Burden of Proof Shifts To the Bulls

SPX – 1089.18

DJIA – 10,189

February 2, 2010

”It has been said that politics is the second oldest profession. I have learned that  it bears a striking resemblance to the first.’”

-Ronald Reagan

February kicked off on a positive note. So did January but that ended poorly with both a down January and a close below December’s low warning trouble lies ahead. More importantly, price and time overbalanced for the S&P 500 (SPX). The Nasdaq 100 (NDX) confirmed later with both price and time overbalancing from its November 2008 bear market low (1018.86).

The key to the primary trend is to watch price and time after a three section advance. If both decline more in both price and time than any from the start of the bull market, it signals a change in the primary trend, often the first meaningful indication, followed later by other indications such as long-term moving averages, moving average crossovers and Dow Theory. Valuation is an important backdrop at either end.

Fear always picks when the market is weak and I think you get greater insight into the market’s technical health on a rally. You don’t want to hang your hat on one technical tool but my bias shifted to the “top is in” scenario. The burden of proof now requires positive stock market action to show otherwise. For example, it’s positive if volume expands, net volume confirms the rally and prices power higher while the crowd waits for a correction.

When I wrote last week’s alert, I thought Wednesday might have marked a the first short-term bottom but the market quickly put that thought to rest. Yesterday’s pop seems a little suspect as the start of a more important advance but be ready. The stock market often puts in a low for a secondary rally soon after price and time overbalance and the MTI signals downtrend for the first time.

The Market Trend Indicator (MTI) registered downtrend on Friday’s close but is back at Neutral with yesterday’s bounce. The SPX and DJIA are below their 18% weekly exponential averages, 1101.18 and 10,273 respectively. The New York Advance/Decline line is 1,392 net advances above its 18% average.

There’s no change in the peak net volume readings, (69.6) for the NYSE and (50.7) for NASDAQ and there’s nothing on the volume front to point to a rally. Weekly net volume also overbalance last week with a (24.3) reading compared to a positive +22.9 figure posted the first week of the year.

A lot of new readers saw last week’s alert following a mention in Michael Santolli’s Streetwise column in Barron’s, so some clarification is in order. Net volume is one of the most important tools in my technical toolbox, a critical measure of demand and supply that acts as a forecasting barometer, important for its bearing on the future, but not necessarily immediate price changes.

Advancing volume is the volume of all stocks that advanced for the day and declining volume is all the volume on stocks that close each day. To determine net volume, I subtract declining volume from advancing volume and divide by total volume.

The result is a percentage that falls in either positive or negative territory. For example, if advancing volume was 780 million shares and declining volume was 525 million shares and total volume was 1.4 billion shares (including the volume for unchanged issues), net volume for the day would be +18.2. If the advancing and declining volume was reversed, the result would be (18.2). Green represents positive net volume (more buyers than sellers) and red represents negative net volume (more sellers than buyers).

I use a three-day moving average to smooth out the daily volatility and still identify change early in the cycle. As long as the net volume on each short-term rally stays above the net volume on each short-term decline, the uptrend remains intact. In a typical rally, net volume peaks early or in the middle of a move. The uptrend remains intact as long as net volume on the rallies exceeds net volume on the declines. Just the opposite is true on a decline when sellers overpower buyers. Markets sometimes bottom on a peak reading but I’ve never seen a top on peak readings.

Net volume is not a tool to pin point tops and bottoms; rather I use it to confirm a reversal early in the move. For example, once the net volume on a short-term rally exceeds the net volume of the preceding short-term decline (not the peak, just the preceding decline), the trend change is confirmed. The net volume signal typically precedes 3-day swing charts (pattern) and moving averages that I use to indicate the change in trend. Weekly net volume is figured the same way using a three-week moving average to confirm intermediate and primary movements, but the signals generally come too late to effectively trade the swings lasting weeks to months that I attempt to capture.

Fourth quarter profits for S&P 500 companies are roughly three times year earlier levels. The Bespoke Group (www.bespokeinvest.typepad.com) reported more than 70% of companies in the S&P 500 beat estimates and over 10% guided higher. The highest percentage of companies topping their estimates were in InfoTech (IT), Consumer Discretionary and Materials sectors. Street estimates for 2010 are around $77 and $94 in 2011.

If the price and time overbalance signal holds up, the 2011 projections are suspect. The Federal Reserve’s program to buy mortgages is scheduled to end in March, the FHA raised its down payment guidelines to 10% from 3.5% and prospects for Fannie Mae and Freddie Mac. What happens to consumer spending if both stock and housing prices drop again?

Americans continue to pay down debt or as Bill Gross says in his February Investment Outlook (www.pimco.com) titled The Ring of Fire, the private sector is deleveraging as government debt escalates, a pattern that slows economic growth and lowers returns on investments. The fiscal 2010 budget deficit is projected at $1.6 trillion or more than 40% of the budget compared to a $1.4 trillion deficit in 2009.

Don’t dismiss the obvious; it’s sure to impact markets. I expect interest rates on long-term government bonds to increase but a countertrend rally (lower rates) is underway. Note in the TLT (Barclays 20-year+ Treasury ETF) chart how the rally where a trendline would be drawn from the high; I haven’t figured out how to do that at WordPress. I expect prices to punch through as fears of a “double dip” drive “flight-to-safety” buying.

The dollar is also in a countertrend rally that I think has further to run, back to being the best horse in the glue factory. There’s potential resistance for the U.S. Dollar index around 80.50-81.50.

