Weekly Trader Alert #94
3/6/2007 9:34:58 AM
The rise of volatility was clearly the theme of the last week, or perhaps it can be simplified as fear. Volatility has to do with price action and its behavior relative to a current norm. Implied volatility is determined by the premium charged to put buyers. Sometimes the two are used interchangeably, but they are clearly different terms, and have different meanings. With that said, both rose in the last week.
The VIX and VXN moved markedly higher in the last week, closing at levels not seen since the bottom in mid-July '06. One thing to note about the implied volatility that the VIX and VXN represent, is that bottoms are marked by reversals from high readings, not by absolute high readings. We will have to monitor these as indictors that a bottom has been reached.
A week ago, trading ended the week on a down Friday in the markets, which generally indicates a down Monday, which was indeed how the week started. However, Tuesday's gap lower was extreme, as was volume and follow-through to the downside as a sell-off began. What caused this to happen?
Well before the open, the Shanghai market closed down 8.8%, the largest one day decline in ten years. This infected all other equity markets as all that we track closed down. It was a record day by a number of measures, but as a percentage move, wasn't as extreme as seen in the past. The Shanghai market was up 150% in the last year and a half, so a correction is relatively small, especially given that the market was up some 13% over the previous six trading days.
It is worth shining a spotlight on the nascent market in China. The Shanghai market is only about 15 years old. It is a market of speculators, rather than the more sophisticated market you see in U.S. exchanges. There are stories of middle-class people mortgaging their homes to trade the markets. Essentially, trading in the Shanghai market is more akin to gambling. Only about 1% of stocks traded on the Shanghai exchange are held by foreigners. So how could one market, 99% held by Chinese traders affect so many others?
The Asian economies, like the world economy, are intertwined, so worries of an Asian Contagion are being discussed. This stems from the last meltdown in Asia in the 90s, due to monetary policies in the 90s. These aren't a factor now, but there is general nervousness anyway.
So what was the real factor in the sell-off in all markets on Tuesday? We would attribute it to complacency on the part of investors coming to roost. A correction has been long overdue, so the markets were psychologically ready to act on a catalyst. What was that catalyst?
Certainly the sell-off in China and the other Asian markets was part of it, but what really caused that to occur? Former Fed Chairman, Alan Greenspan, happened to be addressing a conference in China at the time and suggested the U.S. could enter a recession by the end of 2007. This may have been taken out of context, but you may recall Greenspan's "Irrational Exuberance" speech which started to market collapse in 2000. The Maestro, as Greenspan is sometimes known, may have spoken candidly, but he is still a figure of great import in the financial world, and could very well have been the catalyst to cause the sell-off in China and other markets as well. This builds on the fact that the US consumer has driven a large part of China's export trade that is a mainstay of its economic growth.
After Tuesday's sell off, Fed Chairman Ben Bernanke addressed Congress on Wednesday to calm the markets as he suggested that nothing had changed fundamentally in the economy since he addressed Congress the last time. He suggested that the sub prime lenders problems wouldn't spread to the broader market. The market moved up noticeably while Bernanke was answering questions on the stock market and he is being credited with helping to calm concerns.
Before we go deeper into what the rest of the week held, lets review economic reports released during the week.
Monday: There were no economic reports released on Monday.
Tuesday: An hour before the open, durable goods orders were reported at a -7.8% annual rate for January, with a -3.1% with transportation excluded. Expectations were for a -3.0% headline number and a +0.2% ex-transportation. Probably the most important is that business spending is down 6%, which is quite bearish. Housing starts were above expectations at an annualized 6.4M versus and expected 6.24M. Finally, Michigan Consumer sentiment was reported at 112.5 versus an expected 109, which in itself is quite bullish.
Wednesday: Wednesday's economic reports were disappointing. GDP was revised down to 2.2% annual growth, down from the preliminary number of 3.5% a month ago. The February Chicago PMI was reported at 47.9%, its lowest level since April 2003, and an indication of a contracting manufacturing sector. New home sales for January fell an astounding 16.6%, its largest drop in thirteen years.
Thursday: Reports came in two waves on Thursday...
Economic reports released an hour before the open included:
- personal income rose 1% increase in January, versus an expected 0.3%
- personal spending rose 0.5% in January, versus an expected 0.4%
- initial jobless claims were reported at 338K versus an expected 325K
Economic reports released during the trading day included:
- Construction spending (Jan) at -0.8% versus expectations of a drop of 0.4%
- ISM Index came in at 52.3 versus an expected 50 (manufacturing is growing)
The optimists will cheer all of this except the construction spending, which suggests that housing continues to weigh on the economy. The jobless claims have been elevated for three weeks now, so becomes a concern that a new higher level is being established.
