Safehaven | Weekly Wrap-up: Solid Price Action with Some Negative Divergences

February 21, 2006

Weekly Wrap-up: Solid Price Action with Some Negative Divergences
by Adam Oliensis

The following article was originally published at The Agile Trader on Sunday, February 19, 2006.

Dear Speculators,

The Dynamic Trading System fared well again last week, taking a profit on SPX instruments. SPY traders took a +1.2% gain off the table while auto-trade subscribers to The Agile Trader Index Futures Service netted +14% on capital. The System has been on a tear this year, closing 8 straight winning trades for +134% in net trading gains without a loser. And since the Index System's launch in mid July it has closed trades at a 75% win rate, in line with long-term historical back-testing, racking up +346% in net trading gains and a total return of +95%, net of all commissions and fees.

(Note: Trading Gains are defined as the sum of percentage gains and losses on individual trades. Total Return is defined as the portfolio's percentage gain relative to its initial value. Because the portfolio does not allocate 100% of assets to each trade these figures are not identical.)

Of course the System may not always perform as it has over the past 7 months. And past performance is not a guarantee of future results. But so far, so good. And we'll continue to trade the System's signals carefully and with discipline.

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Let' check in on how the market is doing relative to our forecast for 2006. If you'll recall previous weeks, we've been looking for the market to top out by mid February, which is right where we are now.

The analogues of 1966 and 1994 are still in our minds as we anticipate that a move lower into October of this year will be forthcoming.

The correlations noted on this chart are continuing to improve, albeit fractionally. And they will continue to do so if the market follows the script that they have written. However, if those correlations begin to deteriorate then we'll have an indication that the market may be planning to diverge from the script (and continue to rally).

This past week's rally left the SPX at a weekly close just -0.4 points below its Jan. 13 weekly close of 1287.6. And there are several ways to look at this story as it unfolds.

This weekly chart of the S PX is busy with a horizontal support line (black at 1245), a parallel trend zone (bullish in pink), and 2 possible longer-term lines of rising lows (red -- one intact the other broken).

The SPX is above important support (1245), at the top of a parallel trend zone (regression to the bottom would imply a test down toward 1200), and either holding support on top of an intact trendline or rallying up to test a broken trendline from below, depending on your predisposition.

Any way you slice it price levels are solid, but momentum measures are deteriorating. So, how should we think about this chart? Let's go to our confirming/diverging indices to get a broader perspective:

The Dow has broken 11K to the upside and to a new cycle high. Its Relative Strength (RS) line has shot through its moving averages and is a positive. Nothing wrong with that price action...except that the index is now at the top of a rising wedge, which is often a reversal formation. A break above 11,200 would kill that wedge's bearish implications and could cause the bulls to charge. Failure below that level suggests a test of the lower limit of the wedge with the risk of a breakdown.
The Transports are likely exhibiting bullish price action and RS. But like the Dow, we may be seeing deteriorating momentum as the upper limit of the rising wedge presents resistance.
The S&P 100 has failed to break to the upside. A move over 590 would help confirm the Dow's breakout. But we continue to see poor RS on this chart, though that may be just beginning to change.
The Morgan Stanley Cyclical Index may be running into some trouble. The gorgeous RS trend is in some jeopardy. Above 800 (now 802) this index is in good shape, but a break below 800 projects a test of 785. If that fails then watch out for 700. There's nothing wrong with price here, but waning momentum has raised a yellow flag.
The S&P MidCap index continues to show fairly solid price action. However the RS line has broken its 20-dma to the downside for the first time this year. Another yellow flag. (Not red, just yellow.)
The SmallCaps on the Russell 2000 are stronger than the MidCaps The uptrend line is intact. Only a failure to break 740 would raise concerns.

The overall impression from the broad market is pretty positive, though there are some yellow warnings flags in terms of momentum and Relative Strength.

