No Man’s Land

SPX – 1089.63

DJIA – 10,190

June 15, 2010

“The collapse of the financial system as we know it is real, and the crisis is far from over. Indeed we have just entered Act II.”

-George Soros

Last Tuesday’s test of the May 25^th low held by the skin of its teeth for the S&P 500 (SPX) while the DJIA and Russell 2000 (RUT) had a slightly lower intraday lows. The character of the rally from that low, including light volume and overlapping waves, is indicative of a countertrend move, retracing 36% of the decline in 62% of the time. Let’s hope there’s more because if that’s all there was, it’s going to be a stinking, sinking, steamy summer.

Peak net volume readings on last week’s bounce were +48.3 for the NYSE and +46.4 for NASDAQ, not enough to overcome respective (70.9) and (71.3) hurdle rates to indicate a change in trend. Still, the New York Advance/Decline line is 1,109 net advances above its 18% weekly exponential moving average, shifting the Market Trend Indicator (MTI) into NEUTRAL. The SPX and DJIA are still below their 18% averages, 1115.88 and 10,387 respectively.

“The big question now is whether the rally off the 2009 low is over or whether this is an interim correction, after which the business expansion and cyclical bull market will continue,” said Felix Zulauf, summing up the technical dilemma in Barron’s Midyear Roundtable, adding “Most investment professionals believe this is a temporary correction, declines are buying opportunities and the bull market will continue. I doubt that.”

Stay the course, A correction, not a bear market read the headline on an update last week by the Chief Global Equity Strategist for Bank of America Merrill Lynch but some in the bull camp are beginning to wonder. For example, Tim Hays, Chief Investment Strategist at Ned Davis Research, told The Wall Street Journal, “This correction has had more legs than we thought. We could actually be in a bear market now.”  I’ve been in the bear camp since the week ended May 21 when price and time overbalanced for the SPX while its 3-day swing chart carved out a pattern of lower highs and lower lows and a bear market was signaled under Dow Theory.

The 14-month rally off from the March 2009 bottom kicked off with off with the worst companies up the most, but the entire advance was characterized by constant rotation among groups with the Financial and Basic Material sectors faring the best. Only Gold Mining and REITs remain in the top ten group list from those sectors as money shifts to more defensive groups with Mobile Telecom, Distillers/Brewers, Nondurable Household Products, Waste & Disposal and Computer Services joining three hold outs from the Computer Services sector- Airlines, Gambling and Specialty Retail. Short covering helped Basic Materials and Oil and Gas lead last week’s bounce but I don’t think we’ve seen the lows in either sector.

The Federal Reserve reported that nonfinancial companies hold more than $1.8 trillion of cash, up 26% year-over-year. I expect cash rich, large cap quality to hold the best in the months ahead but you can’t spend relative performance in a bear market. Investment Company Institute data showed more than $2.8 trillion in money market funds last week with approximately $25 billion pulled from U.S. mutual funds since the beginning of May.

Better late than never, mutual fund pioneer Dreyfus filed with the SEC to offer actively managed exchange traded funds (ETFs). It’s hard to keep up but I noticed a new ETF offering exposure to the corn market (CORN) through the underlying futures market. The iPath S&P 500 VIX Short-Term Futures (VXX) was most popular ETF launched in 2009, taking in over $1 billion in assets and providing a superior return on the first section down of the bear market. From ETFdb.com, here are the top ten ETFs started in 2009 as ranked by assets, number ten bringing in $171 million.

1)   VXX         (IPath S&P 500 VIX Short-Term Futures)

2)   GDXJ       (Market Vectors Junior Gold Miners)

3)   BRF          (Market Vectors Brazil Small Cap)

4)   AMJ         (JP Morgan Alerian Energy-linked MLP)

5)   VSS          (Vanguard FTSE All-World, ex-U.S. Small Cap)

6)   SGOL       (ETF Securities Physical Swiss Gold)

7)   DRN         (Direxion Daily Real Estate 3x Bull)

8)   TVZ          (Pimco 1-3 Year Treasury Bond)

9)   SPXU       (ProShares UltraPro Short S&P 500)

10) CWB         (SPDR Barclays Convertible Bond)

In other key markets, the U.S. Dollar backed off a little last week when “flight-to-safety” buying eased but the uptrend looks intact to me and I think higher prices lie ahead. The dollar’s 3-day swing chart is in its 8^th swing.  I still think gold is poised for a “blow off” move but I have no intention of sticking around if it’s parabolic rise is broken. For now, I’m keeping stop positions below the March 24 low ($1090.75 2^nd London fix) for newer positions and below the February 5 low ($1058) for long held positions. More than one-third of the money invested ($34 billion) in John Paulson’s hedge funds are linked to gold instead of the dollar.

As for long-term government bonds, I’m planning a trade on the short side once the rising trendline from the April low is broken. My time horizons don’t stretch far on this potential trade (that comes later) as I suspect this market stays a safe haven on the bear market’s next section down.

Retail spending slipped in May, off for the first time in eight months. What happens to retail sales if stock and home prices fall in tandem as quantitative easing tails off? According to RealtyTrac data, banks repossessed nearly 94,000 homes in May, a new record and most likely due to approximately 278,000 trail mortgage modifications that were cancelled through April.

Back to stocks, the April 26 high (SPX-1219.80) was unusual, ending not with enthusiasm, but complacency with breadth and most sectors confirming the high. I think the rally from the March 2009 lows is best viewed a cyclical bull market, short by historical standards and one that the public sold into all the way up, the sort of selling that indicates a secular downtrend was in effect all the time. If the SPX closes out June below 1122.30, it will be an outside reversal pattern on quarterly candlestick chart (bar chart shown), yet another indication of lower prices in coming months. That’s close to the 50% level for the 2002-2007 bull market of 1121.44 and it’s also negative from a longer-term technical perspective that the stock market is trading below that point.

Harmonic Preview:

(Higher Probability SPX Turning Point or Acceleration Days)

June 25                 (Friday)

June 29                 (Tuesday)

July 1                     (Thursday)

July 16                                    (Friday)

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

For Hollywood, it doesn’t get much worse than starting the summer with 1980’s remakes- “The Karate Kid” versus “The A-Team.” The sickening feeling is a bit like the extreme day-to-day trading in the stock market, highlighted by Trading Index (TRIN) readings ranging from 13.22 on June 4 (extreme selling) to 0.15 on June 10 (extreme buying albeit on light volume). TRIN is a statistic derived  by the quotient of two divisions, advances over declines and advancing volume divided by declining volume.

Conclusion:

A SPX close above its 200-day moving average (1108 and a fraction and still rising) probably leads to more buying. It would also signal a rising trend on the SPX weekly swing chart pattern and offer an entry point for a trading long. I favor ETFs tied to the Nasdaq 100 (NDX) which is already above its 200-day average. A NDX trade above its June 3 high (1898.93) would indicate intermediate-term uptrend for that index, but size positions for a counter trend trade. Once we have evidence the rally has run its course, I think short positions tied to small cap indices and the Basic Materials sectors make the most sense.

For more casual, non-investment professionals who didn’t cut back exposure to stocks on the initial break, it’s time to start selling stocks, at least 30% of your holdings if you haven’t already taken action. The reflex rally probably has further to run, providing a chance to sell more at higher prices but under a worse case scenario that might have been it. If prices were to sell off from here and break the May 25 lows, I would sell the rest. It’s no time to freeze or bury your head in the sand.

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.