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January 03, 2007

Welcome to 2007 and a New Look...
by Mark McMillan

Weekly Trader Alert #85
1/3/2007 6:49:12 AM

Overview

During the last year, the Fundamental Trader deviated from its initial concept, which was to provide regular trade recommendations for stocks. We started writing quite a bit more educational material and began recommending quite a bit less stocks to trade. We also started to focus each week on what was happening with the Major Stock Index ETFs.

Readers have responded with a desire for both. They have also indicated they would prefer a newsletter tightly focused to making regular stock trading recommendations and another that will focus on the index trades. So, that is what we are going to do.

The Fundamental Trader will still have a weekly format that focuses on leading and lagging industry groups. We will produce regular recommendations to trade, with an emphasis on swing trades. We will continue to use the model of taking partial profits on achieving a first target, while we continually adjust the second target to maximize profits, while letting our winners run.

The Index Advisor will analyze and make trade recommendations of the three major Indexes, the Dow Jones Industrial Average, the S&P-500, and the NASDAQ-100. We also regularly monitor the Russell-2000, but will not necessarily publish analysis of it every week. We will start by recommending high probability trades for the underlying ETFs so we may be in cash for periods for some or all of the ETFs we will trade.

Welcome to the redefined Fundamental Trader. We hope you enjoy it and any comments are welcome and should be directed to fundamentaltrader@stockbarometer.com.

Holiday volumes shrank significantly with some of the lowest volume days of the year seen in the last week. We expect all that will change in the coming week as traders return from their holidays.

The last week saw a number of positive events. Energy prices fell significantly during the week. In fact, the stock market seemed to move opposite to energy prices during the week. Oil prices fell significantly on Tuesday and on Wednesday achieve a close below the $61 - $64 price range we have been monitoring. The close was at $60.34. Thursday and Friday saw new intraday lows with Friday's low recorded at $59.90 before dashing back up to close just above the $61 level.

Natural Gas had a similar effect on the stock market as it tested an important support level on Wednesday before bouncing from this level to close below $5.84. Thursday and Friday saw Natural Gas prices move higher, closing near $6.30 on Friday. The broader stock market moved opposite these price moves each day. This is why we have been intently watching the range of oil prices. We continue to believe that if oil moves outside of the range of $61 to $64, it will inversely affect the stock market.

It was a slow news week, but the news that was reported was pretty neutral or positive.

On Tuesday, the National Retail Federation (NRF) said it expects sales to rise 5% for November and December, as opposed to last year's 6.1% rise during the same period last year. They also expect an additional $6B in gift card sales this year, which nearly makes up for the lower rise in sales.

On Wednesday, new home sales were reported stronger than expected, with a seasonally adjusted annual rate of 1.047M new homes sold versus a consensus of only 1.015M, the bulls moved the markets higher. Even homebuilder stocks lifted on the news.

On Thursday, weekly Jobless claims were reported at 317K, 3K below expectations. Existing home sales were reported at an annual rate of 6.28M versus an expected 6.15M. Consumer confidence was reported at 109.0 versus an expected 102. This rose from 105.3 last month, which was revised upward from 102.9. Chicago PMI was reported at 52.4 versus an expected 50.2. Last month's 49.9 showed signs of economic contraction, while this month's report shows continued moderate expansion in manufacturing activity in the Midwest.

There were no economic reports on Friday, but Apple reported that it's CEO, Steve Jobs, didn't benefit from options that were backdated. They will take an $80M charge to cover expenses associated with those options. This was viewed as a positive as investors bid up the stock of Apple (NASDAQ:AAPL) which was largely responsible for allowing the NASDAQ-100 to eek out a positive showing, while the U.S. stock market, in general, sold off.

Finally, bond rates are moving higher, with a corresponding move lower for their prices. Initially, that is generally favorable for the stock market, as money will leave bonds and flow into equities, cash, or other investments.

