Warning Posted for Possibly Even More Whipsaws and Traps

SPX – 1125.86

DJIA – 10,674

August 3, 2010

“Deflation isn’t just a topic of intellectual curiosity, it’s happening. It’s an uncertain world that’s tipping toward deflation.”

-Bill Gross, The Wall Street Journal, August 2, 2010

Inventory filling is largely over, the recovery now dependent on consumer spending to stand on its own. Recovery Loses Momentum Outlook for Remainder of 2010 Darkens Even as Businesses Post Strong Profits summed up the lead headline in The Wall Street Journal’s weekend edition while another headline read Revisions Show Slower Recovery, Deeper Recession.

Treasury Secretary Geithner’s op-ed in The New York Times, Welcome to the Recovery, argues “a review of recent data on the American economy shows that we are on a path back to growth” while the president of the Federal Reserve Bank of St. Louis worries that Fed policies could put the American economy at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.” Instead of keeping interest rates near zero, he thinks the Fed should buy more Treasury Bonds to inject liquidity, the most powerful option left to fight deflation, and one the Street is watching to see if it’s held in reserve or not at next week’s Fed meeting.

On “Meet the Press,” Double Bubble Greenspan thinks the pause could turn into a contraction if home prices decline, but let’s wait to see how home sales trend in September and beyond. It’s likely the slowdown in June home sales after tax credits expired is much like what happened when auto sales slowed after “cash for clunkers” pulled natural auto buyers forward.

From a technical perspective, light volume or not, it’s positive that the stock market continues to rally in the face of the mostly negative headlines, the S&P 500 (SPX) closing yesterday above 1121.44, the halfway point of the SPX’s October 2007 all-time high and March 2009 bear market low. If that point holds and the SPX rallies above its next technical hurdle, the July 21 high at 1131.23, it locks in the April 26-July 1 decline as an A-B-C corrective pattern, increasing the probabilities of more sideways trading between those two levels through the dog days of summer, warnings posted for even more whipsaws and traps, bull and bear alike, and not the best of conditions for trend followers.

S&P 500 - Monthly (Source: Wailuku Capital Advisors)

The SPX, the most important stock index in my opinion and the one I track the closest, is where institutional investors buy and sell, included in the Market Trend Indicator (MTI) to determine what the pros are doing. The 30 stocks in the Dow Jones Industrial Average, the bluest of the SPX’s blue chips and dominated by institutional trading as well, is the index that grabs the public’s attention, leading consumer sentiment surveys in a near-perfect overlay and part of the MTI to reflect public psychology. The New York Advance/Decline line is incorporated to measure how the average stock is doing, the troops leading the generals in this market and the sort of action generally seen when the primary trend is down.

The MTI, designed to identify and follow intermediate-term trends lasting weeks to months, capturing most of the move more often than not, has no predictive value. Signals are straightforward, either uptrend, downtrend or neutral, signaling UPTREND now, each key index above its 18% weekly exponential moving average, the equivalent of a slightly weighted ten-week moving average and standing at 1091.31 for the SPX and 10,285 for the Dow. The New York Advance/Decline line is 7,378 net advances above its 18% average.

S&P 500 - Daily (Source: StockCharts.com)

The other tools I use to confirm the trend include net volume, often the first to suggest a change, and a couple that either indicate uptrend or downtrend but not neutral, the SPX 3-day swing chart (uptrend signaled by higher lows and higher highs and vice versa for downtrend) and the 21-day rule (uptrend when the SPX moves above the high of the previous 21 trading days, staying in effect until there’s a print below the low of the trailing 21 days). Both the 3-day swing chart and 21-day rules indicate uptrend, as is net volume, last week’s late fade not enough to qualify as a short-term downtrend, so peak readings remain intact, +72.2 for the NYSE and +62.7 for NASDAQ.

I would be more excited by these positive readings if weekly net volume figures hadn’t passed their chance to overbalance hurdle rates, (28.3) for the NYSE and (29.8) for NASDAQ, that backed the view that the top of the cyclical bull market is behind us when price and time overbalanced for the SPX in May, confirmed at that time by Dow Theory, which has since shifted back to uptrend status. The SPX would have to trade above its April 26 high (1219.80) to negate the overbalance indications, thus my bias that a trading range is the most likely outcome for now.

