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Reflections of May 2008

With a huge rally from early March to late May, the S&P 500 ETF (SPY) is trading just above its 40-week moving average and a key momentum oscillator is overbought. The 40-week moving average is the weekly equivalent to the 200-day moving average (40 weeks x 5 days = 200 days). Also notice that the ETF is meeting resistance from this key moving average for the second time in two years. SPY first failed at the 40-week moving average in May-June 2008. SPY hit this moving average in late April 2008 and hovered near the moving average for 4-5 weeks. The indicator window shows the 20-period Commodity Channel Index (CCI), which became overbought for the first time since April-May 2008. For the second time in two years, SPY is trading near its 40-week moving average and CCI is overbought. The 2008 decline got started when CCI moved below zero in early June (blue arrows). This is the CCI signal to watch for a downturn in momentum.

 

BIGGER PIPES, BETTER SERVICE

BIGGER PIPES, BETTER SERVICE - On Friday, we upgraded our Internet connection from a 180 Megabit connection to a 1 Gigabit Fiber connection (1 Gigabit is 1024 Megabits).  That's over 5 times more bandwidth!  If you have been experiencing slowness, especially during busy market times, you might see an immediate benefit to this change.  We're going to be monitoring the new connection closely on Monday to make sure it lives up to its promise.  Please let us know if you see any significant changes one way or the other.

DESIGN CHANGES CONTINUE - Look for us to be updating our "Free Charts" area with our new design in the coming days and weeks.

TECHNICAL ANALYSIS 101 - PART 7

This is the seventh part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Chart Analysis - Support and Resistance

Prices are driven by two of humanity’s strongest emotions: Fear and Greed.  When more investors are fearful that a stock will fall, it does!  It will continue to decline until the balance between Fear and Greed is re-established.  The same is true for greed and rising prices.  This phenomenon is referred to as “Market Psychology.”

Support is the price level where “greedy” buyers enter the market to prevent prices from declining further.  Support can develop at a specific price or more commonly in a price zone.  Areas of support can exist for many months at a time.

 The diagram above illustrates how market psychology causes the previous area of price support to turn into resistance.   After breaking support, traders who bought in the zone of support are now holding losses and want to sell as soon as prices approach their original purchase prices in order to break even.  

 
The Volume by Price overlay (volume traded in incremental price ranges) in the following SharpChart of Dover Corp illustrates how strong support at 46 later became significant resistance as greed turned into fear.

 

The concept of resistance is opposite of the support as discussed above.  Resistance is the price level where “fearful” sellers suddenly come into the market and prevent prices from advancing further.  Like support, resistance can develop at a specific price or in a price zone and can be held for months at a time.

 

If resistance is broken, market psychology causes the previous area of price resistance to turn into support.  The diagram above illustrates this market behavior.  Stock holders who sold in the zone of resistance are now regretting selling and want to buy as soon as prices approach the level they sold at earlier.  Prices that seemed too high before now look like a bargain.  The following SharpChart of Parker Hannifin Corp. illustrates resistance later becoming support.  Notice how Volume by Price indicates the potential number of previous sellers willing to buy again if given the opportunity.

Next time we'll discuss trendline analysis and trend channels.

EMERGING MARKETS TAKING THE LEAD

As the markets have rallied off the March 9th bottom, we find it rather interesting that the Emerging Markets have taken a lead role and have outperformed rather handily. The growing consensus believes that when the worlds' stock markets do bottom, then the Emerging Markets will take the role of "leader" once again. However, we would caution, for rarely do the leaders of past bull markets lead new bull markets. Moreover, and from a fundamental perspective - much of the Emerging Market economic growth was built upon the back of Western credit expansion and conduits to these countries rather than internal growth. Western banks were simply "reaching for yield"; and with higher yields come higher risks. We can only look at the debacle occurring in Eastern Europe; but that is a discussion for another day.

We would like to look at Brazil's BOVESPA Index, for it is quite simple from a technical perspective to delineate both bull and bear markets. And, it appears an inflection point / delineation point has just been reached - the 16-month moving average. For now, prices are weakening from this level, and if the 2000 to 2003 bear market is any guide, then the weakness we've seen from this level will continue and perhaps will result in a test of the lows quite far below current levels. If not, and prices rally above this level - then we can be rather comfortable with believing a new bull market has been born, and we should do nothing more than be buyers.

