Weekly Trader Alert #74
10/14/2006 6:48:30 PM

Overview

The market is moving higher, convinced that the Goldilocks economy is in place. Optimism is a wonderful thing, and the markets are just that. We will not suggest investors and traders are wrong to be optimistic, as the direction of the crowd, is the direction of the market.

With the liquidity of money leaving commodities trades, and leaving the real estate market, it has to go somewhere. With the dollar strengthening against other currencies, foreign investors will also be more likely to flow money into U.S. markets. All of this is powering equity prices to climb higher, as money flowing into the market has to be put to work.

Consumers continue to spend, although the latest report showed a pull back of 0.4% in spending. Although that might have been cause for concern, those concerns were dismissed due to the 9.3% drop in the price of gasoline. When gasoline is excluded, consumer spending actually rose by 0.6% last month. Consumer sentiment is also on the rise with the Michigan Sentiment Survey showing a reading of 92.3%, over 6% higher than consensus estimates.

The uptrend has been solidly in place since mid-August. Professional traders have been waiting for a pull-back to enter the markets uptrend. In hindsight, anyone wishing to get long should have done so by mid-August and just let the money ride. But hindsight it always easier than trading, and so a number of traders find themselves needing to get on that bullish train, and are getting frustrated there has not been a nice pull-back to do so. When greed takes over and everyone is worried they will miss the train, there is usually a flood of money powering stock prices ever higher, until there are no more buyers, as everyone has climbed aboard. It is these times that it is dangerous to be attached to stocks in your portfolio.

The late nineties saw this sort of a market that lasted for a couple of years. People at cocktail parties were all talking stocks. More recently, cocktail party conversations were about real-estate investments and commodities. With the air being let out of housing and commodities, and energy prices having fallen from their highs, cocktail party conversations may once again include discussions of the stock market. Indeed, with the Dow hitting new highs daily, the S&P-500 hitting five and three quarter year highs, and with the NASDAQ within fifteen points of its highs this year, cocktail party conversation could once again turn to stocks.

We still believe that market participants are disregarding negative signs, as was evidenced on Wednesday and Friday. Alcoa reported a big miss which started the Dow down on Wednesday. Bellwether GE met analyst expectations and is growing at about a six percent annual growth rate. The Dow opened down on this news but recovered, even with rising oil prices on Friday to power higher. The markets ignored North Korea's claim of a nuclear weapon test, and Iran's continued defiance of UN calls for it to reign in its nuclear program.

Noting market participants' penchant for good news, and their dismissal of negative news, the market is clearly of a mind to move higher. With that said, technical indicators show the market as overbought, and some correction is more than possible in the near term.

The price of oil seems to have stabilized under sixty dollars ($58.57), and natural gas has once again been falling, having closed at $5.66 on Friday. Although the fall in the price of natural gas has been at a significant rate (remember, last Friday it was nearly a dollar higher), Friday's price movement moderated so the downtrend could be slowing. New York has seen its first heavy snowfall of the season, but with the historically high amount of natural gas in storage, it will take a cold extended winter to move prices up significantly in natural gas.

Leadership, which has been one of our concerns, seems to be shaping up to be tech. This is a clear change that we have been waiting for to signal that there will be sector leadership besides retail or energy. In fact, tech has been the first sector where there is a movement into risk, rather than defensively positioned industries. Mind you, defensive plays continue to be in the leaders, but the move to risk signals the uptrend may be sustainable.

We have been decidedly pessimistic in our outlook, and we would like to change that to being guarded. The market is telling us that it wants to move higher. If the Goldilocks scenario continues to unfold without unraveling, then the bull market could continue. We do believe that there are risks to this progress, and will be looking to take advantage of a continued run upward in tech, while keeping a watchful eye on downside risk.

Last week we mentioned that we decided to re-examine our system trading models. We actually use two different timeframes in our models, for signals, and some longer timeframes to indicate overall trend. You are already familiar with the moving averages, and how price has climbed above all the ones that we track on a weekly basis. Although these aren't the indicators we are referring to, it illustrates that price will cross moving averages at different times, which allows you to define whether markets are in an uptrend, trading sideways, in a downtrend, or in a transition state.

We are going to make the intermediate term signals primary, instead of one of the shorter term signals we had been using. This will allow us to enter trades in a timely manner, but keep us from entering some counter-trend trades that haven't worked as well over the last couple of months. So that you are not alarmed, these are the indicators that we have used as our primary input to signals over the years.

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

Market Climate

The market continues to progress in its uptrend. The uptrend is now three months old and has seen the Dow hit all time highs, the broader S&P-500 index rise to nearly six year highs, and the NASDAQ rising toward this year's high. The overall market has seen a lag in small cap issues, with the Russell 2000 representing the largest of these trailing other indexes. The smallest public companies have seen the worst performance.

