Follow-Through Buying

SPX – 1090.17

DJIA – 10,198

July 12, 2010

“The stock market, that great self-organizing supercomputer that weighs all possible futures, is telling us to be very careful here. Pro-growth tax and regulatory policies that encourage business confidence and job creation can keep our fragile recovery alive. But make no mistake about it, stocks are warning that we’re still in a fragile state. We avoided 1932. Now let’s avoid 1938.

-Donald Luskin, Trend Macrolytics, The Wall Street Journal, July 9, 2010

Last week’s turn-on-a-dime rally wasn’t surprising but the degree of follow-through buying was to me, enabling NYSE net volume to reach +74.0, overbalancing a (61.0) hurdle rate and signaling that I was probably viewing the pattern incorrectly, that this rally could carry higher than anticipated. NASDAQ net volume didn’t keep pace, a peak reading of +56.8 unable to overbalance its (60.1) hurdle rate.

On Friday’s close, the Market Trend Indicator (MTI) jumped back to NEUTRAL with New York Advance/Decline line 1,235 net advances above its 18% weekly exponential moving average. The DJIA is close, its 18% average at 10,231 and not far behind that the S&P 500 (SPX), its 18% average at 1090.71, also a potential resistance level (retracing 38%  of the April 26-July 1 decline) but that’s just coincidence.

I’m no fan of head-and-shoulders patterns, tracking trend instead, an uptrend defined by a pattern of higher lows and higher highs and vice versa for a downtrend. When the trend shifts, there’s often enough symmetry that technicians discern head and shoulders patterns, including this year with the January 2010 SPX high (1150.44) marking the left shoulder, the April high (1219.80) the head and June high (1131.23) the right shoulder, the pattern completed when the neckline was violated when prices sliced underneath the May 25 low (1040.78).

When prices power back above the neckline, particularly on higher volume, the head-and-shoulder pattern fails, often followed by robust rallies. A Dow Theory divergence first noted by Richard Russell occurred when the Dow Transportation Index held above its February low while the Dow Industrials didn’t, a possible precursor to greater strength. Investor sentiment, already sliding quickly, fell even more near the low.

The SPX 3-day swing chart is in its sixth swing from the April high (1^st, 3^rd & 5^th down; 2^nd, 4^th and 6^th up). If swing six carries above the June 21 swing four rebound high, it increases the probability of even higher prices and a possible summer trading range. None of these technical perceptions negates the bear market message revealed in May, but that message only indicates the top is in, not the pattern, extent or duration of what follows. If the 3-day swing chart reverses before surpassing the wave four high, and is followed by a decline below the July 1 low (1010.91), it would be seven swings, a count that is typically reached only in union with the primary trend.

Fundamentally, the government threw a lot at the wall during the 2008 credit meltdown, enough sticking to avert the second Great Depression. But my technical interpretation of the stock market tells me the next phase of instability may be at hand, the economy on a tightrope over a treacherous gulch, on one side the threat of a double dip and declining asset prices if some measure of fiscal discipline is imposed on the government’s spending-gone-wild strategy, and on the other side, the risk of currency debasement and a potential bond market crash.

It’s kick off time for second quarter earnings reports and guidance with expectations of 25-30% earnings growth versus easy comparisons for the S&P 500. What counts technically is the stock market’s reaction. Prices sold off amid mostly positive first quarter reports, overridden by sovereign debt concerns impacting the economy.

Sectors, groups and companies most tied to the economy, those that rose the most over a nearly 14-month cyclical bull market fell the most into the June low. The stocks that held the best into that low rallied the least on last week’s bounce. The hardest hit sectors rallied the most, led by Basic Materials, Financials and Energy. Utilities were also up a lot, now dominating the best performing group relative strength list along with other defensive groups and topped by Gold Mining. Economically-sensitive groups dominate the bottom ten list, including Automobiles and Media Agencies as new additions.

Looking through the best performing mutual fund lists at the close of the quarter, it is notable that gold funds dominate the five and ten-year winners. Near-term, gold traded in tandem with the government bonds and the dollar (the other “flight-to-safety” markets) for awhile, but I expect it to pull away from the pack. I’m receiving “how to make big money in the gold market” direct mailings but it’s not yet front page news and I still think a “blow off” rally is more probable than not. Consequently, my recommended trailing stop sell levels are relatively loose, just under the February 5 low ($1058 2^nd London fix) for more recent purchases and under last September’s low ($989.50) for long held investment positions.

Government bonds sold off last week as stocks improved but I expect that market to remain highly correlated to stocks for now, rallying when stocks sell off and vice versa. Since there’s no change in my thinking on the stock market’s primary trend, I wait to establish short positions. The U.S. Dollar index 3-day swing chart is in its eighth swing (down) but I expect a ninth swing to carry it above its first quarter 2009 high.

A page one headline in The Wall Street Journal last Thursday caught my attention. To Fix Sour Property Deals, Lenders ‘Extend and Pretend. According to Foresight Analytics, commercial real estate values are 42% below peak levels achieved in October 2007 and roughly two-thirds of commercial real estate loans held by banks are worth less than the loans. To slow defaults, banks are extending maturities or charging below-market interest rates and the reluctance to take a hit takes a toll on new lending. Three banks were closed by regulators in 2007, 25 in 2008, 140 in 2009 and it’s 90  and counting so far in 2010. Reality always intrudes eventually.

Venture capital legend Arthur Rock (83) was interviewed in the same day’s Journal. His outlook for that industry poor. “In fact I’ll make a prediction,” said Rock, “that returns of the venture-capital industry will be next to zero over the next 10 years because there is so much money around. Some of the good firms will do well, but I think the majority will have negative returns.”

Harmonic Preview:

(Higher Probability SPX Turning Point or Acceleration Days)

July 14*            (Wednesday)

July 16               (Friday)

July 22*            (Thursday)

August 3*            (Tuesday)

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

Wednesday (July 14) is not only a dynamic square that’s kicking but it’s also 55 trading days from the April 26 high. For you Fibonacci fans, the 34^th day was a non-event but there were turning points on the 3^rd, 8^th, 13^th and 21^st trading days. This week is also  the 144^th week (key fixed square) from the SPX’s all-time high in October 2007. The March 2009 low was 73 weeks from the high, missing the halfway point by one week. I realize these esoteric observations are at odds with the simplistic approach I use for planned, deliberate speculation. They certainly don’t hold the secret to stock market profits; money management, trend following and discipline (cutting losses, letting profits run) are the key in that regard.

I’m publishing a day early this week, in part due to last week’s net volume indication and I’ll be at the Global Hunter Securities China Conference (Year of the Tiger) Monday and Tuesday.

Conclusion:

My recommended stop level for short positions is above the June 21 high (SPX-1131.23); I wouldn’t place them any higher. If stopped out, the plan is to short again on the next signal. I’ll defer counter-trend trades on the long side, leaving that to short-term traders.

Look at any broad list of securities you choose and you’ll see few are escaping the damage. Winning investors in a bear market are those who lose the least. I think professionals should stay as defensive-minded as possible, keeping in mind valuations and the operating realities of the underlying business. Small Investors Flee Stocks, Changing Market Dynamics is today’s front page headline in The Wall Street Journal. It’s been going on since the 2007 top and a trend I expect to continue for more than two years, eventually ending in apathy before the next secular bull market begins.

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.