As for gold, I’m maintaining a loose stop point for long positions (just under the September 29 low, 989.50 2^nd London fix) because I sense the stage is set for an outbreak of “gold fever” in 2010. As the monthly chart shows, an exponential climb is underway and I think prices are near the next logical entry point. I suspect there’s one more dip but if gold prices close clearly above the 50-day moving average, it would trigger action. The plan is to raise stop points if and as that move gets underway.

John Embry, Chief Investment Strategist for Sprott Asset Management, explained in a January 18 presentation, “It is gold’s return as money that is going to be really instrumental in driving gold to prices that would seem fanciful to most at the present time. In reality, it isn’t gold that is changing, because it has been a constant store of value for 6,000 years. It is the value of fiat paper money in which gold is priced that is on the slippery slope to oblivion.”

“Avatar” surpassed the $2 billion mark in worldwide ticket sales last weekend. At the $1.85 billion level, Hollywood.com adjusted attendance for ever rising ticket prices and figured Avatar ranked number 24 all-time. I finally saw the movie, slipping in to an IMAX theatre after the close Friday. Even if you’re not a science fiction fan, I recommend taking in the special effects on a big screen.

Back to stocks, Recreational Services climbed into the top ten group relative strength list, aided by Imax, Cinemark and a couple of adult nightclub businesses. But it’s no market to chase strength. Cyclicals and commodity-based stocks were hit the hardest over the past two weeks. Banks held well, particularly regional banks but brokers sold off, particularly Goldman Sachs. From Bespoke Group, the 50 best performing stocks in the SPX in 2009 were down 9.5% from January 19 through the end of January compared to a 2.9% decline for the 50 worst performing stocks. As for indexes and sectors, I ranked them below for performance from their bear market low through the highs to date.

Ranking From Bear Market Low Through the High

­Index

S&P Mid Cap                                       +  89.9%

S&P Small Cap                                     +  89.5%

Russell 2000                                         +  89.5%

Nasdaq 100                                           +  86.1%

S&P 500                                                  +  72.5%

DJIA                                                         +  66.0%

S&P Sector

Financials                                               +168.0%

Materials                                                 +  98.4%

InfoTech                                                  +  96.8%

Industrials                                               +  95.6%

Consumer Discretionary                      +  89.5%

Technology                                              +  79.7%

Telecom                                                   +  64.1%

Energy                                                       +  63.0%

Healthcare                                              +  53.3%

Utilities                                                     +  42.7%

Consumer Staples                                  +  41.5%

Harmonic Preview:

(High Probability SPX Turning Point or Acceleration Days)

February 9          (Tuesday)

February 16       (Tuesday)

February 19*      (Friday)

March 1                (Monday)

March 4*             (Thursday)

*An asterisk denotes a dynamic SPX price square in time; different factors account for the other dates.

As reported in the February Scientific American, an Italian environmental organization, Legambiente, an average of two ships per year disappeared suspiciously during the 1980s and early 1990s, filling the Mediterranean Sea full of ships sunk by a crime syndicate to dispose of poisonous waste to avoid storage and processing costs. It’s enough to drive you to drink. The chart below shows that’s happening in Ohio with rising unemployment.

According to Gomberg, Fredrikson & Associates, California wine shipments fell 9% in 2009, the first decline in sixteen years. Sales of bottles that retail for more than $20 were off 20-30% while the sales of bottles costing less than $6 rose 5%. Trader Joe’s is still selling Charles Shaw by the truckload but my “best buy” recommendation is Trader Joe’s Reserve 2006 Cabernet Sauvignon (black bottle) priced at just under $10. I suspect they relieved a strapped winery that had inventory backing up, a common occurrence in small wineries selling wine for $25-100 a bottle.

I typically publish Tuesday mornings. For new readers who would like to receive a PDF distribution, shoot me an e-mail at wgcfa@yahoo.com.

Conclusion:

Today is only the tenth trading day from the SPX’s January 19^th high (1150.44). Price and time overbalanced, indicating the top of the cyclical bull market may be place; I think that would fool most players. It’s not positive that this signal was given after the SPX dropped into the lower half of its bear market range below 1122.44. The key will be to watch the character of the next rally.

If you’re following my guidance, you were stopped out of ETFs tied to the SPX. I plan to play the rally using ETFs ties to either the NDX or SPX. Keep your trade size reasonable. We may be setting up an opportunity to put on short positions will little risk when the rally fades. I believe some of the best short candidates are ETFs tied to cyclical groups or small cap indices. Potential short candidates include Russell 2000 iShares (IWM), Russell Microcap iShares (IWC), Real Estate iShares (IYR) and S&P 500 Consumer Discretionary SPDRs (XLY). For more leverage, traders could go long inverse ETFs including ProShares UltraShort Russell 2000 (TWM) and ProShares UltraShort Real Estate (SRS).

For investors, figure how exposed you want to be in the next bear market. It may have started. If technical characteristics on the next short-term rally are poor, I’ll probably recommend some selling. Confirmation of a bear market comes with a lag.

The information contained herein is based on sources that William Gibson deems to be reliable but is neither all-inclusive nor guaranteed for accuracy by Mr. Gibson and may be incomplete or condensed. The information and its opinions are subject to change without notice and are for general information only. Past performance is not a guide or guarantee of future performance. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without consent from William Gibson.