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Adaptive Optics - Are You Listening?

Opening Whisper

Being an amateur astronomer, and very amateur I might add, I have been fascinated with the concept of adaptive optics in astronomy. Adaptive optics are used to modify the distortions in incoming light to produce an image that compensates for the detrimental temperature and atmospheric effects. The illustration (courtesy of Gemini Observatory) shows a simplified concept in which the distorted image is reflected off of a deformable mirror. The "distortions" are captured by a computerized feedback control system which continuously quantifies the magnitude and phase shift of the distortion. That reverse feedback is then fed into the secondary mirror (illustration) which changes its shape to correct the fuzzy image and produce an amazing image quality. You can read more and see some of these amazing images at the Gemini Observatory website www.gemini.edu.

Wouldn't it be wonderful if we had this kind of technology that we could apply to our financial markets? This week the equity markets needed just such technology to filter out the distortions caused by Google's blow-out earnings and the week's options expiration. Technical analysis does provide us with some mathematical techniques to filter the noise and find the underlying trends. But as far as this week goes, I believe that the best way to reverse the distortions of the week is to forget about Wednesday, Thursday and Friday! No, really! I am serious! Just look at where we were on Tuesday and Friday at the close;

Tuesday Oct. 18: S&P 500 was at 1178.14, Nasdaq 100 was at 1538.43
Friday Oct. 21: S&P 500 was at 1179.59 (flat), Nasdaq 100 was at 1565.12 (up 1.7% over Tuesday)

For all of the gyrations of the week, SPX was basically unchanged from the Tuesday close. NDX was up 1.7% from Tuesday to Friday and that can be substantially attributed to one company - Google. The question for those of us who try to put our bias' behind us and use "adaptive listening" techniques is this; Can Google carry the Nasdaq market to new highs and can the technology strength of the last few days pull the whole of the equity markets higher? I think not. If we use our filtering techniques to reduce the distortions created this week I believe that we will arrive at a correct conclusion on the underlying trend in this market.

Those of us who give credence to technical analysis know that price contains all factors. But we also know that price contains a lot of noise . Sometimes it contains more noise than at other times. This week was very noisy. This weekend, we need to discount the shortest term, fastest indicators and look to the slower indicators to give us the clarified picture of where we are going next. That is how our adaptive techniques filter noise.

This Week's Technical Perspective: This week produced a divergence between the Nasdaq and S&P-500 indices. On the week, the Nasdaq 100 was up 1.35% and the S&P was down 0.6%. So what is the verdict on the week? Thumbs up or thumbs down? Well, to give us another point of evidence, the Russell 2000 index was flat (down 0.07%), but that number was levitated by the irrational "googlization" on Friday.

The following chart of the OEX (S&P 100), reveals some of the worst damage of the week. The OEX has been in a steady weekly downtrend since the 2nd week of September. The Slow Stochastic, StochRSI, and CCI have all gone to oversold conditions on a weekly basis. The OEX may be the best case for an oversold bounce. The other indices are not so decidedly in oversold territory.

Have we bottomed on these oversold conditions? Can they get worse? Volume has picked up during the decline.

6 Month Weekly - OEX

Shall we try to invent a bounce and new uptrend on OEX at this stage? No way. Our trend following methods tell us that these large cap stocks are in trouble and that any bounce from here is likely to be a "contra-trend" move and not the real deal. If there was any good support level for OEX in this area, you would have thought that it would have been at the 550 level, particularly for an options expiration week. OEX closed the week at 544. That is very close to the six-month low of 542 from back in April.

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Next week, if OEX fails to hold the current 545 level, the next stop is 520 which are the lows from August and October of 2004. The OEX is at a do or die support level. Watch for the bounce or crater action next week. The people and institutions who own these large cap stocks are smart people. Take a hint from them and watch what they do next week. If they sell, we will likely sell the NDX as well.

The fact that the Nasdaq tech bounced higher this week than the other indices, can be justified on the basis of its higher beta (and Google). The forensic evidence for any year-end rally will come when we see higher highs and higher weekly closes for more than one week at a time. Lower highs and lower closes have been the norm in recent weeks. Another point; notice on SPX that all rallies since August 1 and been sold off with greater frequency and greater declines. Selling into rallies is a sign of the prowling bear.

This Newsletter is provided to those who are interested in looking for an alternative to the "buy & hold" investing mentality. This information is not intended as trading advice. It is intended for your information and education only. You should consult a Financial Adviser before attempting any trading strategy.

TREND FOLLOWING COMPLIANCE: This week we are repeating our chart of the Russell 2000 vs. SPX relative strength. As we can see, there has been a slight up-tick in the Russell, but the down-trend of the ratio is still intact. Not much change of the trend.

Frequently we listen to what the Russell is telling us for a clue to the market's next turn. The message here is that there is no turn yet visible.

