&P Spyders (TLT: SPY); and very simply we see that bonds over the past 2 months have outperformed stocks in a large manner. We believe this bottoming formation argues for a continuation of bonds outperforming stocks over the intermediate-term, although the current sharp stock rally indicates a correction in the ratio is taking placeperhaps to the 250-dma at .76. At this point, it would be wise to consider exiting stocks in favor of bondsas stocks are likely to fall further and faster than the current consensus believeswhich argues for a sharply decelerating economy into 2005.

STRAP ON YOUR HELMETS! - As we've been telling you, this coming week is our big change over to the ThomsonOne Data Feed. We've tested and simulated and fine-tuned things to death but starting on Monday we'll begin the changeover for real. Let us know if you see any thing out of the ordinary and we'll get right on it. We appreciate your patience during this transition.

NEW CHARTSCHOOL ARTICLES - We've just added two great new articles to our ChartSchool area - one on "Multicollinearity" and another on "Swing Charting". "Multicollinearity" is a $10 word "accidentally using two indicators that are related". It's a problem that you definitely want to avoid and this article will help you do so. "Swing Charting" has been around for years and has recently made a comeback. Read all about it here, then let us know what you think!

"TOOLS TOUR" DEBUTS - Over the course of the next couple of weeks, we'll be adding several animated movies showing how you can use various aspects of our site and what you should be seeing on your screen as you do so. The first in these series of movies is our "Tools Tour". Enjoy! (Flash required)

GOING FOR DIVIDENDS... A falling stock market -- along with falling bond yields -- should make dividend paying stocks more attractive. And that appears to be the case. Chart 1 plots the iShares Dow Jones Select Dividend Index Fund (DVY), which invests in large cap stocks that pay dividends. The Dividend ETF has acted much better than the rest of the market since last April as reflected in its rising relative strength line. Pricewise, the ETF hit a new four-month high earlier in the week. The two groups most heavily represented in the Dividend Fund are banks (38%) and electric utilities (19%). Other holdings include (in order of size) chemicals, tobacco, insurance, fixed line communications, and energy.

S&P MONTHLY BARS OVERBOUGHT BUT STILL IN LONG-TERM UPTREND... The monthly bars in Chart 2 carry good and bad news for the S&P 500. First the bad news. The monthly stochastic lines above the chart are still weakening from overbought territory above 80 (see circle). In addition, the price bars show that the S&P bull trend stopped at its early 2002 peak (see box) -- after recovering half of the 2000-2002 losses. The good news is that the S&P remains above its (dotted) 20-month moving average (see arrow) which qualifies the current price drop as a correction as opposed to a bear market. And, finally, the monthly MACD lines which turned positive at the start of 2003 (see arrow) are still positive.

Since setting a new low of 9783 last Friday, the Dow moved higher during four of the last five days and is now approaching the 10203 peak that it set back at the start of August. This rally - and the successful IPO of Google - has greatly improved the general mood of the markets however resistance from the 50-day MA line - not to mention the rising price of oil - make it is likely that the Dow reverses before moving above that August peak. I'm looking for a retest of the 9783 low in the next couple of weeks.

While you wait to see what happens, why not kick back and enjoy this jammed-packed issue of ChartWatchers? After I continue my series on John Murphy's Ten Laws of Technical Trading, John looks at a little known ETF that is breaking out right now, Carl sees several Bullish signals on his S&P 500 chart, Richard sees a declining economy in 2005, and Arthur finds evidence of lower inflation expectations by bond traders.

LAW #5: DRAW THE LINE

Murphy's Law #5: Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a straight edge and two points on the chart. Up trend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect, and the more times it has been tested, the more important it becomes. - John Murphy

It still amazes me how many people, when they first get into technical analysis, jump straight into indicators and oscillators without first learning the core concepts of support, resistance, and trend. Although I've said it many times before, I'll say it again here: At its core, Technical Analysis is about detecting stock trends in time to take advantage of them financially. Step one in that process is to look at the charts are draw trend lines. This is how smart ChartWatchers "pay their dues" and develop confidence in their projections. Its the basis for chart pattern analysis and it sets the stage for understanding indicators and oscillators. When in doubt, go back and redraw your trend lines. Properly created trendlines are always correct - the question is "Can you see what they are telling you?"

Trend lines aren't magic. They work for the same reason that support and resistance lines work. The majority of the people that are trading a giving stock feel that the intrinsic value of that stock has changed and that change is getting "priced into the stock". Why the value changed isn't important. How the majority came to their conclusion isn't important either. The job of trend line analysis is to detect that a change is underway and what its direction is.

As John indicates, drawing trend lines is all about finding "significant" peaks (AKA highs) and troughs (AKA lows) on a chart and then connecting the dots. It's actually harder than it sounds, but with a little practice, anyone can master it. One of the hardest things to learn is how to spot a real reversal - something that I wrote about last year. Now would be a great time to re-read that article (and bookmark it for later study!).

Another "gotcha" with trend lines is to forget to check the "Scale" setting for the chart you are looking at. Trend lines on logarithmic scale charts are very different from trend lines on arithmetic scale charts. Our ChartSchool article on Trendlines go into much more detail.

