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September 25, 2006

A Slowing Economy...
by Mark McMillan

Weekly Trader Alert #71

Overview

The Markets started the week continuing the rise started this summer. They also continued to rise up without clear leadership, with one exception. The trade rotating from commodities to tech seems to be in vogue. The money that has been steadily leaving the commodities trade has to go somewhere and traders and investors seem to have decided that tech is the most undervalued sector.

With that as the backdrop, the Fed provided their latest policy statement on Wednesday. It noted risk of a weak housing market effecting slowing growth for the overall economy. They also noted that the drop in energy prices may have a benign effect on inflation. Overall, it was a mixed bag. We believe that the slowing economy raises the risk of a slowing economy more than benign inflation reduces risk of further Fed rate hikes.

On Thursday, the market reversed their climb on the Philly Fed's release of the manufacturing growth. It was expected to come in the 14% range, which would indicate slower but steady growth. Instead, they reported a -0.4% rate, which is actually a contraction of the manufacturing sector. While this is only one region of the United States, it is an influential report, and provided the catalyst for profit taking the last two days of the week. While there will be a debate over whether the economy will contract or continue to grow at a reduced rate, it brings up the question of a hard of soft landing, and we believe you will hear more commentary on the "R" word. Yes, we believe that more possibility of a recession exists than has previously been acknowledged.

The reason for this concern is the steady decline in housing. The homebuilders and the National Association of Realtors continued to deny that there was an issue, as the bubble continued to grow. They continue to spew the same message quarter after quarter, reneging on their previous statement that things are OK and would be getting better. They then follow that with a message that they expect things to get better soon. Essentially, they are in denial, just like the supporters of the commodity bubble were.

Both of these trades (real estate and commodities) saw a tremendous amount of speculation. The effect of speculators rotating out of these trades can be devastating to prices, as we have seen in the volatile commodities markets.

For an example, Amaranth, a $7.5B American Hedge Fund reportedly lost $5B (yes, that is B for billion) last week. This was due to a bad leveraged trade on natural gas. This trade had apparently been responsible for their assets growing to around $9B before the collapse, so in effect, assets are probably worth around $4B at this point, shaving half the value of investors in the fund. The leverage that hedge funds use allows them to move the markets disproportionate to their size, and with greatly increased risk. This seems to be causing Congress to re-examine regulations that govern how hedge funds may operate.

The point of this is that speculators are "the hot money". When they all rush into a trade, it forces prices to climb, often disproportionate to the underlying value of the asset. When they reverse and want to exit the trade en masse, prices sink precipitously. It doesn't take a large percentage of speculators in the market to do this, so the same sort of effect can easily be seen in housing. This occurred in Silicon Valley in 1989, when new $900,000 homes were offered for sale in the range of $600,000. That is a 33% haircut! We aren't suggesting that home prices will fall this far, but to those that say home prices won't fall at all, but rather prices may stop climbing, they better take a reality check.

Natural gas continued to sell-off. It is apparent that Amaranth had a lot to do with the rise and subsequent collapse of natural gas. How many other funds have been speculating in this space is an open question. Natural gas closed the week at a new two-year low closing below $4.63. We are still waiting to speculate on a long trade in natural gas. Stocks in natural gas companies will likely move up prior to the bottom of natural gas prices, as investors anticipate results.

Oil has continued to sell off, closing at around $60.55 on Friday, which is nearly three dollars less than the close a week ago. Oil hasn't quite collapsed below the lows set in March of this year, which were about three dollars below Friday's close. We don't think we will break that price level, but we will monitor for a rebound at around $58.00. If that doesn't happen, then this would likely fuel a bullish move in equities.

We continue to believe that higher food prices will counteract lower oil prices in terms of the overall effect on inflation. Whether reflected in government reporting, or just in the pockets of consumers, higher food prices take a toll on weekly budgets. We explained some of the food shortage issues causing price pressure last week.

We are in our third 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. Thus far, the markets are still up for the month, but this week saw an overall decline. We continue to remain skeptical that the market will continue to make new highs, and we will see evidence of this in the charts of the indexes that we will examine.

Market Climate

The market entered the week relatively flat to last week, trading around the 200-day moving average. It showed its first crack in the façade on Tuesday, when price collapsed back below that important level. Wednesday saw a rally back up and over the 200-day moving average, which then collapsed on Thursday with a clear break downward on Friday.

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 Bollinger Band is narrowing, with the upper Band collapsing downward, and the lower Band remaining relatively flat. Price close just below the 20-day average, and intraday trading tested the lower Bollinger Band, which is just above the 50-day moving average. The intraday low was also coincident with the lower boundary of the uptrend channel, that began in early July.