For now, the risk-reward favors selling short Brazil, and one can do that via EWZ; however, if the 16-month is violated to the upside, then one should be a buyer. We believe a bear market is in force given the manner in which the 5-month RSI is trading, but our battle line at the 16-month is drawn, and now we can asses our risk and trade around it.

Good luck and good trading,
Richard

ANOTHER LOOK AT JUICED ETFS

In February, I wrote an article discussing the fact that juiced ETFs (ETFs designed to double or inversely double the returns of an underlying index) do not perform as you might expect.  There was a huge response to this article and mostly positive feedback.  There are plenty of reasons why taking another look at juiced ETFs makes sense, but the inability to perform over longer periods is the primary one.  To give you a recent example, the Dow Jones U.S. Financial Index fell precipitously early in 2009, but since has rallied strongly reversing earlier losses.  From the January 6th high to the May 8th high, the index has been flat, but there was plenty of volatility in between.  Because this index is the underlying index for the UYG (Ultra Financials ETF) and the SKF (UltraShort Financials ETF) and it was essentially flat over a four month period, it was an easy point of reference to determine how the UYG and SKF have performed in tracking that underlying index over time.  Check out the 3 charts below:

till think it's a good idea to buy these juiced ETFs and hold them for monster gains? From the proshares.com website, here is the disclaimer on the SKF:  "This ETF is designed to meet daily objectives; results over longer periods may differ.  There is no guarantee that any ProShares ETF will achieve its investment objective."  There are a couple of words I'd focus on here.  First, and perhaps the biggest, is the word "daily".  Juiced ETFs are designed to track their underlying index on a DAILY basis.  That's it.  So long as the underlying index moves in a straight line - either higher or lower, the juiced ETFs will perform as expected.  As the underlying index experiences volatility, that back and forth movement is the cause of juiced ETF erosion.  The second word I'd focus on is "may" as in "results over longer periods MAY differ.  Throughout my studies, there is no question in my mind they WILL differ.
 
One of the primary reasons I decided to re-visit this topic was the sight of a "professional" on CNBC last week touting that he was "building" a position in URE (the Ultra ETF that tracks the Dow Jones US Real Estate Index).  You cannot "build" positions in juiced ETFs.  Every day that you hold these ETFs, your risks rise and your potential returns dwindle.  It doesn't mean this professional won't make money.  It simply means that risks grow every day the URE is held and potential "juiced" returns decrease.  Isn't the essence of trading the desire to generate above average returns with below average risk?  Building positions in juiced ETFs will have the opposite effect.  If professionals are trading these juiced ETFs incorrectly, it only stands to reason that thousands, perhaps millions of individual investors are doing the same.
 
So the next series of questions arise - are all juiced ETFs created equal?  Do they all lose value at the same rate?  Do some hold their values better than others?  Should you even consider trading juiced ETFs?
 
I want you to benefit from my study.  I studied the recent volatile period - from September 1, 2008 through May 6, 2009.  There were periods of chaos within this study, from the panic-driven selloff in October and November to the surge in prices off of the March lows.  I feel this is a representative sample to determine performance of various juiced ETFs.  Included in my study were the following indices (and their related juiced ETFs):
 
* S&P 500 (SSO and SDS)
* NASDAQ 100 (QLD and QID)
* Russell 2000 (UWM and TWM)
* Dow Jones US Financial Index (UYG and SKF)
* Dow Jones US Real Estate Index (URE and SRS)
* Dow Jones US Oil & Gas Producers Index (DIG and DUG)
 
To view this study and the results, click here.
 
Happy trading!

MARKET FAILS TEST OF JANUARY HIGH

I started the week on Monday with the headline that "Upside price and time targets had been hit" and added that overbought readings suggested that the market was vulnerable to profit-taking. The NYSE Composite Index had just reached overhead resistance at its January high and its 200-day moving average as shown in Chart 1. A number of other indexes (like the Nasdaq Composite in Chart 2) and sector indexes were stalled at their 200-day moving averages as well. So were numerous foreign stock markets. Chart 3 shows the MSCI EAFE (Europe Australasia and Far East) Index stalled at its January high and 200-day line. It was no surprise then to see global stocks selling off this week. When a market has rallied too far and is ripe for profit-taking, some fundamental trigger usually starts things off. A weak retail report on Wednesday caused stocks to sell off on heavy volume and got the correction started. After a modest bounce on Thursday, stocks fell again on Friday. The result was a weekly loss for all of the major stock indexes. I also suggested that a pullback to the 50-day moving average was likely and could be part of "right shoulder" in a bottoming formation. Arthur Hill expanded on that idea during the week. In addition to some fundamental trigger, there are technical triggers as well. Chart 1 shows two examples. The 14-day RSI line (top of chart) broke its two month support line after reaching overbought territory at 70. The MACD histogram bars (below chart) turned negative (red circle). There were other technical triggers as well.

