What Do You Mean the Economy is Slowing?

By: Mark McMillan | Mon, Oct 30, 2006
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Weekly Trader Alert #76
10/30/2006 8:52:36 AM


Last week saw about one third of S&P-500 companies report and the results are no less than outstanding. Of the roughly two thirds of companies that have reported, about 70% are reporting above expectations, about 15% at expectations, and about 15% below expectations. That in itself is stronger than normal, but when also taken with the pre-reporting expectation of S&P earnings of around a 14% annual growth rate, and the actual reporting trending to more like an 18% annual growth rate, it is no wonder the markets have continued to move up.

That is the good news. The bad news is that several prominent companies have taken down guidance for Q4 2006 and/or for 2007. We have seen these warnings largely ignored by investors, probably due to the stellar earnings being reported. On top of that, the bugaboo of a collapse in the housing market dragging down the rest of the economy has also been largely dismissed.

We have been suggesting the market is priced to perfection. It doesn't take much to increase fear levels, especially in tech, as many traders and investors recall the trouncing the NASDAQ received losing eighty percent of its value in less than three years. The criteria we suggested would have to be maintained to keep the "priced to perfection" formula intact were:

On Wednesday, existing home sales came in at 6.18M, below the estimate of 6.23M. This is the sixth continuous month of a decrease. This number is 14% less than the year ago period and 16% less than the peak. There are 7.3 months of inventory of homes on the market. Year over year pricing is now, on average, -2.8% of last year's price.

On Thursday, new home sales were reported at 1.075M, an unexpected rise of 5.3%. However, the price for new homes declined by 9.7%. That fall in the price of new homes is the largest drop in nearly 36 years! It has created concerns that the slowdown in housing will cause the consumer to reign in spending. That, by itself, didn't derail the markets as the markets hit a new high, in spite of the reported concerns over housing.

The reality check came on Friday when the GDP number came in at 1.6% growth, rather than the expected slowing to between 2.1% and 2.3% growth. Housing was widely expected to slow GDP by around 1%, which when take from a three to 3.5% number leaves GDP around two to 2.5%. The housing problem is contributing either a greater drag to GDP or other aspects of the economy aren't kicking in as much growth as they should.

Finally, with the market relatively neutral but down just slightly on Friday afternoon, Goldman Sachs spooked the markets by suggesting that demand for PC main boards was "falling off a cliff". Their analyst just returned from Asia and painted a grim picture for PC demand and therefore the related tech food chain that supplies components to PC makers, etc.

This week, the Fed again released a policy statement after they met, leaving rates unchanged, and really doing little to change the language used in the statement. Fear of another rate hike has diminished and allowed the markets to continue their upward trek.

Looking at the energy markets, since last week, oil has risen four dollars in price to $60.85. Natural Gas has dropped nine cents during the same period.

So, examining the six criteria, we have failures on three out of the six as inflation is still under control (measured by CPI), the Fed didn't raise rates, and no geo-political event has caused the markets to react. The North Korean nuclear testing, the Iranian nuclear program, and the Iraqi conflict still loom large. With mid-term elections occurring in the United States, the majority of the House and/or Senate could shift from Republicans to Democrats.

Once again, tech rallied through the week but sold off significantly on Friday, but is still up for the week. There is clearly some emergence of tech leadership, but it isn't yet significant. There is little risk taking, with small caps continuing to trail their larger cap cousins.

By far, current market leadership industries are primarily retail or a mixed bag. The leading sector continues to be steel. Investors and traders are betting heavily on the consumer. This is usually a buy on the rumor sell on the news affair, so most traders will begin to close their positions before retailers announce holiday sales. The steel trade still looks to be strong, and if sustained, could provide leadership to the market.

We continue to see a trend of the market over-looking companies issuing downside guidance for 2007 or even Q4 of 2006. Many of these are the larger established companies that figure prominently in the S&P-500 or the Dow. The market has yet to react to this, but we continue to be guarded.

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

Market Climate

The market moved up again last week, with Friday seeing some profit taking and a pull back in the non-stop ascent. Follow-through to this move could indicate weakness to the uptrend, but the market is still clearly in an uptrend.

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:

Friday was an important day, in that all our indicators moved in the same direction, downward. That is, Price, RSI, and MACD all moved in sync to the downside on Friday. MACD hasn't crossed its signal line, and RSI hasn't broken its trend line. Price is very near the top of its uptrend channel, so the uptrend is still intact.

To understand more about the potential of this move, we need to examine what happened during similar changes to Price, RSI, and MACD. We will examine six cases, with A, B, C, and D marking reversals in all three. Case 1 examines a change while MACD is around zero. Case 2 examines where the market is trending sideways and no meaningful signals are provided by our indicators.

Case A: Price, MACD, and RSI bottom. MACD crosses its signal line within three days. Price moves up for two weeks time.

Case B: Price, MACD, and RSI reverse from a top. Slope of MACD and RSI are quite shallow. MACD never crosses its signal line, indicating the uptrend is still intact. Price drops for only two days.

Case C: Price, MACD, and RSI make a definitive move downward for one day. There is one day of follow-through for all three indicators and two days where price forms doji candles. The market enters a period of confusion (see case 2).

Case D: Price, MACD, and RSI make a move downward on Friday. RSI actually preceded this move by a day on the heaviest volume day seen on this chart. Could this be a blow-off top?

Case 1: MACD is at zero, but fails to cross-over. RSI and Price move down. This is bearish and is reflected in declining price for seven days (price rose one day during this time but trend was downward). Price reversed back upward when MACD turned up before its signal was crossed.