Investors will be reviewing return to risk ratios and as interest rates on bonds rise, investors will be more attracted to them. Once they believe that interest rates are high enough, they will start buying bonds and the interest rates will stabilize. Money in equities will move into bonds and the stock market will sell off, and the risk of the stock market and returns from investments made in it will not be able to outweigh the long term safety and return of bonds.

Risk adjusted, as long as stock market earnings continue to grow at a faster rate than inflation and interest rates, then the stock market will attractive. The timing is when the risk of equities is considered high enough that the risk adjusted return is below that of bonds. We are a long way off from that occurring. But it is something to watch for over time.

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

Market Climate

The market rallied in the first two days of the week along with a significant drop in energy prices. The last two days of the week, the market sold off in conjunction with rising energy prices. For the week, the market is up but that move was on light volume, and came during a seasonally bullish period known as the Santa Claus rally. With the return of normal volumes in the coming week, the market will establish it initial direction for 2007.

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:

When we look at the chart for the US Composite, it is clear that the market has been weakening, even as it has been achieving new highs. The high hit two weeks ago has seen a rally attempt that failed and resulted in a lower high. The Bollinger Bands have narrowed, which occurs prior to a larger move in the market. In many ways, the end of year downtrend and narrowing Bollinger Bands appear to be mimicking the year end activity for the Composite in 2005. In 2005 that resulted in an immediate strong move up in the markets that lasted for more than a week. That also resulted in the top for the NASDAQ-100 until fall.

At this time, we see reasons to argue that the markets will move up and arguments that suggest the market will move down. The long term uptrend is still intact, but the short term trend in down. The short term downtrend has occurred on light volume and is therefore suspect. We would recommend waiting to see what trading looks like on Wednesday to get volume confirmation of a move. If the U.S. Composite moves below the 20-day moving average for at least two days in a row, then we believe the market will enter a more bearish phase.

Our final analysis of the VIX and VXN is included as a supplement to the Fundamental trader as a bonus for subscribers.

This will be our final examination of the VIX as a tool to determine Tops and Bottoms. We should reflect that the VIX and VXN are tools that are applicable across a class of stocks, or generally to the equities markets in general. They are well suited to this purpose, but we will point out where they are most reliable and where they sometimes come up short. It should be noted that VIX and VXN can be used interchangeable in this discussion. Just keep in mind that the VIX is applicable to the broader market and the VXN to the NASDAQ-100.

For years, we have watched prognosticators predict market tops when the VIX dips to a low level. Time and again, the VIX kept moving lower, so commentaries regarding a top due to an absolute level proved to be ineffective at calling a top. Instead, we would suggest that when the VIX reaches a low level, that watching for bottoming patterns and trend breaks can aid in calling a market top.

In point of fact, the VIX is best when calling a market bottom. When the VIX has moved steadily higher and finally shows a topping pattern and breaks the uptrend, it is a powerful indicator that a bottom is in. Let's take a look at a chart of the VIX and its correlation to market tops and bottoms.

Below is a weekly chart of the VIX in the period when the market topped when the dot com era transitioned into what became known as dot bomb. While the broad market didn't undergo near the devastation of the tech stocks, the market entered a bearish period. From the highs in March 2000 until the lows in fall 2002 and then another test of the lows until March 2003, it was a tough time to be a bull. The rallies kept getting stifled and the market was on a continuous slide.

You will note the market top in March 2000, followed by a test in August. In March, the top was correctly forecast by the bottoming of the VIX on March 17th, but the market continued to move higher until March 27th. Note that the VIX was making a pattern of higher lows as the market approached its top. The VIX clearly gave warning signs of this top, but it would have been hard to tell exactly when it would occur from the VIX. The series of higher lows indicated that traders were becoming more concerned about an impending top.