1 Year - Russell 2000 / SPX Ratio

The following chart tells a completely different tale. The NDX vs. SPX relative strength has dramatically changed its picture this week with a large differential gain of the NDX over the SPX. [(+1.35% - (-0.6%)] = +1.95% relative gain. The ZigZag lines on this ratio now tell us that a consistent uptrend has been in place since the April lows.

We need to be cautious on our use of relative strength ratios. These ratios are excellent at identifying the market turns when at extremes, but when they get long in the tooth, they tend to lose their forensic forecasting capabilities until the get past mid-range.

1 Year - NDX / SPX Ratio

Since we have a difference of opinion between what RUT/SPX and NDX/SPX is telling us, let's take a look at the RUT/NDX relative strength ratio to find out which index has more relative strength at this point.

3 Year Weekly Relative Strength - RUT / NDX

This 3 year chart of Russell 2000 / Nasdaq 100 relative strength is telling us that RUT has weakened relative to NDX for the last 3.5 months. The ZigZag indicator on this ratio also reveals a decreasing cycle period, i.e., quicker zigs and zags. I believe that this is indicative of a top formation.

NDX ZigZag Compliance Chart - 5%

Our Fault Tolerant Cash Safety Stop is calculated as of the close on Friday to be 54 points. Since we are in Cash, we do not need an exit stop level. Should we get a Buy or Sell signal on Monday before the close, we may then use our 54 point calculation to judge our exit point. However, a 54 point stop is equivalent to 3.4%. Given our use of 2x leverage, that amounts to a potential loss of 6.8% on an initial entry signal. That is quite a price to pay to find out that you are wrong. We may set a closer stop initially and then widen it if we get a move in our direction.

If we get a signal mid-week, subscribers will receive instructions and a revised trailing stop level. Market Listeners will get those instructions via email. Market Listener Founder discounted subscriptions are still available, but only until October 31 . For details send an email to: subscribe@MarketListener.com with "FOUNDER" in the subject line.

RISK ASSESSMENT: SPX remains below 1200. This appears to be the make or break level for the next rally. Yes, NDX is up 3% off of the recent bottom. But we need a broader participation in all market indices to get us to go long at this point. The risk for not buying is that we will miss another 2% of a potential rally. The risk to buying is that the downside sell-off might include some capitulation selling. Make a guess for the next 2 weeks; possible upside rally? 5%; a possible downside sell-off? 8-10%. Cash is good until we get a confirmed direction. We don't need to be in the market just yet.

Our Trading System – What The Numbers Are Telling Us

Here is our review of the NDX weekly model chart (below).

Slow Sto - Stochastic : Remains in down trend sell signal. We have not seen the NDX Slow Stochastic at this level and moving down since January 2005 and we all know what happened in the first couple of months of 2005.

StochRSI - This indicator has gone fully oversold but can stay oversold for some time as witnessed by what it did in early 2005. I would sit up and take notice if StochRSI moves above 0.50.

Volume - Volume remains above the 60 EMA, but has apparently moved down for the second week. Is volume weakening? Maybe. Weakening volume on upward price movement is a divergence that may be telling us that this NDX rally is losing its strength.

MACD - Our upper MACD ( 12-26-18) made a crossing of the zero line last week and the histogram lengthened in the negative direction. This is another indication of a retracement that is coming to an end in that the price rise is fighting with weakening moving averages.

You can read more about these indicators at: http://stockcharts.com/education/

NDX – 1 Year Weekly Chart Model – Friday Oct 7, 2005

Our stop was hit at 1559 on Wednesday and booted us to cash. We came out of that Sell signal with a slight 0.6% profit. The circuit breaker worked, but now we need to re-analyze where we are in our weekly model.

StochRSI and CCI have just barely peeked above their buy lines. But these are not confirmed by the Stochastic yet. We need SlowSto, StochRSI and CCI to VOTE TOGETHER against the MACD to advise us that we have evolved into a Buy signal. Dips of all indicators back below their "buy" lines would give us ammunition for a re-entry of our sell signal.

Let's take a look at one more NDX chart to make sure that we have covered all of the bases. I have made several points on the following 30 day chart. The most important one in my mind is the orange support/resistance line. If we break out definitively to the upside above 1575 from here on NDX, then we will have broken through that former resistance line at about 1570 or so and the rally could have more upside.

My conclusion from these charts is that the NDX rally of 3% off of lows has nearly run its course. The retracement of the downtrend off of the recent low is very close to the 62% Fibonacci number.

30 Day 60 minute Chart of NDX

What About Gold? - The gold miners had another bad week being down 2-3%.

Newmont Mining (chart below) and the other miners are in Sell signal mode. It would take a huge reversal to turn this chart around. We need to wait for NEM to form a base on the StochRSI and perhaps let the Slow Stochastic get to the oversold 20 level on the weekly before we even consider a Buy signal.

NEM is in SELL mode. Wait for StochRSI to form a bottom and then turn up before considering a buy.

1 Year Weekly - Newmont Mining

What Is The Current Market Sentiment?

