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November 13, 2006

Is Gridlock Good?
by Mark McMillan

Weekly Trader Alert #78
11/13/2006 9:17:42 AM

Overview

Last week saw a new balance of power in Washington. The Democrats took control of the House and the Senate in the mid-term elections. While the majority is slim, it allows the Democrats to take control of the committee chairmanships. The Republicans retain control of the Executive branch, with George W Bush as President. The initial reaction on the day after Tuesday's election saw gains continue. Thursday saw a high volume sell off but Friday saw very light volume gains.

Our suggestion of political gridlock is intact. The leaders of the House and the Senate met with the President to find common ground to move forward on legislation. It made for nice sound bites and photo opportunities, but we will have to wait to see what progress is made. Generally, there is an opportunity to move things forward initially before things break down into more polarized camps.

We also predicted that healthcare would be assailed and that was the weakest performing sector in U.S. Equities last week. We also predicted U.S. oil companies would be adversely affected. The proposal to tax California producers of oil was defeated by California voters, which is a warning to the Democrats not to get too carried away with efforts to tax big oil, if it adversely affects consumers. The stocks of U.S. oil producers appear to be strengthening at this time, perhaps because of the warning by the defeat of the California legislation.

Finally, we predicted the democrats would push for an early withdrawal from Iraq. This is a popular idea with the American people (who wants to have soldiers in a foreign country being killed everyday?) but most policy makers seem to realize it would destabilize the Middle East. While some Democrats have made noise to immediately recall U.S. troops, most seem to be waiting for a plan to emerge. The Democrats ran an effective campaign of blaming the Republicans for the War and suggesting they would bring the troops home, but never suggested a plan for doing so. They now have to figure out how to accomplish that, or the voters will remember in the next Presidential election in 2008.

One of the events that took place last week, but that was overshadowed by the elections in the United States, was that the Bank of England decided to raise interest rates by a quarter of one percent on Thursday, November 9th. England is seeing rising inflation in terms of rising housing prices. This is expected to happen in other non-domestic markets as well. This weakens the attraction of the U.S. dollar.

Money has flowed out of U.S. Equities Funds and into non-domestic funds, into domestic bond funds, and most importantly into cash, in the form of money market funds.

In terms of our constant reminders of a looming housing problem, the homebuilders took down their own guidance last week. The talk seems to have shifted from the "problem is nearly over" to "it will take about three years to work through the inventory glut that exists today". We'll have to wait to see if this has any lasting effect on the psychology of traders and investors.

Looking at the energy markets, oil gained forty-five cents week over week to close at $59.59. Natural Gas fell nine cents during the week to $7.79.

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

Market Climate

The market recovered and moved up to resistance by Wednesday of last week. Thursday saw a higher open and immediate sell-off on high volume. Friday showed a very narrow trading range on very light volume and where prices moved up only modestly.

The U.S. Equity market has been building energy as it consolidated for the last two and a half weeks (or more). It is pretty obvious the market is at resistance. We suspect that in the first half of the coming week, the markets will either move up to break through resistance or down to break through the 20-day moving average.

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 Bands have narrowed, and the range between the upper Bollinger Band, which is coincident with resistance, and the 20-day moving average has narrowed, such that something has to give soon.

The Composite's move up Friday (a week ago) while the major indexes moved down correctly forecasted a move higher, as investors and traders took on more risk.

We would suggest that a lack of immediate continuation of the move up in price and RSI predicts a new test lower. A minor move upward but not followed through by mid-week, also projects a lower move. We believe the market must make a definitive move upward in the first half of the coming week, or it will fall of its own weight.

Now, let's take a look at the charts for the major indexes.

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.

While the DIAmonds are still clearly in their four month uptrend, they have been trying to break through resistance for two and a half weeks. While they could move sideways for another week before having to break one way or another, this would constrain trading to relatively narrow trading ranges.

The evening star of two weeks ago has provided the resistance level that continues to contain the market. This warning should never be ignored. Friday's small doji candle shows indecision by traders. Once again, price is constrained between the upper Bollinger Band which lies just above resistance, and the 20-day moving average. Something has to give soon.

We have included the choppiness indicator in all index charts this week. We also included the Stochastic as well. It appears a new trend may be starting. The stochastic oscillator favors as the lines have just crossed to indicate that move. If this is the start of a new trending move down, then the market should move strongly to the downside this week. Sometimes the stochastic will reverse, but the lower highs on the choppiness indicator and the stochastic argue that a new downtrend is about to get started.

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

The SPYders have risen to their resistance line once again. Once again including the choppiness indicator and including the stochastic, it appears that a new downtrend may be just getting started to the downside.