Market internals are of interest as well:

The NYSE Cumulative Volume line is consolidating above support, with its RS line doing likewise. Not bad. We'll keep an eye out for either a breakout to new highs or a breakdown below support as the next "tell."
The NYSE Advance/Decline line is weaker. Note how its RS line declined during the market's Oct-Dec rally, and has been making only "moribund feline rebound" gestures since then. If the market is narrowing, that's another yellow flag.

In Tech land the Nasdaq Composite continues to consolidate between support at 2150 and resistance at 2300-ish. Again, while price action is solid, momentum has gone flat since November and Relative Strength is showing some signs of decrepitude.
The situation is even more pronounced on the Nasdaq 100, which is leading the Nasdaq down.
The Sox has been the stalwart of Tech Nation with semiconductors attracting investors' interest. The trend zone here is intact and the RS line is fairly healthy. The key here is whether 560 can be durably broken to the upside. If so, then the broad market rally may have some legs. If 560 fails, then we'll have another warning flag.
Breadth on the NDX is execrable. An broad market breakout would likely require the NDX Adv/Decl line to show positive RS.

BOTTOM LINE: While our cyclical outlook calls for a market top to be forming now, there are few signs of significant price deterioration on the indices. That said, we do have a number of warning signs on Momentum and Relative Strength. So, will the broad market follow the SOX and the Transports higher or will it follow the Nasdaq 100 lower? The 2 nd half of February could be key in determining the next mid-term trend.

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EARNINGS, VALUATION, AND THE YIELD CURVE

The SPX's Consensus Forward 52W EPS Estimate (blue line) continues to creep higher. However, since consensus estimate for '07 i not out yet, the forward series (blue line) is using a proxy for 1Q07, and so it will be subject to revision. Trailing 52W Operating EPS (yellow line) ticked down for the first time since October last week. Downward revisions to EPS for the financial sector in 4Q05 were responsible. Moreover, the consensus for 1H06 is also being revised downward.

Should these downward trends in revisions continue, that could create some problems on the following chart.

Currently the Y/Y growth in the F52W EPS estimate (blue line) is at a robust +14%. However the 3-month annualized rate of change (red line) has fallen sharply. A quick rebound on the red line could save the blue line from a decline below the +10% level. But if the red line cannot rebound, then the blue line will begin a more serious descent. And, as we have discussed in the past, when the blue line is either declining below +10% or is below the ZERO line, the market generally provides some problems for the bulls.

So, stay tuned.

With the Yield Curve already inverted at terms between 6 months and 30 years...

...most "carry trades" (borrow short-term and lend long-term) now carry an intrinsic cost rather than an imbedded profit margin. And that makes it more difficult to borrow money...which in turn, often works as a brake on economic growth.

With the difference between the yield on the 10-Yr Treasury and the Fed Funds Rate just a hair above ZERO...

...the entire curve is now on the verge of getting dunked under water.

The market's recent optimism suggests that it believes that the Fed is just about done and that the Curve will steepen again soon. We see that optimism in the PE -- red line -- beginning to rise ahead of the blue line on the chart above. Now, generally the market's PE does tend to lead the yield curve (note how the red line fell ahead of the blue line in '04). But if the Fed continues to tighten, and/or if foreign central banks continue to buy longer-dated US Treasuries, thereby driving down long-term interest rates, then the Curve will go deep underwater and we could very well see existing "carry trades" forcibly unwound. And that could have some ugly consequences.

With inflationary pressures mounting (capacity utilization is tightening, employment markets are taking up slack, upward trends in commodity prices are not yet broken, headline CPI is rising, long-term rates are too far below nominal GDP to NOT be inflationary) the Fed may be FORCED to continue to raise rates beyond (whatever is) NEUTRAL.

Our cyclically bearish outlook for a market retrenchment between now and October hinges on the Yield Curve's full-on inversion. Should the Fed manage to avert that inversion (or avert its being sustained and severe) then it's possible that such a retrenchment could be averted.

Any way you slice it, we suspect that 2006 will see market volatility rise significantly, and that should be a net positive for our Dynamic Trading System's results, as the System tends to thrive on volatility.

Have a great week! Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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