Rally Debate, Markets, and Gold

I want to highlight on some recent technical developments in the markets of late. I'm growing more and more confident that we have a meaningful short-term bottom in place that could last a couple of weeks; however, May's correction has significantly pulled the brakes on the market. Technical damage has been done to the momentum of the March 2009 uptrend, which may have lasting effects throughout this summer.

First, let's start with the big picture. I realize that there is a lot of debate right now on whether the rally since March 2009 was a bear market rally or the start of a new cyclical bull market. I wanted to weigh in from a different angle than many have taken; such as Dow Theory, Lowry's buying and selling pressure, and more. If you look at which sectors have performed since March 2009, sector rotation analysis indicates that Mr. Market is in a cyclical bull market. I'll explain.

Based on Sam Stovall's Standard & Poor's Sector Investing, certain sectors perform at different stages in the economic cycle. The relationship is easy to understand and see in a Sector Rotation Model. This model can be viewed for free at Stockcharts.com and I'll show it here:

The best performing sectors since March 2009 have clearly been Financials (due to the panic selling valuations), Technology, and Cyclicals. Recently this year, Industrials have been lifted above their peers. Because these sectors continue to be the best performers, I conclude that we are still in the crossover from full recession to early recovery. In the early recovery stage: consumer expectations are rising, industrial production is rising, interest rates are bottoming out, and the yield curve is normal and steep.

Source: Econoday

Source: Econoday

Source: Stockcharts.com

I'll look to the economists to point towards a recession trough date and so far they have not conclusively come to a decision yet, thus far. The National Bureau of Economic Research met on April 12. After reviewing recent data for all indicators, despite many indicators turning higher, they felt that determining a trough on current data would be premature. Instead, they reaffirmed December 2007 as the beginning of the recent recession.

Moving on to the markets

Like I said earlier, I think we have the beginning formation of a short-term bottom that could take us up to the 50-day moving average (DMA) on the S&P 500. For now, however, we need to first get through the 200 DMA. Here's a list of green flags that have been triggered over the past two weeks:

I'd like to break here and talk a little more about the hammer candlestick because the formation has had a reverberating effect on the market in its wake—just as it did in February. On February 5th and on May 28th, I wrote to our clients about the Japanese candle formation known as the hammer. Here's an excerpt from last week's article to our clients.

On May 25th, the S&P 500 hammered out a bottom. As I explained in the February 5th In the Know, "Hammer Time," takuri is the Japanese translation of hammer, which roughly translates as "trying to gauge the depth of the water by feeling for its bottom" (Steve Nison, Japanese Candlestick Charting Techniques, 2nd edition, New York Institute of Finance. 2001, p 33). As on February 5th, this Tuesday bulls took back control intraday from the bears. How long that control will last is another matter. Essentially, Tuesday made the bears reconsider their strategy. Confirming the strength of the signal, it happened near the same support in February that turned back the bears.

May 25th met all the criteria of a hammer according to Steve Nison (Nison, p34):

Back to discussing the green flags on the S&P 500:

Now the bad news

It appears we have completed 5 waves up in the market since March 2009 and it's time for a breather. Elliott Wave theory believes that the market expresses itself in five-wave patterns. Waves (1), (3), and (5) help progress the market in the primary trend while countertrend waves (2) and (4) serve to give the primary trend some time to gather its strength. (You can find more info on Elliott Wave Theory here)

Unlike the June-July 2009 and the January-February 2010 corrections, this correction has put the brakes on the market's momentum. In previous corrections, the bears were only able to retrace less than 38.2% of the previous impulse waves. This correction retraced 100% of the February to April impulse wave. Whereas previous corrections of less than 38.2% were interpreted as very bullish, the latest correction is going to make it incredibly difficult to break the April high for a long time.

Which Wedge Will Work

Let's talk about tomorrow, a key day technically in my opinion. Recently, I've seen the work of many technical analysts citing two different wedge patterns. I guess it would be a good idea to keep your eyes on both.

First, the near-term bearish wedge:

And the bullish wedge:

If you picked up that the recent 15-minute pattern on the S&P 500 could be considered bullish (H&S pattern) or bearish (wedge), you're right. That's something I'm sure many non-technical analysts just hate reading. Well, unfortunately, technical analysis is an art more than an exact science. We come up with scenarios and then when the market tells us which one is correct, you execute your sells or your buys. The goal is to take the emotion out of the equation; however, that's never completely possible. Your biases are built into which pattern you see. Tomorrow's job data (whether you think it's bogus or not) should resolve which chart pattern is correct.

As my colleague, Scott Middleton, will always demand from any technical analyst he follows, "what's your opinion, don't give me any of this 'it can go either way' crap," I'm going to say that there's enough bullish momentum this week on good economic reports and bullish technical indicators to justify a move back above the 200 DMA tomorrow, to complete the bullish H&S pattern, and test the 50 DMA. If I'm wrong and we fail to break above the 200 DMA, then buckle up because the chain lift (rally) over the past week and a half just reset this roller coaster for another decline.

Gold

If you recall in 2008 there was a 3 stage cycle for the way gold traded. Stage 1 was a continuance of the inflation trade as gold climbed higher with its brother commodities. Stage 2 was a deflationary stage in which all commodities fell. Stage 3 was the safety trade in which gold and the dollar both rallied and other commodities fell. I believe 2010 will be the reverse for gold.

So far, we've seen the U.S. dollar and gold rise in 2010 based on stage 3, or the safety trade, amidst a euro currency crisis. As this crisis continues during the summer of 2010, it appears as though we may get another whiff of disinflation like we saw in 2008. It is well established that Europe is slowing down as well as China. You'll notice over the past couple of weeks that the U.S. dollar has risen and gold has seemingly peaked with a lower high as of today.

Concerning gold's recent peak, I wrote to our staff yesterday about the numerous red flags I'm seeing in the technical indicators I follow. I'll list some of those red flags here.

Coincidently, after my report to the staff yesterday, I received an email today from Chris Puplava about a Gold newsletter writer who just joined the deflationary camp today. Deflationary camp versus inflationary camp, it seems both like gold long-term; however, a whiff of deflation or disinflation could cause gold and gold mining stocks to fall this summer—a period typically known as the off-season for gold when Indian purchases subside until the Fall.

Conclusion

If there's one theme that is an underlying factor in everything right now: be nimble. This is not an investor's market in which P/E ratios are in the low teens or high single digits to pick up on cheap stocks. While investor sentiment has done a complete 180, we're not at puked out bearish sentiment levels like we saw in late 2008. It was an investor's market from the March lows, but now I think the market will have to concede to the nimble traders and hedge funds. Volatility is back. If you can't take the heat right now, take a time-out and step to the sidelines—especially if you don't have a professional managing your money who can watch your portfolio.