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September 17, 2006

Markets Nearing Record Highs... Where do they go from here?
by Mark McMillan

Weekly Trader Alert #70

Overview

The Markets have had a lot of positive news in the last week, and reacted in a very positive way, running prices to new local highs. The Dow Jones Industrial average is within two hundred points of a multi-year high, having touched 11,750 in January 2000, and closed around 11,723. The S&P-500 is in a similar position to regaining highs not seen since May 2001, but far off its highs of 2000. The NASDAQ is more than 135 points from regaining the 2006 high, and is a far cry from reaching its 2000 peak. The mood on the floors of the exchanges seemed euphoric and the coverage of the markets by news agencies was constant talk about hitting new highs.

Natural gas has had quite a sell-off, meaning it is at two year lows closing below $5.00. Actually, the low was Thursday, but on Friday Natural gas future completed a Harami-like pattern, indicating a braking of the downtrend. The second candle was also hammer like, with a long under shadow. Natural gas is a notoriously volatile commodity, and everyone seems convinced that the price will continue to drop, due to large supplies in the ground here in North America. Since "everyone" is bearish on the price of natural gas, and there is a sign of a bounce from clearly oversold levels, it is worthwhile to speculate on a long trade here for a short term trade.

Oil has continued to sell off, closing at around $63.33 on Friday, which is about eleven cents higher than Thursday's close, but is the lowest level since March of this year. The important price break was at $68.00, which will provide strong resistance if there is a rally in the price of oil soon. The 200-day moving average for Light Crude is just below $68.00, so this is the battle line for bulls and bears. In addition to oil dropping like a rock, mined commodities are down, way down. Gold, copper, iron, etc. are all racing downward.

Reiterating last week's statement, the lower energy prices bring down overall inflation, and are causing a sell-off by speculators and profit taking by some investors in energy. The lower energy prices will help reduce inflation, but higher food prices will counteract that, and tight labor markets continue to see wage hikes of 5% on an annual basis.

It is important to note that wheat prices are up due to shortages from bad weather. Corn prices are up due to ethanol production and the fact that wheat prices are up, so crop rotation from corn to wheat causes shortages for corn, etc. This affects the prices of many foods, as well as feedstock prices, which drives up prices of meat and dairy. You get the idea that food prices aren't coming down soon, and could get worse. This is on a worldwide basis. The only positive is that ethanol production may slow with the drop in the price of oil, but food supplies are so low that prices are likely to remain high into next year. That will continue to maintain inflationary pressures that will keep the markets guessing as to what the Fed may do.

Finally, housing in North America and other countries has been going through a boom that has come to an end in the United States. There has been talk of a housing bubble, and supplies of houses for sale, new and used, has gone up to multi-decade high levels, the length of time to sell homes has doubled, and the East Coast and West Coast markets have actually seen prices falling. There are signs that the bubble won't burst and housing completely collapse, but we will have to wait to see how this plays out. If the job market continues strong, then eventually there will be buyers of the homes where the jobs are. However, other markets that are not being driven by jobs will likely see price declines as speculators have to dump the homes or rent them, which causes a ripple effect to other owners.

We are in our second full week of September, which is notorious for being the worst month for stocks, and the month that actually carries a negative average gain for stocks. While some weakness was seen last week, this week has seen the markets move up sharply, getting into a position to challenge new highs. There seems to still be healthy skepticism about the markets being able to topple these highs, so it may actually occur. We are doubtful the rally will be maintained in September, but there really hasn't been any sort of news to derail the markets yet, and with the current euphoria, common wisdom is that they are heading higher.

Volumes increased somewhat last week, and it is evident that the big money players are back in the action. We now have some interesting trade set-ups, so let's turn our attention to the Market Climate.

Market Climate

The market rallied strong during the week culminating in a gap up on Friday and then falling back to close at the 200-day moving average for the composite of the US equities, with all major indexes showing a similar pattern of a gap up opening and selling pressure through the day accompanied by higher volume.

The US Composite touched the upper Bollinger Band the last three days during intraday trading. There is a very clear resistance line that was challenged in mid-August and early September. It will have to be breached for the market to move higher in the near term.

A chart of the composite of over 8,000 stocks traded on the U.S. Stock markets continues to be included.

The U.S. stock market composite chart:

The predicted battle at the 200-day moving average continues to be fought. The MACD continues to leave us guessing and RSI is also of no help, showing neither a well defined trend nor being at a likely level of a reversal.

