Market Approaching Critical Technical Juncture

The market is approaching a critical technical juncture. Let’s take a close look at some of the reasons why this is the case and pay attention to what to watch in the days and weeks ahead. First, both the S&P and the long bond are approaching channel resistance and support levels. The S&P has been contained by a downtrend channel on the weekly chart since August of 2000. The rallies of December 2000 to January 2001 and of March-May of this year both hit this upper trend channel resistance level and bounced down to make new lows. Currently the market is approaching this resistance channel on the weekly chart at the 1185-1200 level. The SPDRs show downtrend channel resistance at 118-120. The last two weeks have witnessed an incredibly steep decline in the long bond, as investors are beginning to anticipate an economic recovery. 

The long bond has been confined to an uptrend channel since January of 2000 on the weekly chart. Nearby bond futures show this critical weekly trend channel support at the 101.5-103 level. Bonds are acting inversely to stocks, but are also approaching a critical support level. The S&P and Nasdaq index are both also getting close to their 200-day MA resistance levels. We would therefore expect at least some kind of consolidation or decline off of these resistance levels in stock indexes. Should the Nasdaq close above 2000, the S&P close above 1200, and U.S. nearby long bond futures close below 101.5, then the technical condition of the market will become substantially stronger, and investors should adopt a strategy that is more upward biased than we have suggested at any time since March of 2000. Investors should also be on the lookout for these resistance levels holding, and indexes turning down on an intermediate-term basis off of these levels.  

I have been advising investors to watch economically sensitive commodities for some time now. In almost every economic recovery since WWII, economically sensitive commodities have based and broken out to the upside of those bases, prior to the commencement of the economic recovery. Over the last couple weeks, economically sensitive commodities have finally stopped declining, and may in fact be starting to form bases. Nearby cotton futures having broken through a major weekly downtrend line last week. Cotton needs more time to form a base but may indeed be developing one between the 30-40 level now. Nearby weekly lumber futures prices.  Lumber has witnessed a waterfall decline from 370 to 220 over the last six months, but its January 2000 lows have held and it is consolidating in a tight range just above the 200 level. Copper has been in a weekly downtrend channel since November 2000. A break above the 70 level will move copper out of the downtrend channel and allow it to form a base between 50-72. I would like to see these economically sensitive commodities ALL break out of sound bases on the upside before getting wildly optimistic about the stock market’s upside, and the emergence of an economic recovery. Watch carefully.  

I have also been advising investors to watch economically sensitive currencies, like the NZD and Aussie Dollar. Both of these currencies are forming very long and sound bases. The NZD is basing between 47.5 and 54.5 – a breakout to the upside would be very encouraging to the outlook for global economic recovery. Similarly the AD has been putting in a very long-term base between 39-46.5. Here too a breakout on the upside would be very encouraging for the outlook for a more prolonged bull market in the economy and in stocks than we have seen since March of 2000.  Ideally, we would like to see as many economically sensitive commodities and currencies confirm an upmove as possible, along with very positive action from stock indexes and leadership, before becoming aggressively bullish.  

Unfortunately, so far the breadth indicators mentioned in many of these columns since Sept. 21 have yet to flash two or more up signals. While a bull market can develop without two or more breadth signals, it hasn’t happened since WWII – an we would be a lot more confident if another one of these breadth signals confirmed stronger technical action as suggested above.

As we've been commenting since the Sept. 21 low, the most important aspect of the market, leadership, is still somewhat lacking.  UNTIL we get a lot of valid breakouts of 4+ week consolidations (flags or cup-and-handles) of upfuel stocks and/or close calls that are making our Top RS/EPS New Highs list in leading groups, THEN AND ONLY THEN will we begin steadily increasing our allocation to the long side. Here leadership has been improving slightly, but not to the degree we would like to see in order to get aggressively bullish.  I suspect that breadth and leadership will improve markedly if the market and the economically sensitive markets can all confirm a breakout as indicated above.

Let's look at the breadth numbers on our lists for the week. Top RS/EPS New Highs vs. Bottom RS/EPS New Lows for the latest week were 20/4, 14/1, 10/1, 18/2, and 10/0. This is still trading range indicative. Look for longs to 20 or higher consistently on a week before becoming very bullish.  Breakouts vs. breakdowns of 4+ week consolidations on our lists for the week were 1/3, 0/0, 1/0, 1/0, and 3/3.  Breakout numbers remain pathetic, but we did find one solid long trade, (POSS | Quote | Chart | News | PowerRating), and another close call in (CEDC | Quote | Chart | News | PowerRating) that ran away from us to much to enter via our regular strategy. 

Our overall allocation is back to DEFENSIVE with 84% in T-bills awaiting new opportunities. Our model portfolio followed up weekly in this column ended 2000 with about an 82% gain on a 12% maximum drawdown, following a gain of around 41% the prior year.  For year 2001, we are now up about 12.6%, with nearly a full cash position. 

For those not familiar with our long/short strategies, we suggest you review my 10-week trading course on TradingMarkets.com, as well as in my book "The Hedge Fund Edge," course "The Science of Trading," and new video seminar most of all, where I discuss many new techniques. Basically we have rigorous criteria for potential long stocks that we call "upfuel," as well as rigorous criteria for potential short stocks that we call "downfuel." Each day we review the list of new highs on our "Top RS and EPS New High list" published on TradingMarkets.com for breakouts of 4-week or longer flags, or of valid cup-and-handles of more than 4 weeks. Buy trades are taken only on valid breakouts of stocks that also meet our upfuel criteria. Shorts are similarly taken only in stocks meeting our downfuel criteria that have valid breakdowns of 4+ week flags or cup-and-handles on the downside.  

In an environment unclear directionally, we also only buy or short stocks on leading or lagging industries according to our group and subgroup new high and low lists. We continue to buy new signals and sell short new short signals until our portfolio is 100% long and 100% short (less aggressive investors stop at 50% long and 50% short). In early March of 2000 we took half profits on nearly all positions and lightened up considerably as a sea change in the new economy/old economy theme appeared to be upon us. We've been effectively defensive ever since.

Upside breakouts meeting upfuel criteria (and still open positions) so far this year are:  Apogee Enterprises (APOG | Quote | Chart | News | PowerRating) @ 15.82 (14.73) w/13 1/2 ops, and (POSS | Quote | Chart | News | PowerRating) @15.3 (16.05) w/ a 12.7 ops;  Also look to buy (CEDC | Quote | Chart | News | PowerRating) @10.3 OB w/ 8.5 ops if filled. Continue to watch our NH list and buy flags or cup-and-handle breakouts in NH's meeting our upfuel criteria - but continue to add just two per week, and only in leading groups.  If we get two or more of our breadth criteria for the overall market developing from here on, we'll then drop the two per week only advice on longs - but until that develops let's remain somewhat cautious.

On the short side, this year we've had breakdowns from flags (one can use a down cup-and-handle here as well) in stocks meeting our down fuel criteria (and still open positions) in: NONE. Continue to watch our NL list daily and to short any stock meeting our downfuel criteria (see 10-week trading course) breaking down out of a downward flag or down cup-and-handle that is in a leading group.  The oversold nature of the market leads us to suggest that investors remain cautious by only adding two shorts in a week.

Let’s watch and see carefully what the plurality of markets will tell us at this upcoming critical juncture.  When the majority of markets speak in one direction, we’ll know how to move.