The retest of the March top in August shows a different pattern. In August, the VIX had signaled a series of lower lows as the market continued to make higher highs. Traders were getting more and more complacent that the market would continue going up. It wasn't until the VIX turned from a level below 20 that the market indeed put in a top. In fact, all the VIX lows below 22 resulted in tradable market tops with the noted lag for the penultimate top.

If we look at the opposite instances, the market bottoms, we can see that they are clearly marked by high VIX reversals, with values above 28. First, the bottom in early October 1999 was clearly marked with a VIX reading that shot up above 31. The next bottoms were in January and February of 2000, both with the VIX around 29. The next bottom in early April saw the VIX rise to 39! A reversal of the VIX here caused VIX traders to get on-board for what would be a series of higher highs and lows for the S&P-500 until the final retest was unsuccessful and the market collapsed into a double bottom low in late March early April 2001. This S&P low had a corresponding VIX reading near 37. The market continued to move lower into October 2002.

Let's fast forward to our current timeframe and see if we can figure out whether the market is now topping and if what level the VIX has been reaching lately at market bottoms and tops.

One thing is clear by looking at the above chart is that the "normal" range for the current timeframe is quite different from the range in the 2000 to 2001 timeframe. Since late 2003, the VIX hasn't been above 23. The high VIX reversals in 2004 were in the 18 to 19 range. Recently, the VIX moved to closing lows below 10 with the intraday low falling below 9.

Probably the most historically interesting period on the chart is the period from the beginning of 2004 until August of that same year. You will notice the VIX was moving sideways as the market was making a series of lower highs and lower lows. Normal VIX action is to move opposite the market, i.e. when the market is moving higher, complacency grows and implied volatility drops. When the market is moving lower, implied volatility rises. In this case, we see that the market was moving down further and further, but the VIX was moving sideways. So, options were being sold with the same range on premiums throughout this period. This indicates the downward trend wasn't real. The move down was real, but the downward move was going to fail. Note the failure wasn't known until early October, when the series of lower lows was finally broken. That bottom was accompanied by a VIX in the 16.5 range whereas all the other bottoms saw the VIX reach the 18.5 to 19.5 range.

After that period, we see a double bottom of the VIX in July and December 2005, which accompanied a series of higher highs that continued into late April 2006. This period has particular relevance as even though the market continued to make a series of higher highs and higher lows, the VIX appeared in the short term to move opposite the market uptrend, which is normal and suggested a healthy uptrend. The key was to have a perspective on the double bottom, and when you take into account the December 2005 to April 2006 VIX, it is obvious it is making a series of higher lows. This is not normal as the market was also doing the same. Remember that normal action for the VIX is to move opposite the market. As we know, when the two move in the same direction, this tends to result in a dramatic reversal.

Now let's look at where the market and the VIX are today. We see the market moving up in a series of higher highs and higher lows since the summer. The VIX has been in a downtrend since mid-August. On December 7th, the VIX jumped up and out of the range it had been trending in but quickly retreated back within the downtrend channel. On December 14th, the VIX put in a double bottom (slightly higher close) but then began to move higher in a series of higher highs and lows. It is currently just below the upper boundary of the downtrend started in the summer. If it breaks up and reaches the area of 13 or higher, this will mark a higher high and a new pattern will have emerged where the VIX is moving in the same direction as the S&P. That tends to see a dramatic reversal occur.

So, for the VIX, we are waiting to see if we have a reversal lower, and the S&P starts moving higher again or a move back above trend with a close well above 12, with the S&P likely headed lower. That would forecast downside action ahead.

With the VXN acting for the NASDAQ-100 in a similar fashion that the VIX is as a counterpart to the S&P-500, let's examine it's chart and see what it can tell us about the NASDAQ.

This first chart is a weekly look at the VXN. We see important tops and bottoms occurred when the VXN was above 19 or below 15.5. You will also note that over the last year and a half, the value of the VXN lows has moved in an upward trend, while the NASDAQ-100 has move higher. We know, from our examination of the VIX, that when the trends of implied volatility and its index move in the same direction, this ends with a dramatic reversal.