The MACD has just crossed downward, indicating a downtrend is in place. Probably the most important thing to note is that while price has been rising since early July, RSI has been in a shallow downtrend since mid-August. This is a bearish divergence, and we believe it will cause an acceleration to the downside, once the 50-day moving average is breached.

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.

The DIAmonds have indeed sold off as we suggested they might. The bearish engulfing on Thursday is a strong indicator that a reversal is in progress. We are looking for Friday's weakness to be followed by more weakness on Monday. A number of internal indicators also support a continued move to the downside.

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 continued. The question is, will the week ahead finally break from this pattern and see another down week. The possibility of a double top was noted last week and it came about. That has been emphasized with a Harami pattern that indicates a braking of the uptrend. While this needs to be confirmed, we believe that it is a stronger Harami and more likely to lead to a continued sell off.

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

Wednesday and Thursday's tweezer top formation indicated the uptrend was out of steam. With a piercing of the lower boundary of the uptrend channel on Friday, the SPYders are close to breaking down out of the uptrend. One thing to note is that Friday's candle can be interpreted as a hammer. A hammer occurs after a downtrend, which signals the downtrend is over. Our interpretation is that a clear downtrend didn't exist for this candle to be meaningful, as the SPYders had been in a sideways trade, and only just broke out of that on Friday.

We look for a continued move to the downside, in that weak Friday's usually lead to weak Mondays.

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

The SPYders weekly chart is eerily similar to the DIAmonds with a possible double top. That top matches with the mutli-year highs set in May, and we believe that the markets may, in fact, be getting ready for a significant sell-off.

The Harami is well-formed, making it more meaningful than other Haramis, but all haramis need to be confirmed. The price decline, although small, was on the strongest volume of the last three weeks.

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

The SPYders hourly chart is important in that it shows the price increase through the day on Friday was on diminishing volume. This is a bearish divergence and is likely to be resolved to the downside.

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

While price did close higher during the middle of last week, the close below $40.00 confirmed the downside trade. We are looking for downside momentum to gather in the coming week.

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

As we predicted last week, the QQQQs were likely to reverse. The move must be confirmed in the week ahead. The recent strength in the QQQQs may evaporate on worries over slowing economic growth, so we will monitor the weekly chart again next week to look for confirmation.

Fundamental Trends

There are now seven retail industries, three food industries, three chemical, and two bank industries in the top thirty industries. The other half are a mix of industries, including airlines in seventh place, a single utility (telephone), and a broad mix of others.

Leadership has been somewhat consistent for two weeks now, with Airlines falling to seventh, and being replaced in the top five with Plastics. Note that Airlines and plastics have an inverse effect from the price of oil. It is cheaper to fly airplanes and to make plastic when the price of oil is down, and therefore, their profits go up.

Thus far, we haven't seen the emergence of significant leadership, but we will continue to monitor this week by week.

Repeating last week's statement, "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 bounce in gold has increase some interest in minig stocks, but the companies supplying that equipment continue to be unloved. Coal is officially at the bottom, although things turned around for some of these stocks at the end of the week. Two petroleum industries have made it to the cellar dwellers, which, given the price drop in oil, is understandable.

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

Trade Recommendations

We are going to wait another day before recommending a new trade. We have been cautious in entering a short trade on the 20-year Bonds (Amex:TLT) and with good reason, after the run they had last week. However, they may, in fact be topping now.

Current Portfolio

With the exception of special pick, FDG, all trades are moving in the right direction. We may issue an alert to take some profits this week on SA, but that can come with other trade recommendations as well.

FDG finally bounced at the end of the weak. As we know from tracking industry leaders and laggards, coal has been hard hit. FDG declared an 80 cent dividend payment at the end of this month, which on an annualized basis is more than a 12% annual dividend, which investors will likely find attractive. Their prices are fixed for their existing customers as are their labor costs with the unions. The only variables are in the amount of coal they sell and in the costs to the railroads to transport it, which could go down with the lower price of the oil used to power the locomotives.

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

Fear is growing. Fear over a slowing economy. We are entering earnings reporting season shortly, and thus far, there are not a lot of companies warning. The companies that are warning appear to be associated with homebuilding and building materials.

Oil continues to slide, and so does natural gas. Companies that supply coal rebounded at the end of the week, just as the markets turned over. Coal, to some degree, can be a replacement for oil and natural gas, so there is some big money speculating that these stocks have slid far enough, and that they may be a good investment at this point. It bears watching for a turnaround in these commodities and just prior to that, to the companies associated with them.

We currently expect a sell-off to get underway shortly, but the markets could have one more push upward left. After follow-through weakness on Monday, it will be important to watch Tuesday's trading to see if the bulls can get one more rally underway.

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Regards and Good Trading,

Mark McMillan
Fundamental Trader Alert

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