Before the open
on Friday, the markets remained in a mixed state, with neither the bears nor
the bulls having a distinct advantage. From a psychological perspective, the
bears have a leg up with recent declines having ignited high levels of fear.
The bears also have legitimate concerns about the European debt markets.
The bulls do have
some reasons to hope, including:
continuing global recovery.
market breadth in U.S. stocks.
- A weakening
precedent of choppy economic recoveries.
Wide Participation In Rally A Good Sign
One excellent way
to take the stock market's temperature is to study breadth. Market breadth
refers to the number of stocks participating in a given rally (advancers vs. decliners).
The Summation Index is an intermediate-term measure of market breadth. In the
chart below, notice the S&P 500's performance after the Summation Index
makes a sharp turn up (steep slope). The S&P 500 is shown below the
Summation Index. Compare the current move in the Summation Index (right side
of chart) to recent moves (left); they look very similar, which leans
Less Demand For Dollar's Safe Haven
The U.S. dollar
has served as a "safe haven" currency during recent periods of
turmoil in the financial markets, which is ironic given the ever-growing debt
problems in the United States. While the dollar's uptrend remains intact, it
is showing some cracks. A countertrend move back toward the pink trend and
support lines may be in the cards (see chart below). In general, a weakening
dollar tends to support risk assets such as stocks, commodities, and
commodity-dependent currencies. Moving Average Convergence-Divergence (MACD)
is one of the simplest and most effective momentum indicators available.
Notice the MACD histogram (blue vertical bars at top of chart), made a
significantly lower low during the dollar's current decline. A lower low can
be indicative of negative momentum building steam.
S&P 500: Bulls & Bears Butt Heads
While the dollar
appears to be weakening, the S&P 500 is trying to switch from an
intermediate downtrend to an intermediate uptrend. Compare and contrast the
MACD histograms (blue bars) for the dollar and S&P 500. The S&P 500's
MACD histogram made a series of higher lows during the recent nerve-racking
declines; this is indicative of a weakening downtrend (see green arrows
below). On the positive side of the ledger, the MACD blue vertical bars on
the S&P 500's chart recently made the highest high we have seen in
several months, indicating a strengthening uptrend (upper right corner of
chart shown below).
ADX is an
indicator used to monitor the strength of a trend, either up or down. ADX is
shown at the bottom of the chart above. Notice when the black ADX line
"rolls over" from high levels, a change in trend can follow. The
good news for the bulls is the ADX black line has rolled over, increasing the
odds stocks may rally further.
The S&P 500
has made two steps toward completing a basic trend change (from down to up).
First, the intraday low on 5/25/10 was 1,040; a higher low was made on 6/8/10
coming in at 1,042. The second step toward a possible change in trend was
completed on 6/15/10 when the intraday high of 1,115 exceeded the intraday
high of 1,105 made on 6/3/10. This is all good news, but it means little if
the next decline cannot produce another higher low, followed by a higher
high. Another move below 1,040 would possibly open the door to lower ranges for the S&P 500 including
1,020-1,030 and 991-996.
More Shorts or Short Covering?
The S&P 500
is also attempting to retake its 200-day moving average (MA), successfully
closing above it on Tuesday, Wednesday, and Thursday (see blue line in chart
above). Closing above it for three days is a step in the right direction, but
it is not all that significant until the market can move decisively away from
the 200-day MA, which is now at 1,109. Markets often cling to the 200-day for
a few days and then make a decisive move one way or another (up or down). If
the S&P 500 can move decisively above the 200-day MA, the shorts may run
for cover giving additional momentum to the upside. However, the same can be
said of a decisive move below the 200-day MA; it may attract more shorts and
increase the downside momentum. In this light, it is easy to understand why
many traders are reluctant to make moves until we get a break up or down.
Recoveries Tend To Be Choppy
In the context of
history, the June 6, 2010 weak job numbers are not all that troubling. The
current market and economic cycles are very similar to what we saw between
March 2003 and June 2004. The last bull market had to endure five months of
slowing job growth in 2004, including "terrible" job creation of
less than 100K in the summer of 2004 (sounds familiar). Like 2010, stocks
corrected in 2004, and it felt like a new bear market had started.
Stocks did quite
well after five months of slowing job growth in 2004. Those who remained
patient were generously rewarded with gains approaching 50% from the 2004
correction lows. Every cycle has some unique characteristics, but they also
have numerous similarities. The events of 2004 remind us the importance of
understanding history and keeping an open mind (which is not easy to do in
the face of falling markets).
We may still have
a few weeks or a few months of difficult times, including some more
disappointing reports on the employment front, but at this point the odds
still favor higher highs in stocks later in 2010 or in 2011. A new bear
market is possible, but not probable with the information we have in hand. We
respect there are still problems with banking, debt, and credit, but we
should get little to no movement from the Fed for the balance of 2010 (which
was not the case in 2004).
On the retail
front, sales announced on June 11, 2010 were weak. Just as employment gains
in this part of the economic cycle can be choppy and disappointing at times,
the same applies to retail sales (see the green box in the chart below).
Despite choppy retail sales, the S&P 500 gained 48% off the 2004 lows.
This week's numbers were not good, but it is also not that surprising given the
stock market's poor performance in May.
Hope for the Best, Plan for the Worst
There is a reason
our analysis leans toward the bullish end of the spectrum. Our historical market models remain bullish
longer-term, which means we will err on the side of staying with the bull
market. However, it is important to have a detailed exit strategy in place in
the event recent declines evolve into a more serious and lasting bear market.
500 intraday lows hit 1,042 and 1,040. The closing lows were 1,062 and 1,050,
which tells us that longer-term support below 1,050 has some meaning in the
minds of traders. Going back as far as the late 1990s, longer-term areas of
support, come in at 1,048, 1,045, and 1,040. A break of 1,040 could open the
door to 1,030, 1,018, and 978. While it would be painful, a drop to 945
cannot be ruled out, since corrections/mini bear markets in 1990 and 1998 saw
stocks drop roughly 22% before rallying more than 60%. This scenario is the
most difficult to manage through in terms of balancing the need to protect
hard-earned capital and remaining invested to capture what could be
significant gains after a correction/mini bear market. These are the things
that keep money managers up at night. Part of being prepared is not only
having strategies and tactics in place for such an unfavorable intermediate
outcome, but also to become mentally and emotionally prepared for the
possibility of having to make decisions under even higher levels of stress.
This is not the time to be skipping workouts or long runs. If you understand
and accept now that a 22% decline from the April highs has historical
precedent, it will be easier to make decisions should history repeat itself.
comments can be found in Short Takes.
Chris Ciovacco is the Chief Investment Officer for Ciovacco
Capital Management, LLC. More on the web at www.ciovaccocapital.com