Friday: Michigan consumer sentiment was reported at 91.3 versus an expected 93.3. You will recall that two thirds of the economy is related to consumer spending, so any retreat in sentiment here will cause great concern among investors.
After the markets moved higher from the open on Wednesday, the market opened markedly lower on Thursday due to worries over the Yen carry trade. The chief financial official in Japan suggested that the trade was not one way, which after Tuesdays 2% rise in the Yen's value versus the dollar, drove the Yen up even higher. Some investors took this as a sign to repay their Yen loans and thus closed their US equity trades to create the funds necessary to repay those loans.
This is bigger than it may appear on the surface, as now the worry is that all the hedge funds that have been using inexpensive Yen loans will look to unwind these trades at the same time, causing further weakness in the markets as these positions are liquidated to generate funds to repay the loans. This is a rather serious concern, as it has been obvious during 2006 that we had a liquidity fueled rally, based on private equity monies, hedge funds (using the Yen carry trade), and foreign investors. If any/all of these are withdrawn, the equities markets could collapse.
Oil rose fifty cents for the week closing at $61.64. The next resistance level above lies at $64. Natural gas fell by a like amount, closing at $7.243. Both energy products continue to find support above their uptrend lines.
If you will recall, a week ago, the major bullish argument was that the Fed wouldn't raise rates due to concerns over the collapse of the sub-prime lenders, and its possible effect on the rest of the economy. This was meant to counteract the Fed's need to raise rates in the face of rising inflationary pressures. Reflecting on this only a week later, it is clear that the level of risk in the market continues to rise as prices have been since last summer.
You may recall that by Tuesday, Iran's defiance of the UN was in focus, an assassination attempt on US Vice President Dick Cheney was unsuccessfully carried out in Afghanistan, in addition to the comments by Alan Greenspan, and the market sell-offs experienced around the world. Add in the back pedaling from the Yen carry trade and risks are clearly on the rise. The market seems to have finally shifted to begin to confront those risks rather than continuing to ignore them, which is causing the markets to retreat, as risk is starting to be priced into the markets.
Oh yes, we almost failed to mention that all of this is happening as the markets are slowing from the average S&P-500 company double digit earnings gain in the last reported quarter to an expected 5% gain and a soft landing or recession in the cards for later in the year. Don't mistake that we continue to believe that company profits will continue to grow, and growth is good. It is just that there are a lot of risks out there that have been overlooked, and until these come into focus, we believe the markets are vulnerable to a continued sell-off.
Last week, after suggesting that investors have been ignoring risks, we acknowledged that this had been going on for some time, and that some catalyst would be required to cause a change in the relentless bullish behavior. We received that by last Tuesday, so we now have to wait for the dust to settle.
To understand more about our view on the markets, we will have to look at the charts.
The market began the week with a continuation of its move lower at the end of last the prior week. The common saying in the markets is that weak Fridays lead to weak Mondays.
On Tuesday, the bottom fell out, and as we discussed in the Overview, risk is starting to be acknowledged. The behavior that has been rewarded since the summer of '06 was followed, but may no longer be working. Buying on the dips in a bull market tends to be a rewarding strategy early on in the bull market, but become riskier the longer the market continues, as it eventually becomes more bearish.
Volume has increased, similar to what happened a year ago at the end of February '06. Last week we noted that the small caps and NASDAQ continue to move upward, and the adoption of risk may mark the end of this uptrend. You can never be certain of how far a move will continue, but we do expect follow-on downside action, so we should look at the individual charts to gain further understanding.
This week, we will take a look a year back at the US Composite and then a closer view of what is happening right now.
The U.S. stock market composite chart (A year long look):
Looking back a year, the market actually saw extreme volumes at the end of February 2006. We don't know why it occurred, because it isn't a regular pattern in previous years. However, what is of interest is double bottom pattern in June and July 2006. You may note that on the first leg down to the June bottom, it was in May that RSI hit its lowest point, which was below 3.0 (on a 0-100 scale). The actual bottom saw an RSI of just below 23. The second bottom (in July) saw RSI as low as ten and half before reversing higher. MACD also, similarly showed the lowest value early on and never reached that low a level as the market retraced to the double bottom.
What we are stating is the initial thrust lower, as measured by price, may see a divergence with the indicators. We are only on a first leg of a downward move here. If there were a second leg, you might see a divergence with RSI not making a new low with price, while MACD may initially follow price downward. That would suggest the market is bottoming. If both indicators moved lower with price, this would have more bearish underpinnings.