Second quarter results in the Consumer Staples sector (Colgate, Kellogg and Procter & Gamble) reveal a lack of pricing power, supporting the case for deflation. Automobiles (helped by Ford and a couple of foreign manufacturers) and Travel & Tourism, the two best performing groups over the past month, leapt to the top of the Top Ten Group List as measured by relative strength weighted between six and nine months. Group performance by the leaders hasn’t lasted long enough yet to indicate momentum returning to the market. The greatest number of new highs and new lows were both in medical-related stocks last week.

30-year Government Bonds - Weekly (Source: DecisionPoint.com)

Much like the stock market, I’m not quite sure what to make of long-term government bonds near-term. I am lowering my recommended stop sell level for short positions from just above the July 1 high to just above the July 30 high (TLT-100.61). As for gold, I suspect that may have been it for the pullback, possibly followed by a powerful advance in coming months, taking it into bubble territory. The bull market in gold is well into its 11^th year, long past the level for rational investments but if it moves above its 50-day moving average (with stop orders just under last week’s low), trade results could be meaningful.

Barclays 20-yr+ Treasury ETF (TLT) - Daily (Source: BigCharts.com)

Gold (continuous contract) - Daily (Source: StockCharts.com)

Gold - Monthly (Source: DecisionPoint.com)

The lack of sovereign debt concerns in Europe may have helped stocks but punished the dollar. The U.S. Dollar index is barely above its last 3-day swing low and weakness from here would cap its advance at seven swings and move momentum indicators into oversold territory.

U.S. Dollar Index - Daily (Source: DecisionPoint.com)

Back to housing, Census Bureau statistics show U.S. homeownership continues to fall, down to 66.9% in the second quarter from a peak of 69.4% in 2004. John Burns Real Estate Consulting estimates that six million of the approximately eight million homeowners behind on their payments could lose their homes in the next two years. As the chart from Morgan Stanley shows, sales of non-distressed real estate in San Francisco slipped last month, begging the question of what happens to consumer spending if both stock and housing prices fall together.

San Francisco Non-Distressed Home Sales (Source: Oliver Chang, Morgan Stanley Research)

With the Texas Rangers franchise in bankruptcy, yet leading the American League West, sportswriters  are starting to suggest the Rangers should replace the Cowboys as “America’s team.” Sticking with sports but switching to the NFL, Willie Brown wrote in Sunday’s San Francisco Chronicle, “Al Davis is watching the TV news one night and he sees a kid in Baghdad elude a squad of baton-wielding cops and hurls a brick 100 yards through a window. ‘He’s the answer to all our problems,’ Davis says, and promptly dispatches his aid to sign the kid for the Raiders. The kid comes over and indeed turns the team around. The night before the Super Bowl, he calls his mom to tell her of his success. ‘That’s very nice, my son,’ the mother says. ‘But since you have been away, your brother has been shot, our house has been ransacked twice and our car has been set on fire. ‘Son, why did you bring us to Oakland?’”

Harmonic Preview:

(Higher Probability SPX Turning Point or Acceleration Days)

August 9         (Monday)

August 11       (Wednesday)

* An asterisk denotes a dynamic SPX price square in time; different factors account for the other dates.

I’ve listed August 9 and August 11 but there are possible harmonics including anniversary dates each day through the August 9-12 period. It’s positive if the SPX can maintain its uptrend through this period and hold above the bear market halfway point (1121.44); otherwise, it negative.

S&P 500 - Hourly (Source: Wailuku Capital Advisors)

Conclusion:

My recommended stop level for long positions in ETFs tied to the Nasdaq 100 is under July 20 3-day swing low (1056.88 for the SPX and 1784.55 for the NDX). For remaining short positions, I wouldn’t have stops any higher than just above the June 21 high (SPX-1131.23). If stopped out, the plan is to short again on the next signal, focusing on exchange traded funds tied to small cap, basic materials and the VIX.

As for investors, don’t lose sight of  the operating realities of the businesses you own in a world in which the major economic powers are still deleveraging. I would expect my emphasis on large cap defensive issues to underperform on any rally while holding better if and as the trend changes. Of course, you can’t spend relative performance in a bear market.

The information contained herein is based on sources that William Gibson deems to be reliable but is neither all-inclusive nor guaranteed for accuracy by Mr. Gibson and may be incomplete or condensed. The information and its opinions are subject to change without notice and are for general information only. Past performance is not a guide or guarantee of future performance. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without consent from William Gibson.

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