Case 2: Sideways trading indicated by continued fibrillation of MACD, RSI, and Price. The market really was indeterminate at this time. While the major indexes all moved higher during this period, small cap stocks were obviously moving lower, where investors were clearly rotating from riskier small caps into large cap and mid-cap names.

What does this tell us for what will happen in the market going forward? If price, MACD and RSI continue their downward path, we would likely see RSI break its trend line, and MACD cross its signal before price hits its lower uptrend channel boundary. However, this would be enough to confirm either a new downtrend or a sideways trading market. We will have to wait for trading action in the early week, but until these things happen, we would have to favor the uptrend, based on this chart.

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.

The trend has been up since mid-July and the DIAmonds closed near the upper range in their uptrend channel. With that said, a very bearish candlestick pattern appeared on Friday, known as an evening star.

We would look for some more serious testing to the downside in the coming week. If the uptrend is unbroken, then the upward move may resume shortly, but we would look for several key areas to be tested before this occurs.

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

The SPYders have a similar evening star pattern as seen for the DIAmonds. We are looking for similar downside testing to occur for the SPYders in the coming week.

This week, we will look at the weekly NASDAQ 100 ETF (QQQQ) Chart before the daily. It is below:

We saw a one day break-out (or fake out, as it turned out) above the resistance line on Thursday. We have been discussing the strength of the resistance here, and sure enough Friday saw a reversal to the downside. When we look at the chart above, it is clear that the bulls keep attempting to have price close above this line, but seem to lack the conviction to force it to happen. There is enough fear of a failed rally in tech that profit taking occurs in this area on a regular basis.

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

As referenced in the weekly chart discussion, the QQQQs broke above resistance on Thursday and fell back hard on Friday. Since the candlestick pattern wasn't an ideal evening star pattern, we would look for confirmation of a continued downtrend. The critical level to watch is $41.59. If that is broken would mean a lower low. The closing low to watch for is below $41.69. Either way, the lower boundary defining the uptrend channel is at these levels, so a lower close breaks the uptrend.

Fundamental Trends

The top screen (31 industries) contain six retail industries, two steel industries, two transportation industries (airlines and rail), two metal industries (Distributors and Containers), two leisure companies, three tech industries, one food industry and the farm machinery industry, and a lot of unrelated industries, including painting products, fertilizers, auto and truck tires, and the telephone utilities.

What does it mean? It seems that there has been some rotation into risk and consumer discretionaries. There are still defensive names in the top screen for sure, but many seem to be betting that the lower price of oil will encourage business (retail and leisure) or lower costs (paints, chemicals, tires).

Contrary to what you might hear asserted on financial news stations, the much talked about health sector has not a single industry in the top screen. Financials have only the brokers (in 27th place). When everyone knows and anticipates something and therefore buys it and then talks it up, there is no one left to buy it, so it doesn't move up. We believe that is what is happening with Health Care. Financials that are sensitive to the yield curve are being affected by the inverted yield curve.

The leader this week is Toy/Game makers, led by Hasbro Inc (NYSE:HAS). Marvel Entertainment (NYSE:MVL) is another. We suggested looking at them for a possible shorting opportunity if a correction set in. Hasbro reported a blow-out quarter, which is an aging boomer play, where seniors are being targeted to buy gifts for grandchildren. The targeting has been successful, and the numbers bear that out. Still, the uptrend has been quite steep, and a shorting opportunity may yet exist, just not yet.

One last thing to note, is that US Integrated Oil companies are in the top screen (28th). There was only a small rise in the price of oil from last week, but clearly there is an interest in owning U.S. oil companies going forward.

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

Examining the laggards, both vaunted Healthcare and Retail show up. Drug stores are facing competition from Walmart, which revealed a $4 prescription drug plan, which would seriously hurt traditional pharmacy companies. Machine tools and Automation machinery in the laggards indicates the being out of favor due to a slowing economy. They would be good industries to watch, as when they start becoming in favor, once again, it would be an early sign of a renewed economy.

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

Trade Recommendations

Last week, we wrote: "The awaited pull back in the market is imminent. It may take the place of a sideways move. Either way, unless we get a broken uptrend, we will look to enter some long positions shortly."

This week, we will see how far down the pull-back can go. On a reversal back into an upward path, we would look to add some long exposure.

Current Portfolio

Unfortunately, our steel related stock, FDG, supplies metallurgical coal to the steel industry, but the steel industry has learned to use a small amount of inferior coal in their coking process (less than 10%), so we haven't seen the outsized gains we were expecting. This past week they announced their quarterly dividend of CAN$0.83, which will again reduce our cost. At the current stock price, the dividend is approximately 12% of price.

FDG fell a quarter to $25.02. SPY moved a dollar higher from last Friday to $137.91. Neither of these moves is significant. We have to see how far downside action can take the SPYders down. If the SPYders bounce at a likely uptrend line, then we will likely close the position.

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:


Very similar to last week, we suggested that if market leadership emerges, and we specifically called out tech, then we could see a continuation of the rally. This occurred until Friday's mother board demand "Falling off a Cliff" story hit the trading floors in the early afternoon. There was a significant tech sell-off at that time.

We have seen more of a move into risk in the last week, but with Friday's pull-back, we have to see if any real move gets started. It is also clear that while the major indexes have continued to move up, large cap stocks have dominated the move with a somewhat narrow advance, leaving small caps trailing the gains of larger caps.

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Regards and Good Trading,



Mark McMillan

Author: Mark McMillan

Mark McMillan
Fundamental Trader Alert

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