The U.S. stock market composite chart (A close-up):
The daily chart shows that price has continued to move down, following the lower Bollinger Band. MACD just crossed below 0, which often is the point at which you will see a bounce before a continuation of a move downward.
Last week, we used the semiconductor index as an indicator of where the NASDAQ, and therefore, the general market might go. Well, clearly the market headed downward last week, with the semiconductors leading the way down.
The weekly chart of the semiconductor index (INDEX:SOX) is below:
While this doesn't show Monday's trading (it is a weekly chart and would be skewed to show a single day), it is obvious that the market turned lower, and wasn't able to break through resistance.
The daily chart of the semiconductor index (INDEX:SOX) is below:
Monday's trading was also to the downside, with an inverted hammer suggesting a possible bottom here. You will note the parallel uptrend lines which suggests the SOX is actually finding support here, readying for a move higher.
This would have ramifications to the health of the overall market, as the semiconductors are an influential sector determining the course of the NASDAQ.
There is one builders in the top five industries, and three others in the top screen. This means one of our builders has dropped back a bit, as there are some concerns over a slowing economy (not much concern as of yet). Funeral services have been a much proclaimed growth industry as aging baby boomers are dying to find a final resting place (yes that was a terrible pun, but I couldn't resist). Interestingly, the strength of the auto and truck tires industry that we have monitored for months continues. After doing some digging, this doesn't have anything to do with passenger cars and trucks, which we know has been somewhat weak domestically. Rather, there is a tire shortage for all those large mining and construction vehicles giving sustained demand and pricing power to tire makers, such as Goodyear and Cooper tires. We have been watching the charts, and even though there hasn't yet been a sign of their slowing down, the charts look like they are racing to a blow-off top. We will monitor these stocks for a quick blow-off move that would be a shorting opportunity, although not necessarily for a very long period of time, probably after a short covering rally caused them to achieve the blow-off top we are looking for.
The fertilizer makers continue to back in the returns offered by constant demand by the foods industries. Interestingly enough, the most effect inflation is having on consumers is in the price of food. While oil and gasoline prices grab headlines, about twice as much of a consumers budget goes for food. Food prices have been increasing noticeably for more than a year, and the food producers and related industries (fertilizer) have benefited from this trend.
The Dairy and Meat industries are in seventh and twenty-third place respectively. Another Food industry, restaurants is also in the top screen.
The US Integrated Oil industry moved from eighteenth to second place as market pundits continue to say that money is being rotated out of oil and commodity plays. We don't think that this trend has played itself out yet, due to the lag on exploration projects that can begin to produce new supplies of oil.
The Industry leaders (ranked 1st-5th out of 190) are:
Personal (Funeral Svcs)
Food (Dairy Products)
Petroleum (US Integrated)
Personal (Funeral Svcs)
Auto & Truck (Tires/Misc)
Building (Maint and Svcs)
With all the negative talk about the sub prime Mortgage lenders, the mortgage industry has moved out of the cellar dwellers. Plastics makers are back in the cellar dwellers as are appliance makers.
The Industry laggards (ranked 186th-190th out of 190) are:
Retail (Consumer Electronics)
Petroleum (Cdn Expl/Prod)
Retail (Consumer Electronics)
Petroleum (Cdn Expl/Prod)
Petroleum (Cdn Expl/Prod)
Petroleum (Intl Specialty)
Financial (Mortgage Svcs)
We will wait to see how trading progresses Tuesday before adding to our half positions or adding new trades here.
Last week's newly entered half positions suffered as the market sold off vigorously. However, these stocks are all near bottoms, with RDY and ROG both showing signs of readying to bounce.
BPT looks like it may fluctuate a bit in the next week as oil sold off on Monday and BPT moved down in sympathy.
FDG moved up toward the $26.00 level we suggested it would, but never made it as the market downturn moved it down, coupled with an announcement of a sixty-five cent dividend payment, which was disappointing and attributed to the weather. While it is FDG seasonally weakest quarter, it caused the stock to see a fair amount of distribution to a level around $21.00 on Monday. This may well be the nadir, but bears watching. We are long FDG.
* 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:
We believe that the markets may be likely to bounce here, but may then move lower again before this move is finally completed. We are going to position ourselves in long positions to ride up from the bottom. Since we are cautiously entering only half positions until we have confirmation of a bottom, we are still mindful of a possible further move down.
Oil remains above the $60 level, which will cause consumers to tighten their wallets. More importantly, food prices remain high which will affect the consumer all the more.
We remain cautiously optimistic that the markets could find a bottom here, but we'll have to see more how trading goes on Tuesday.
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Regards and Good Trading,