Creating your own trend lines at StockCharts.com couldn't be simpler. Just create a SharpChart for the stock that you are interested in and then click on the "Annotate" link located just below the chart. After our Java-based ChartNotes program loads, you can simply click and drag to create as many trendlines as you want. If you are a member of our Extra service, you can even save your annotated charts in your account and then see how your trendlines "hold up" over time.

You should also experiment with the "Zig-Zag" price overlay when learning about trend lines. While it has some significant limitations, it can help you spot significant peaks and troughs automatically. For more info, see this ChartSchool article.

Of course, there are several great books in our bookstore on trends. One of my favorite is "an oldie but a goodie" - William Jiller's "How Charts Can Help You in the Stock Market". Written in 1962, it shows the timelessness of these ideas in a clear, concise format that's MUCH less expensive ($14.45) than the Edwards & Magee book while covering much of the same ground. Of course, John's classic introduction book is similarly priced and similarly useful.

Can't wait for the next installment? Click here to see all of John's Ten Laws of Technical Trading.

The AD Line is a cumulative measure of advances less declines within a given group of stocks. For example, the S&P Large-Growth ETF (IVW) has 335 stocks. If there were are 200 advances and 135 declines, then the difference would be +135 (335 – 200 = +135) and this would be added to the cumulative AD Line. The chart below shows the AD Line for the six different style ETF’s.

Despite the decline over the last few weeks, the AD Lines for two styles are holding up a lot better than the other four. Notice that the AD Lines representing large-value and mid-value are holding well above their May lows (green arrows). Conversely, the AD Lines for large-growth and mid-growth moved below their May lows and remain the weakest of the six (red arrows). Small-growth and small-value are holding above their May lows for now, but are quite close to these important support levels and clearly weaker than large-value and mid-value. Even though the overall market may decline, these AD Lines suggest that large-value and mid-value will outperform (advance more or decline less) than the other four styles over the next few weeks and months.

Recently, the price of crude oil has taken the spotlight as having a major influence on the price of stocks. On the one-year chart above we can see that there was no consistent relationship between oil and stocks as long as oil was priced below $35; however, when oil moved above $35 in March, we begin to see a consistent negative correlation between oil and stocks.

Long-term resistance for crude oil is around $41-42. When crude oil reached that level at the end of July, stocks attempted another rally, in anticipation that crude oil would turn down again at resistance. Once crude broke to new all-time highs, the short rally in stocks failed.

If crude prices continue to move higher, I think we should be alert for the possibility that there will be another disconnect in prices. Specifically, if the price of crude moves well above $42, short price declines may not translate directly to a rally in stocks because prices will still be too high. This is not to say that stocks can't rally, just that gyrations in the price of oil may not transmit directly to stocks.

For the record, I have no opinion regarding the price of oil. As you can see on the long-term chart, it has moved into uncharted territory and is above historical resistance levels. It could be headed for a major blowoff, or it may have moved permanently into the bottom of a new long-term trading range.

The weakness over the past several months is stark, which was made "more so" over the past two-day decline in all the major indices due to rising energy prices as well as a "punk" employment report. As a consequence of each of reports (and others) - our presumption is for consumer spending to remain weak in the weeks and months ahead...perhaps progressively becoming worse.

To understand this somewhat better, we turn to a very broad sector ratio we like to use - Consumer Discretionary (XLY) vs. Consumer Staples or (XLP). It goes without saying that if consumer spending is likely to weaken further, then consumer discretionary shares will weaken relative to the more necessary consumer staple shares. In fact, this has been occurring, but at still remains at historically high levels above 1.35. However, the emerging consolidation pattern below trendline resistance and the 40-week moving average argues for a new leg lower to have begun. If this is the case, then a move lower towards the 200-week moving average would be expected.

Hence, once again - it time to sell discretionary shares vs. staple shares, but remember...if a bear market has begun, then all shares are likely to decline...only the defensive staples shares will drop as quickly.

DATA FEED UPDATE - We're continuing to prepare for our upcoming data feed transition which we mentioned several editions ago. At this point, the new hardware is in place and working well and our testing is almost complete. We are working on getting the final paperwork in place from the various exchanges and expect to switch over to the new "ThomsonOne" feed before the end of August. Our goal and our expectation is that you will not notice any difference between the feeds and we're working hard to make that happen. Still, data feeds can be wily beasts and so we ask your understanding if any unforeseen hiccups happen. Rest assured that we'll be working hard behind the scenes to correct things ASAP.

SURVEY SEASON - It's almost that time of year again - time for our end-user survey where you get a chance to tell us how we can do things better. Keep an eye out for a survey in your mailbox (or, heaven forbid, your spam folder) in the next couple of weeks. Can't wait? Feel free to send Chip an email (chipa@stockcharts.com) with any feedback you have (both good and bad). Did you let your membership lapse recently for some reason? Chip would love to hear why.