The chart shows that the Stochastic continued to put in higher lows during the entire advance in conjunction with the choppiness indicator moving from its high into the range where trends are generally terminated.

Friday saw a turn lower on both the stochastic and choppiness indicator. The narrow trading range on light volume indicates indecision. With the 20-day MA lying just below, and resistance lying not far above, a dramatic move is likely within a week.

We include a new chart this week, which shows the Advancers versus Decliners on the NYSE:

Since this is a new chart, we will explain it briefly. The thin black lines reflect the value of number of advancers versus decliners on the New York Stock Exchange (NYSE) that day. The green line represents the 3-day moving average of those values. The blue line represents the 5-day moving average.

You will note that we have placed trend lines indicating a gradual contraction of the absolutes of those lines. In addition, since late September, the absolute values of the Advancers versus Aecliners have been moving downward. From about mid-September, the high for the 5-day MA has been slowly rising as have the lows with one notable exception. The sell-off a week ago broke that pattern and resulted in a significantly lower low. A follow-through to a new lower low on the 5-day MA would break the four month uptrend and indicate the start of a new downtrend.

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

This chart shows the QQQQs are challenging their annual high, which has been providing significant resistance thus far. The chart indicates a dramatic move downward would leave a double top pattern. The weekly choppiness indicator shows the previous (upward) trend is exhausted. The stochastic turned over but now looks indeterminate. The four month uptrend is still intact (except for last week's minor breach).

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

The choppiness indicator began a move down last week, indicating the start of a new trend. The stochastic moved to the upside during this period suggesting the new trend will be to the upside.

We believe that the market may begin a move to the downside, and that the trend start indicated by the choppiness indicator could, in fact, be to the downside, after a temporary move upward. Until the four month uptrend line is broken, we believe that traders should be hesitant to take on much short exposure. With that said, the double evening star formation has clearly presented resistance and a new downtrend is forecasted.

We include a new chart this week, which shows the Advancers versus Decliners on the NASDAQ:

Similar to the NYSE chart, shown above the QQQQs chart, the thin black lines reflect the value of number of advancers versus decliners on the New York Stock Exchange (NYSE) that day. The magenta line represents the 3-day moving average of those values. The blue line represents the 5-day moving average.

While the trend of the actual values of the advancers versus decliners continues to contract, the 5-day moving average is on a different trend than for the NYSE. While the trends may appear similar (upward), a look at the 5-day moving average (blue lines) indicates a downward bias for both the highs and the lows. A confirmation by the 5-day MA turning lower on Monday would indicate the most likely path for the NASDAQ is down.

Fundamental Trends

The big surprise this week is that two retailers are back in the top five after having made a hasty retreat the previous week. All five are repeats within the previous two weeks.

Outside of the top five, foreign banks continue to be strong in sixth place and U.S Integrated Oil companies are in ninth place. The steel trade continues to be a good one. When I study the top screen (top 31 industries), the main difference I see is that there are now three oil industries in the top screen with equipment suppliers to that industry also showing up. Retain continues as a theme as does transportation and utilities. No healthcare (big surprise) and the rest is somewhat mixed, with no great propensity for risk.

We are continuing to look for an oil play, but we want to try to get a bargain, and they are hard to find right now.

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

Not a lot has changed in the laggards, other than another Healthcare industry has joined and Coal left the bottom five in favor of moving up another twelve places.

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

Trade Recommendations

We sent out an Intraday Alert on Wednesday suggesting we were going to start entering a long trade each week until the trend was broken. Thursday morning saw a gap up opening followed by a heavy volume distribution day. Friday was a very light volume trading day, so we are back to waiting for the market to break up or down. We will be making a trade recommendation this week, but we need to see the market tip its hand to ensure the best returns.

Current Portfolio

FDG continues to sell-off, mostly due to weakness for Canadian Royalty trusts due to the Canadian governments decision to tax existing trust beginning in four years. Coal hasn't been enjoying a lot of support either, so we must be patient here.

Our short position on SPY is at resistance. We will either get a move down in the market from here or we will exit this trade.

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

We had our predicted stealth rally last week, but we are once again at a cross roads. Resistance lies overhead for the market. The market will move decidedly up through resistance of down through the 20-day moving average and will challenge the four-month uptrend line. A break through of that line indicates a new trend for the market.

A continuation of the rally would indicate a good time to enter new long positions. We must wait for clarity here, which should occur sooner rather than later.

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Regards and Good Trading,

Mark McMillan
Fundamental Trader Alert

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