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October 10, 2006

Another Week of Absent Leadership...
by Mark McMillan

Weekly Trader Alert #73

Overview

Last week was typical since this summer. There was something of a euphoria that unfolded by mid-week after a speech by Fed Chairman Bernanke did little to cause fear that the Fed would take action to further raise rates. The market seems to collectively believe in the Goldilocks scenario of an economy that will be neither too hot nor too cold. Even comments by two other Fed members that were somewhat hawkish failed to quell the optimism in the market.

It wasn't until Friday's non-farm payroll report came out at 51K jobs created in September did the market decide to take a breather. That is decidedly lower than estimated and signals the economy may be slowing faster than expected. That data can be notoriously volatile, but it may show that all may not be well.

We continue to believe that weak housing will have a larger effect on the economy than the bulls are allowing for. In fact, the overheated markets in Florida, the North East, California, and Las Vegas are all showing steady declines in home prices, new and existing. Inventories are at multi-decade highs. Buyers are walking away from deposits as the prices of comparable homes have dropped liked rocks. Realize that there are speculators and homebuilders looking to unload bloated inventories, along with existing home owners that wish to sell their homes, and they are all competing for the same potential buyers. It will continue to get worse, which has all sorts of ripple effects as construction workers can't find work as homebuilders don't want to add further to bloated inventories.

The price of oil seems to have stabilized around sixty dollars, but natural gas has been on the rise, now trading at around $6.50 per MBTU. That is a 50% rise in the price of Natural Gas in about one and a half weeks!

We still have the concern over a lack of clear leadership. This week saw a nice one day move for the NASDAQ, but leadership from tech or any other sector that could lead the markets higher seems to be lacking. Investors remain defensive.

Given our decidedly pessimistic outlook, we decided to examine why we seem to have a problem believing this rally is real. Other than the oft-stated housing meltdown and the effect of high energy prices we discuss regularly, why are we so pessimistic?

First, the S&P500 and Dow Jones Industrial Average have reached the price level where we have calculated they would form a top. We haven't seen a lot of evidence of a top yet, but do believe that a correction is likely.

Second, the indicators that generally predict downside action continue to indicate a high probability of this. The problem has been that shorter term indicators continue to predict a downturn, but each downturn is so short that the trades are not profitable. We have recently seen a bit of a change in some of this behavior, and believe that more sustained moves might be around the corner.

Third, we are skeptical of a sustained move without sector leadership. Fleeing other investments and that money finding its way into the stock market, is not leadership, but rather a defensive move that is not likely to be sustained.

Finally, the geopolitical realities are being ignored. We have rising casualties in Iraq and prominent Republicans stating that the situation has to be re-examined there. We have Iran continuing to pursue a nuclear development program. We have Korea vowing a nuclear test. We have unstable oil and natural gas prices which could once again fuel inflation. Finally we have Fed governors providing hawkish tones that are currently being ignored by the markets. It isn't going to take a lot for this house of cards to fall, and the current euphoria to fail and a more realistic/pessimistic mood will take hold.

We also decided to re-examine our systems trading models. There is nothing wrong with the models, but they are not optimized for a see-sawing of directional moves with a frequency of two days, at times. It may lead to a lot of trading, which chews up profits, but doesn't show a whole lot of returns. While we have found ways to optimize for the current choppy conditions, we will hold to our time-tested system but consider re-weighting of indicators within our system to optimize for current conditions, essentially providing a low weight to indicators that aren't useful in this kind of trading action.

To understand more about our view on the markets, we will have to look at the charts.

Market Climate

The market continues to progress in its uptrend. However, price tested its upper boundaries this week and pulled back 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 resistance level we have been referring to was broken on Thursday and may now act as support preventing any real downside from getting started. The bearish divergence between RSI and Price has been resolved with RSI chasing price.

The 20-day and 200-day moving averages are lined up just below that support line, so we don't see significant downside action getting started until those lines are tested and broken.

The MACD continues to vascillate in a sideways pattern, meaning it is all but useless in providing input as to a trading direction. Finally, the Thursday/Friday pattern was a Harami. If there is further downside on Monday, that will confirm the Harami, and upward progress is likely to be muted in the short term.

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 mnemonic:
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.

Friday's retreat from the upper Bollinger Band indicates downside action is likely to follow. Several of our indicators also provide a downside directional bias. The DIAmonds are currently oversold so down is the most likely direction for the DIAmonds to pursue.

With all of that said, the trend has been up since mid-July. Since mid-August, the DIAmonds have made several test to an uptrend line that has consistently provided support. For downside action to really get underway, this trend line must be broken.

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

The SPYders chart seems to mimic the DIAmonds. Price moved outside the Bollinger Band and then returned. They have also been following an uptrend line that, when tested, has provided consistent support. It will have to be broken for serious downside to get underway.

What we are really looking for is a break of the euphoria that has allowed the uninterrupted uptrend to continue. For that, we will have to watch trading action in the coming week.

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

The QQQQs continue to move to the upside but turned around on Friday. We are looking for downside action early in the week that may test toward the 200-day moving average. To get to that important average, the uptrend line that has been providing support would have to be broken. A break of that line would indicate that the uptrend is threatened and the bulls will certainly defend it.

We will have to wait for trading action in the coming week to determine whether we will see such a battle.

Fundamental Trends

Many retailers are in the top industries. There are also utilities companies and food companies at the top. Airlines have leapt into the number one position, while air freight is now. Consumer confidence has risen recently, but that is understandable given falling gasoline prices, etc. With a lower jobs report and growing concerns about the housing market, we will have to see if that confidence continues.

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

The laggards list is all but unchanged from a week ago. Coal has left the laggards, but only moved into 182nd out of 190 industries. Gold/Silver Mining has dropped into the laggards and Canadian Exploration/Production oil companies have joined their US counterparts as cellar dwellers.

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

Trade Recommendations

We expect downside action the first days of the week. We need to how that action is treated before recommending further trades.

Current Portfolio

The three ETFs were exited at Thursday's open at small losses (2.4% to 2.9%). SA was exited its stop level for a gain of 7.3%.

FDG has continued to sell off but rallied on Friday. We are looking for follow-through to the upside in the coming week.

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 characteristics of the markets in the last two months have made it difficult to effectively predict directional moves that last more than a few days. This makes it difficult to profit from such moves, so patience is required.

As stated in the overview section, we continue to believe that the uptrend that we have been seeing is suspect, due to the lack of leadership. The defensive positioning is allowing a slow and steady rise, but markets don't tend to "take off" without leadership. While Airlines look strong in the last week, this industry is not significant enough to lead the market higher, and one week does not a trend make. Certainly the leadership from retailers is not something that will provide long term leadership as these stocks are notoriously volatile.

The rising wedge patterns of all the major indexes were broken to the upside, but then seemed to immediately break down. We may now finally see a more serious test to the downside or we may not. It is clear that the uptrend line has provided consistent support for each major index, and a break of that would signal a new trend is afoot. Until then, the multi-month uptrend will continue.

We suggested the markets might have one more push upward left before a sell-off might begin. We saw that push, but we will have to wait to determine if downside action will be contained, or whether the uptrend line will finally be broken.

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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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