We saw the NASDAQ-100 achieve a top in early January, sell off and fail in an attempt to reach a new high in April, with a dramatic sell-off into early July. You will note that the NASDAQ-100 tops were in a roughly sideways range, while the VIX bottoms were in a downtrend. During the dramatic sell-off, the pattern shifted to higher trending tops for the VXN, and lower lows for the NASDAQ-100. After that sell-off, the pattern once again moved to the market moving in a pattern of higher highs and higher lows, while the VXN moved in the opposite pattern, ie in a normal inverse relationship.

If we look at the daily VXN:

The NASDAQ-100 formed a high on November 22nd. That was followed by a double top on Dec 5th and on December 15th. A week later, the NASDAQ-100 put in a low. During this time, the VXN fibrillated a bit, but it did form a higher low then a lower low on the successive market highs, as well as a higher high and then a lower high on the VXN when the NASDAQ-100 lows first moved sideways and then broke downward.

What does it mean? Currently, the VXN highs and lows appear to be moving downward. The NASDAQ highs and lows appear to be moving downward. This will likely resolve itself with a dramatic move lower for the NASDAQ-100 and the VXN finally breaks the downtrend and moves higher. Why? Since the normal pattern is for implied volatility to move opposite its index (fear goes down in an uptrend and up in a downtrend), when implied volatility moves in the same direction as its index, things tend to get resolved in dramatic fashion. When will this occur? We would expect the NASDAQ-100 to break down or up within a week. If you watch for the pattern to change to a higher high or higher low on the VXN, this should signal a breakdown in the NASDAQ-100. A continuing pattern of lower highs and lower lows with the NASDAQ-100 following these down would actually suggest a bear trap and the market will continue to move higher.

If you didn't understand all that, don't feel bad. It is pretty complex. If you take one thing away, realize that It is normal for implied volatility to move opposite the market. If they are moving in the same direction, this is usually resolved by a dramatic market reversal.

Fundamental Trends

Four out of five of the leaders repeat from last week. The Internet Networking industry has moved into the leaders, and residential and commercial builders have moved into sixth place!

Four building industries are in the top screen, with three business services industries as well as a like number of the petroleum industries. There are no retail industries in the top screen, due to the normal buy the rumor, sell the news reaction, and somewhat disappointing performance of the retailers. There are two food industries in the top screen and the rest are the usual list of suspects. There is only a single utility (telephone) in the top screen.

It appears that there is more of a move toward a soft landing scenario and there is less interest in defensive positioning.

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

The only newcomer to the laggards is the electrical connectors industry. There has been a bit of a reshuffling, but the same names continue to appear there. It is interesting to note the departure of Plastics, but they only moved up to seventh from the bottom. It may indicate a thawing of the bearish grip it has been in, based on the recent dip in oil prices.

We are going to go bargain hunting if we see a bounce off of the bottom for these industries, which will start with the recent move in plastics.

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

Trade Recommendations

We will wait to make trade recommendations until we see how the market trades on Wednesday.

Current Portfolio

We entered a short trade for the QQQQs at the open on Tuesday. The QQQQs rallies last week on light trading, but downtrend is still intact, so we will stay with this position to see how trading shapes up in the coming week.

FDG announced a $0.95 quarterly dividend and then sold off. It bounced from support on Friday and we expect it to move higher from here.

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 would be cautious about entering any long positions at this time. We would recommend being short the major indexes, with the QQQQs leading the markets downward, the SPYders ripe to test downward further, and the DIAmonds showing potential to post further losses.

The time period we find ourselves in is seasonally bullish. We found the markets rallied during a seasonally week period during the summer months. We believe there is potential for a short sell-off here, that could develop into something larger. Usually, the end of the year will often set the market off on a new trend. We will be watching in the coming week, to see if we might have a sign of further weakness or a strengthening of the market going into the New Year.

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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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