DOW HITS RESISTANCE

After a massive 9 week advance, the Dow ran into resistance with its biggest weekly decline since early March. There is a resistance zone coming into play around 8700-8800 from the falling 40-week moving average and the Oct-Nov consolidation. After establishing support in Oct-Nov, this triangle consolidation now turns into a resistance zone. In addition, notice that 14-week RSI is trading in the 50-60 zone, which acted as resistance in April 2008.

Prior to this week, the Dow was up eight of the last nine weeks and advanced around 2000 points. We do not need a momentum oscillator to figure out that this rally is overbought. With the Dow at resistance and overbought, the odds favor some sort of consolidation or correction. A consolidation would involve a flat trading range over the next few weeks, while a correction would involve a retracement of the March-May advance.

REVERSE HEAD AND SHOULDERS FORMING?

The ascending wedge pattern we discussed last week has broken down as we expected. Considering that the market has rallied nearly 40%, I think it is reasonable to expect more corrective action.

The next development to watch is the possible formation of a reverse head and shoulders. We currently have the left shoulder, head, and neckline. The correction that has started could result in a right shoulder, if the correction does not turn into the next leg of the bear market. The ideal resolution (if you are a bull) would be for the correction to end in the area of 750-800, then for a rally to blast up through the neckline. If that were to happen, the minimum upside target would be equal to the distance between the top of the head and the neckline -- about 1200. Interesting to contemplate, but, hey, we are way ahead of ourselves at this point.

As you can see on the chart below, intermediate-term indicators are still very overbought. This evidence supports the idea that the correction is not over yet.

Bottom Line: The short-term indicators, although oversold, have shifted from a persistently positive range to a more normal range. I interpret this to mean that the invincible nature of the rising trend has come to an end. Coupled with the fact that medium-term indicators are still quite overbought, my conclusion is that there are probably a few more weeks of correction ahead of us. The appearance of some elements of a reverse head and shoulders offer some hope that a major bottom could be forming, but it is too early to turn up the optimism in that regard.

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IMPROVED INTERNET CONNECTION COMING SOON - We very close to upgrading our connection to the Internet from our current 180 Megabit connection to a 1 Gigabit(!) connection.  That's over five times more capacity than our current circuit.  Just another way we are continuing to improve our service behind the scenes.

TECHNICAL ANALYSIS 101 - PART 6

This is the sixth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Chart Scaling

Charts are created with one of two different kinds of vertical price scales.  An arithmetic scale evenly spaces price along the right side of the chart.  Arithmetic chart spacing between $10 and $20 is half as tall as the spacing between $20 and $40.  A log scale evenly spaces price in percentage terms.  Chart spacing between $10 and $20 has the exact same chart spacing as between $20 and $40 since they represent the same percentage increase. 

  

The SharpCharts above illustrate the differences between the two scaling methods.  On the arithmetic scale, three different trend lines were required to keep pace with the price advance.  On the log scale, the trend line fits the price trend during the entire rally.  Log scaling should be the first scaling choice when using trend lines, especially over long time frames.
 
 

Volume

StockCharts.com provides several ways to plot volume data on a chart.  The following price and volume SharpChart of AAPL illustrates how volume is typically plotted.

Volume can be plotted in an ‘indicator panel’ above or below the ‘price plot area’ or in the price plot area as an ‘overlay’.

 

   
When the ‘Color Volume’ option is used, the volume bars are shown as black for up days and red for down days.  Color volume bars allow the chartist to quickly see where heavy or weak buying and selling activity is happening.

 

CandleVolume Charts

CandleVolume charts are similar to candlestick charts except that each candle's width is proportional to its corresponding volume value.  This charting style allows one to visualize the volume activity ‘in’ rather than ‘below’ price moves.  Depending on the style of analysis, volume bars could be omitted to simplify the chart.

The time axis for these charts is not uniformly spaced since the candlestick bar widths vary with volume values.  As a result, trendline analysis using CandleVolume charts should always be confirmed with a standard candlestick or OHLC chart.  The SharpChart above of AAPL shows how volume bars correlate to the candlestick widths.