Friday saw the largest trading volume since mid-June. That move was a gap up open followed by a sell-off through the day. The close was still higher than Thursday's close so there may be unfinished business, but this is looking like the market is getting ready to add more volume and is more likely to roll over than continue on. With the increase in volume finally getting underway, the market should be less choppy and we are looking to put on a number of trades.

A look at the chart for the Dow Industrials is represented by the Diamonds ETF (Amex:DIA).

Abbreviations and color key appears below:

Note the following order is Red, Yellow, Green, just like a stop light, so it might be a helpful pneumonic:
Thick Red line represents the 200-day simple Moving Average (200DMA),
The yellow line represents the 50-day simple Moving Average, (50DMA)The green line represents the 20-day simple Moving Average, (20DMA)
The light blue line represents the 3-day Moving Average, moved forward three days in time, (3x3MA)
The thick blue line indicates the exponential 13-day Moving Average (13DMA)
Bollinger Bands are abbreviated as BB. There is an upper and a lower Bollinger Band that varies in distance from a central moving average (shown as light red/pink) based on the volatility of stock price movements.
RSI stands for Relative Strength Index. It is an oscillator, which can be used to determine how overbought or oversold a stock may be.

Our prediction of a likely resistance and reversal around the $114.40 level was dashed as the market took off. There was no failed rally below $114.90, so there was no short trade to put on at that level.

With that said, the rally did fail on Friday, as price gapped up at the open and then sold off through the day. All this occurred on higher volume, in fact the highest since mid-June. Price is right at the upper boundary of the shallow uptrend channel and reversed at the upper Bollinger Band, which is a high probability trade set-up.

A look at the weekly chart of the Diamonds ETF (Amex:DIA) may be seen below:

The pattern of one week up, one week down has made for short term trading opportunities. It appears as if the market is ready to sell-off in the coming week and repeat. We believe that the market will begin to sell-off in earnest soon. The possibility of a double top pattern coming into focus is quite real right now.

The S&P 500 ETF, known as the Spyders (AMEX:SPY) is shown in the chart below:

The SPYders sold off after gapping up at the open. They are more affected than the other indexes with a good amount of the index made up of energy companies. While the prospect of cheaper oil lowers inflation risks, and lowers costs to operate many businesses, the fall in the price of the stocks of these companies is hitting the S&P500.

The Friday reversal lower on higher volume bodes ill for a continued uptrend. Traders should be short the SPYders as downside potential is high.

A look at the weekly chart for the SPYders appears below:

It is reminiscent of the DIAmonds weekly chart with the alternating long white candles and the shorter red candles.

This week's NASDAQ 100 ETF (QQQQ) Chart is below:

We believe the reversal off the upper Bollinger Band indicates another trip to the downside is likely. A trade to the downside would be confirmed on a failure of the $40 level to hold.

The weekly NASDAQ 100 ETF (QQQQ) Chart is below:

The weekly chart is self-explanatory with the notations. The QQQQs are likely to reverse here, but the question is how far with the reversal go. Last week, the QQQQs performed the stongest of the major indexes.

Finally, a look at the QQQQs 60 hourly chart illustrates a similar trading pattern for all the major indexes:

Reversal signs may be seen in all the charts. All the hourly charts show a gap up small candle followed by a large red candle. In this chart, we call the first candle a shooting star. It actually doesn't qualify as a shooting star, as it doesn't have a long enough overshadow. However the engulfing candle that follows in the second hour is quite bearish. The most bearish pattern of all is the Evening star candle. This would optimally occur at the top, but holds when there is a clear uptrend. Note the support of the $40.00 price level, which we have mentioned is an important support/resistance level. A failure to hold the $40 level would be an indication that this rally is in jeapordy.

Fundamental Trends

There are now six retail industries and four food industries in the top thirty industries. The other twenty industries are a mixed bag, with the only utility represented being water.

Leadership continues to change, which is not setting up for a sustained predictable market. We suspect that leadership and laggards will continue to cycle until the market puts in a real bottom. The market is searching for leadership, and without it, upward moves will lack staying power.

The tone is decidedly defensive still, with speculation on the latest trend with consumers showing resilience and lower gas prices likely to keep this going.

The Industry leaders (ranked 1st-5th out of 190) are:

The laggards now include three industries related to mining, one oil industry, and coal producers. These all derive from the collapse in commodities and energy prices.

We had noted the tremendous drop in gold/silver mining stocks and now they have made it from the middle to the bottom in a week. Ouch!