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:

The market continues to move higher and is trading at the top of its uptrend channel and its upper Bollinger Band. The boundaries formed an rising wedge before this, but the uptrend channel is now just that, with parallel upper and lower boundaries.

The MACD continues to rise in a clear uptrend. When it turns down, it would indicate the uptrend is pausing or over. If it crosses a downtrend would be indicated. Right now, that is just speculation, as all indications are currently for a continued uptrend, but perhaps with a pull back in the short term.

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. Since mid-August, the DIAmonds have followed an uptrend channel. The uptrend channel looked like a rising wedge until the end of the last week. With the DIAmonds are the upper limits of the channel and volume decreasing, a pull back or sideways trading action are likely.

We wouldn't want to get aggressive with short opportunities until the trend is broken.

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

The SPYders looks similar to the DIAmonds. What appeared to be a good shorting opportunity for the SPYders last week, turned out to be a bear trap. The sideways trading action for six days straight was broken out of with a move to the upper Bollinger Band on Thursday. Thursday's and Friday's volume was light, so the move upward is suspect. With that said, the uptrend would remain unbroken, even with a pullback next week to the $134 level. We will watch to see what opportunity the SPYders give for a long entry next week.

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

The QQQQs continue to move upward, having registered larger gains than the other major indexes last week. What is important to note is that they have touched the line defining the tops for this year, from January, April, and for last Friday. If resistance is seen here, then a significant battle may ensue here between bulls and bears.

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

The QQQQs have closed higher than their open for nine days in a row. Counting is a legitimate strategy in trading, and right now the odds of a pull back are high. With that said, tech is on a roll, so the pull back may take the form of a sideways move.

The 20-day moving average has served as support for this uptrend since early August. Price has rarely traded below the 3x3 Moving Average, with the last time being Oct 2nd before price bounced off the 200-day moving average. In other words this has been a very strong and steady uptrend with little room for successful counter trend trading. What that implies is to trade with the trend until something gives.

As indicated in discussing the weekly QQQQs chart, a possible battle may ensure between bulls and bears now that the QQQQs are at a resistance line. They are also approaching their 2006 top levels so either of these could provide significant resistance, or, at least, resist the initial move higher. We will have to wait for trading action in the coming week to determine whether we will see such a battle.

Fundamental Trends

Other than the one week blip of airlines showing up in the top five last week, not a whole lot has changed. Airlines fell to tenth in our ranking of 190 industries.

Retail continues to provide leadership as the American consumer continues to spend. Consumer priorities include shoes and clothing, as well as things for their homes. A report was issued late in the week that showed consumer spending slowing. This, as it turns out, was due to lower gasoline prices. When gasoline was factored out, consumer spending rose by 0.6% last month.

In addition to retail, food industries are favored and we are finally seeing tech wade in. Telecomm, Networking, Software, and semiconductors are all in the top screen (thirty-one top industries). With tech making a strong showing, we may finally be seeing the sort of leadership that can power a rally.

One surprise is that both basic steel and steel alloys are in the top screen industries now. The steel trade has been improving, so stocks related to it have improved significantly, of late.

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

The laggards list is little changed from a week ago. International Petroleum replaces Canadian Petroleum and Control Instruments are replaced by home textiles.

Coal has moved up to 178th out of 190 industries. As a source of fuel to produce heating for homes, or other forms of energy at power plants, this move has been understandable, with the drop in oil and natural gas prices. However, metallurgical coal is high quality and required to make steel. Prices for stocks that supply this have also been hurt by the general fall in energy prices, but may bounce back with the steel trade.

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

Trade Recommendations

We are going to wait to see if there is a tradable pull back to enter long positions in the coming week. We will need to see what the early part of the week brings, but it is the time when the market looks to be at its most vulnerable.

Current Portfolio

We were stopped out of the LRCX short trade as tech has heated up to have a number of industries in the top screen.

FDG has rallied with a slow rally in the coal industries, in general, and a definite rally to place both steel industries in the top screen.

We are behind a little on our short trade on the S&P-500 (Amex:SPY). We will wait one more day to see if a sign of weakness will emerge before closing this trade.

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 are amending our take on the market to suggest it may be time to get on the train as it leaves the station. That is known as greed. The opposite of greed is fear. When enough investors get greedy, then it will be time for the market to turn back down. When there is sufficient fear, the market hits a bottom.

With leadership emerging as tech stocks, it is not time to stand in the way of the liquidity rush which could be sustained for quite some time. With that said, we would like a pull back to improve our entry into long positions.

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Regards and Good Trading,