That wraps up our look at how charts are constructed.  Next time, we're going to start to talk about how charts are analyzed - starting with Support and Resistance analysis.

ENERGY vs S&P 500: A MAJOR MOVE SOONER RATHER THAN LATER

The past several trading sessions have shown an increased propensity for traders to "allocate or rotate" funds into commodity and natural resource stocks. Those gains were no starker than during Friday's trading session, when the S&P Energy Sector (XLE) was higher by +3.23% versus the S&P 500's (SPY) +.54% gain. This circumstance however, hasn't been the norm in recent months, but perhaps it is the beginning of a larger rotation move out of those sectors that have done relative well off the S&P 500 March 9th low such as the S&P Technology Sector (XLK). Time will tell as they say, but the technicals behind the XLE/SPY ratio are setting up reasonably well for a larger XLE move higher against SPY.

The daily XLE/SPY chart is clearly in an uptrend, with the 600-day moving avearge being the fulcrum point of this rally. Once again this level is being tested and arguably given yesterday's sharp move in XLE vs. SPY...it has begun to show its technical merit. The question is whether there is sufficient buying pressure to push the ratio above its 200-day moving aveage that would "seal the deal" for perhaps another run at the highs near .70. In our opinion, there is sufficient cause to believe this will be the case given the 40-day stochastic is plumbing down to near-oversold levels, which in the past has been a bullish harbinger of rallies.

Given these circumstances, and given the XLE is now clearly breaking out above its 100-day moving average - we would think that if long positions were to be added at this juncture, then Energy names would be at the forefront of any list.

Good luck and good trading,
Richard

IT'S ALL RELATIVE

The PerfChart below shows the percentage change for the S&P 500 and the nine sector SPDRs. The S&P 500 acts as the benchmark for relative performance. Sectors with greater percentage gains are outperforming the S&P 500. Sectors smaller percentage gains are underperforming. Defining the leaders and the laggards can tell us a lot regarding the quality of the rally. Relative to the S&P 500, the Financials SPDR (XLF) is the leader of leaders since early March. Other leaders include the Consumer Discretionary SPDR (XLY), Industrials SPDR (XLI) and Materials SPDR (XLB). Surprisingly, the Technology SPDR (XLK) is simply performing in line with the S&P 500. Leadership from the consumer discretionary sector is probably the most important aspect of this rally. This is the most economically sensitive sector and leadership here bodes well for an economic rebound.
 

NASDAQ TESTS 200-DAY LINE

One of the problems with doing an analysis of the "stock market" is choosing which market index to represent it. Like most analysts, I rely on the S&P 500 which is generally viewed as the market benchmark. As we've pointed out several times, however, some parts of the market have been rallying much stronger than others. One of those groups is technology which is heavily represented in the Nasdaq market. Generally speaking, relative strength by technology and the Nasdaq are good signs for the rest of market. And the fact that the Nasdaq Composite has already exceeded its January high is a definite sign of leadership. However, the Nasdaq is undergoing another test of its uptrend. Chart 5 shows the Nasdaq Composite Index testing its 200-day moving average near 1750. It's a good idea to keep an eye on that test. It's also a good idea to watch the rising 20-day average (green line). The Nasdaq needs to stay above that rising support line to keep its uptrend intact.

STEADY ADVANCE PERSISTS

I have been referring to the slow, steady advance of the last few weeks as a "correction". To be more specific, it is a "running correction", which means that prices have moved higher as indicators have chopped sideways and lower. This is evident on the chart below which shows the CVI and STVO (two short-term volume indicators). The CVI has been oscillating above the zero line in an ever-narrowing range for almost two months. The STVO is almost become a flat line. This kind of indicator activity is very unusual, and the impression I get when I look at the charts is that it is not likely to last much longer.

Looking at the medium-term breadth and volume indicators below, I am concerned that the overbought conditions are so extreme and the indicators have just barely topped. This condition must be cleared, but it doesn't necessarily need to be cleared by a big price decline. Looking to the left side of the chart, you can see two instances where overbought conditions were cleared as the market moved higher. I believe we will see a similar resolution this time.

Bottom Line: We are in a long-term bear market, but we also have a medium-term buy signal, which means that bull market rules apply at the present time. Market action has been persistently positive since the March price low, and overbought conditions are most likely to clear in a non-destructive way.