The Industry laggards (ranked 186th-190th out of 190) are:

Trade Recommendations

We continue to watch for a shorting opportunity on the Ishares Lehman 20-year bond (AMEX:TLT). No good entry has yet presented itself, so we will continue to watch for a retest of the highs As discussed, a reversal at the previous high of $88.20, or as high as a reversal at $88.80 (Fibonacci 61.8% level), or a fall below the lower boundary of the uptrend channel, with a close below $87.25 would be tradable.

We may again recommend entry into BPT. At this time, trading has been choppy, and we will watch it day by day.

We suggest that you take short positions in the QQQQs (NASDAQ:QQQQ), SPYders (Amex:SPY), and DIAmonds (Amex:DIA) at the open. These will be market orders at the open.

Buy x shares of QQQQ at market open.
Buy x shares of SPY at market open.
Buy x shares of DIA at market open.

As you we able to tell, we believe the most likely direction for these index ETFs is down. Note, however, that the position may reverse by the end of the week, and we can't know this until we watch trading through the week.

We have also identified several individual stock trades.

We are targeting an entry to Seabridge Gold (Amex:SA). This will be a long position in this highly volatile gold mining stock.

Buy x shares of SA at market open.

I may adjust the entry price to around $10.40, depending on what the market does prior to the open. We don't want to overpay if the price shoots up. Set a stop price of $9.75 for SA. The 200-day moving average is at around $10.00, and will likely provide a floor. Don't get stopped out on an intraday swing, so it is best to set a mental stop and check the price in the afternoon. This is a highly volatile stock, so fasten your seat belts.

We will wait on our other recommendations, given that we already have four long recommendations today. You can take heart that we are looking at a natural gas play in the near future and one candidate has recently been traded in this portfolio.

Current Portfolio

Hang in there with FDG, as it has gone through tough times, with its industry selling off big. The quarterly dividend will be healthy at the end of September. This will again bring our cost basis down by an amount likely between $0.75 to $0.90 cents per share. It also appears as if FDG may bottom soon and bounce up hard. At this time, oil and natural gas are likely to bounce some, which may ignite short covering on coal stocks, as they are an alternative to oil and natural gas to produce electricity.

Generally, our model uses set stop prices to control risk. Index ETFs, including DIA, SPY, QQQQ, and IWM are managed somewhat differently, in that trades will be reversed to time the market, as opposed to using a set stop limit.

Unlike the majority of position trades in the fundamental trader, our ETF trades may see us exit positions prior to specific profit goals being achieved, as we are more concerned with positioning for the correct direction of the market more than with achieving a specific profit level. The reason for this is the profits come over time with a fair number of exchanges for long and short trades.

* Initial stop prices are set to cause us to exit our positions if they close below these levels. You will note they are generally kept pretty tightly the opposite side of the trades we initiate. Historic volatility would imply that intraday price action may trade outside of these values, so that condition is insufficient to cause an exit from an existing position. On significant movement beyond our stop prices, we may issue an intraday message to exit the position or to maintain the position. You may chose to implement an absolute stop below these suggested stop values, but that stop should be wide enough to take care of the daily volatility for the stock in question. You can examine the candlesticks for an idea of intraday price fluctuations.

Entry prices are adjusted to account for dividends paid. The stock price was adjusted by your broker, to reflect the dividend taken out. The non-adjusted entry price reflects the actual entry price, without the adjustment for dividend values.

LVPB Concept: The concept is a Light Volume Pull Back, where a stock's price will pull back to a support level on light volume. Obviously, heavy selling is a sign of weakness, and we would not want to buy on a heavy volume pullback. However, we will occasionally place stocks on the LVPB (Light Volume Pullback List) to indicate a "re-entry" buying opportunity, when we have already entered a position. This should be used to add to existing positions, or to enter a position if you missed the initial entry.

LVPB Portfolio Stocks:

Conclusions

The equities markets are trying to attain new highs. The bulls are out in force trumpeting the market advance. We have noted healthy skepticism, so it is possible that the markets will attain new highs shortly. With that note of caution, the markets are currently overbought and have shown signs of a reversal with high probability trade set-ups. We believe we are in for a downtrend, and if it doesn't gather momentum by the end of the coming week, we may move back out of the way, as the bulls may try to push the market to new highs.

Timing an exact bottom or a top isn't possible, but catching the turns near the tops and the bottoms is how you can continue to grow your returns, whichever direction the market wants to pursue.

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Regards and Good Trading,

Mark McMillan
Fundamental Trader Alert

Please use fundamentaltrader@stockbarometer.com for questions/coments.

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