The 8 day moving average (DMA) of the CBOE Total Put/Call ratio is the single best argument for a rally that we have. The CPC is working down from its peak above 1.3 and that downward movement is a bullish signal. We have had a "buy alert" for two weeks now. However, there are two reasons why we might choose to minimize those buy alerts or delay in taking them as a signal.

1. The "buy alert" came at a point much too close to a recent high. We are within 4% of recent highs and not at significant lows and turning up.

2. There may be some structural put/call reason as to why the peak in the 8 DMA is not as significant as it looks. This peak in the 8 DMA seems to be the result of a general and slow growing "bearish" sentiment rather than a capitulation sell-off. We have had no real capitulation yet. When we get that 2.5% down day on the major averages, then the selling may be close to an end.

One Month - CBOE Total Put/Call Ratio (Daily)

The VIX and other sentiment indicators are also leaning toward a bullish interpretation, i.e., too much bearish sentiment which is a contrarian sign and therefore bullish.

Our proprietary adaptive MACD calculations which are based on VIX and CPC have just "curled up" slightly. They are nowhere near a Buy signal just yet, but could flash us the buy signal next week if things get moving upward. We will let you know.

Where Do We Go From Here and How To Listen For the Next Signal?

Sentiment is telling us that a rally could be near, however the non-technology indexes are dragging their feet and keeping us from being raging bulls at this point.

The Nasdaq Summation index is still accelerating down in spite of the NDX volatility of the week.

No hint of any turns yet. Keep watching this one.

6 Month Daily - Nasdaq Summation Index ($NASI)

The SPX is still firmly entrenched below the 1200 level as shown below. The key to a year-ending rally seems to be the SPX getting back above the 1200 level. If our bullish sentiment signals are valid, then SPX is likely to break out and confirm what the NDX is telling us.

2 Year Weekly - S&P 500 (SPX) Support/Consolidation Levels

The Markets Are Whispering - Are You Listening?

So here is our plan for next week. Watch to see if SPX rises above 1200, I might hesitate to go to a Buy signal until the day after the SPX closes above 1200 if it looked like the 1200 level was now going to be support for the rally. Our weekly NDX chart will give us clues also.

Market Listener Trend Timing Signal Summary

Current Signal: 100% CASH (Bought Rydex RYMXX Gov't. MM Fund)
Subscribers were advised in advance of our stop level of 1559 and by email on Wednesday Oct 19 that we were close to our stop level.

Fault Tolerant Cash Safety Stop - There is no stop level as long as we are in cash. Stops are only used to exit vulnerable Buy or Sell signals.
We will issue an email to subscribers next week if we get a buy or re-entry sell signal.

ML Signals & Results

(YTD Return approx. + 26.5% as of Oct. 21 / 6 mo. Return= 6.6%, 12 mo.= 60.7%)
Recent Signal Slo. Stoch.
ML Signal3
Oct 19, 2005 Sell Buy - Sell Cash
Oct 05, 2005 Sell Sell Sell Sell Sell (100%)
Sep 30, 2005 Sell Buy - Sell Sell (50%)
Sep 15, 2005 Sell Sell - Buy Sell
Sep 14, 2005 Sell Sell - Buy Cash
Sep 07, 2005 Buy Buy Sell Buy (mod.) Buy
Sep 06, 2005 Buy Buy Sell Neutral Cash
Aug 08, 2005 Buy- Buy Buy Buy Sell
Aug 04, 2005 Buy Buy Buy Buy Cash
July 08, 2005 Sell Buy Buy Buy Buy
June 24, 2005 Sell Sell Sell Buy- Cash
May 13, 2005 Buy Buy Buy Sell++ Buy
May 06, 2005 Buy Buy Buy Sell+ CASH
Feb 11, 2005 Sell Sell Sell Sell Sell
Feb 04, 2005 Sell Cash Sell Sell Cash
Jan 14, 2005 Sell Sell Sell Buy Sell
Dec 31, 2004 Buy Buy Buy Sell Cash
Aug 27, 2004 Buy Buy Sell Sell Buy
3This Market Listener signal is our base signal. The MACD is our primary weekly input, but can be "out-voted" by the other faster indicators on a daily basis when we need to go to cash to implement our Fault Tolerant Cash Safety Stop (FTCSS). You should not base your trading on this or any other single indicator. Our trend following system dynamically adjusts parameters based on current market conditions including volume and sentiment factors.
With Rydex Dynamic funds, we can trade in the morning and 5 minutes prior to the close during the trading day/week when we see that one or more of the fast signal indicators have changed signals. This is particularly important if we need to go to a CASH position in order to preserve capital. The above table shows the results of the Adaptive System Model Signals.

Listen To What He Says

KJV Psalm 116:1-2 I love the LORD, because he hath heard my voice and my supplications. Because he hath inclined his ear unto me, therefore will I call upon him as long as I live.

I am working on the art of listening and hope that you are also.

Best Profits,

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