DON'T FORGET THE BOOKSTORE! - We've added almost 100 new and exciting books on financial analysis to our online bookstore in recent weeks. Be sure to check out our newest offerings by clicking on the "New Additions" link on the left side of the bookstore pages. Or, justclick here.

DROP IN BOND YIELDS HURTS DOLLAR, HELPS GOLD... Bond prices surged on Friday's weak job report. As a result, the yield on the 10-Year Treasury note tumbled to a four-month low and ended below its 200-day moving average (Chart 1). The sharp drop in U.S. rates pushed the dollar into a 2% decline. Chart 2 shows the dollar failing at its March high and ending under its 200-day line as well. The drop in the dollar pushed gold $7.30 higher and back over $400. Gold is also back over its 200-day average. That made gold stocks one of Friday's few winners. [The only other winners were rate-sensitive homebuilders and utilities].

EARLY 2004 SECTOR ROTATION WARNINGS... In my Thursday update, I chastised economists for missing the threat from rising oil prices earlier in the year, and made reference to earlier warnings that I had published on the subject. I thought it might be useful to list a few of those earlier messages, which discuss early sector rotation warnings. Two themes you will see repeated over and over is that leadership by energy stocks and underperformance by technology is a bad combination for the market. I've repeated those same warnings in recent messages. Those negative signs were written about as early as January and February. You can access those Market Messages by clicking on "More Archived Updates" in my Market Message section: --January 27: "Loss of Leadership From SOX Index May Be Bad Omen for Nasdaq" --January 29: "Tech Continues to Lead Market Lower -- Market Rotates to Consumer Staples" --February 4: "Loss of Nasdaq Leadership Could be Bad for Market" --February 10: "Rising Oil Is A Threat to Market" --March 10: "Sector Rotations Are Similar to Spring of 2000 -- Why Energy and Consumer Staple Leadership Isn't Good"

The major markets sold off dramatically at the end of the week due, so we are told, to wild speculation in the oil market. The Dow closed at 9815 which is significant because it is less that the 9852 low that it set back in May. This is the "lower low" level that I pointed out in our last edition. Despite all of the teeth gnashing in the financial press, nothing has really changed - yet. The markets are in a downtrend and lower-lows are to be expected. If the current pattern holds, the Dow may bounce some next week, but be prepared for more new lows before its next significant rise.

All our analysts are bearish these days (something that contrarians love BTW!). After I go over John Murphy's "4th Law of Technical Trading", John looks at the real reasons behind this week's fall, Richard sees a rough road ahead for consumer spending, Carl looks at the Oil market, and Arthur Hill examines the A-D lines of popular ETFs.

LAW #4: KNOW HOW FAR TO BACKTRACK

Murphy's Law #4: Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum retracement is usually two-thirds. Fibonacci retracements of 38% and 62% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area. - John Murphy

The concept of "retracement" is closely related to the concepts of support and resistance that we looked at last week. When there are no obvious support or resistance levels near the current stock price - maybe because the stock is breaking out to new highs for example - you can often use percentage-based retracement levels to "invent" new support or resistance levels.

To create a percentage retracement level, measure the most recent significant move that the stock made - i.e. the distance from the top of the last important "peak" on the chart to the last important "trough" on the chart. Now, mentally consider that distance to be "100%". By multiplying that number by the appropriate percentage, you can determine where these new "invented" support/resistance levels are.

For instance, as John indicates, stocks often reverse at the 50% retracement level. Thus, you'd multiple the distance you measured above by 0.50 (50% - the same as dividing by 2) to determine how far the stock would need to move (from the previous peak or trough) to hit that retracement level.

If that sounds like a bunch of needless math to you, you're right! And you're in luck - StockCharts' ChartNotes annotation tool can do most of the work for you quickly and easily. Start by creating a SharpChart of the stock you are interested in, then click on the "Annotate" link located just below the chart. In a couple of seconds, our Java-based annotation tool (which we call "ChartNotes") should appear with your chart loaded up and ready. It should look something like this:

To study retracements, first click once on the "Fibo Retracement" tool from the top toolbar (marked with a blue square). Next, move your mouse to the previous significant peak or trough (on the GM chart above, let's study the big move in December 2003). Then, click and hold down your mouse button while dragging the pointer to the next significant trough or peak. As you drag, we automatically display the important retracement levels and their values. When you have your mouse in the proper place, simply lift up on the button to finalize things. You should see something like this:

(Note: To duplicate this exactly, you'll need to move your mouse horizontally to the right edge and then use the "Expand Right" tool a couple of times.)

Now, why do retracement levels work at all? What's the "magic" behind them? The magic is the natural human tendency to worry. For example, after a stock has risen for a while, it's natural that some of its stockholders will start to get nervous and start thinking about "locking in" their profits (i.e., selling). The point at which that actually happens is different for each individual shareholder, but statistically, shareholders act on those nervous feelings in three clusters - one around 38%, one around 50% and one around 62%.

In the case of the GM move last December, notice how many of the investors later "locked in their profits" (i.e. "gave up") around the 38.2% and 50% retracement levels of that big move (red arrows).

Retracement analysis lets you and I take advantage of this natural nervousness in others.