What to Watch For

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Technicians have been predicting a correction for a month now in the equity market. Some place targets down near 1250 for the S&P 500, while others have been more conservative with a target near 1340. Many investors are starting to get the jitters with the old adage, “Sell in May and go away." Here we are at 1400 and all of the major indices are trading back above their 50-day moving average—even the Russell 2000 by the skin of its teeth. I’m still bullish, but it’s always good to have your emotions in check and use technical indicators. If we were to go through another topping process like we did in 2010 and 2011, there’d be certain “tells” we’d get along the way like we did then. Let’s talk about some of these tells and what we should be on the watch for should the worst case scenario occur.

Let’s be honest, Europe isn’t getting any better. The manufacturing data we got on Monday was terrible. But in the midst of that, our market recovered after the initial morning weakness. Spanish yields have risen and investors are concerned we’re going to see the Sovereign Debt crisis reassert itself in global equity markets. Recall last year that the euro collapsed in the midst of rising bond yields and falling economic outlooks. What’s different now?

The euro isn’t rolling over. 1.30 Euro/USD has held for two months now despite growing concerns the Eurozone is losing liquidity support. This is good for commodities as the CRB has closely followed the path of the euro.

euro crb

The top three sectors this year are financials, technology, and consumer discretion. These are early cyclical leaders. So if we’re going to see the economy roll over, you’d start to see the staples, healthcare, and utilities outperform like last year. What about the late-stage cyclical stocks in industrials, materials, and energy? We haven’t seen these sectors outperform yet, so many macro fundamentalists think we have plenty of time yet for this cycle to continue. The chart above should interest the material and energy sectors very much. A turn for the better in the euro is a good sign for commodity and risk assets. The euro is still officially in a downtrend from the April 2011 peak. The bearish trend has not broken, but we are no longer seeing new lows for the currency either. The euro has the makings of a possible bottom. A break above 1.35 would confirm a reversal and bottom. It would also put the currency above the 200-day moving average for the first time since the October low.

Another sign that commodities may be reversing their 2011 downtrend is the rally in the Shanghai Stock Exchange Composite Index based on better economic reports (the first time in a long time in case you doubt their numbers). Premier Wen is now predicting they will increase their GDP next quarter, which would be the first increase in more than a year. A chart I’ve showed two weeks ago was the Shanghai and the CRB index. Notice the very close relationship? There’s a reason analysts say China is important to watch for commodity demand while Brazil is important to watch for supply.

shanghai crb

The euro and the Shanghai Index are both pointing towards a commodity recovery in our near future. Sector rotation theory also coincides with this train of thought as the next sectors to outperform in this cycle are the industrials, materials, and energy. Maybe that’s why these areas have been the best performers in the big upticks we’ve seen in April for the equity markets. The XLE, XOP, and XES energy ETFS are all trading above their short-term 20-day moving averages. Two of those three are trading back above their long-term 200-day moving average. The energy and material stocks have had a very hard time recovering from the 2011 correction. Maybe now is their time to shine. Circumstances seem to be aligning just right for that to happen.

Let’s say none of the above happens and we continue to correct in the equity market. Never mind the S&P 500’s trend held this week. Never mind the markets are trading back above their intermediate-term moving average (the 50-day MA). Never mind the positive trend in earnings and revenue for companies this earnings season. Never mind that 79% of the S&P 500 stocks are trading above their 200-day moving average. If we were to top here, there’d be a number of signs to watch for and I’ll give them to you for free.

#1 Breadth

Something we’ve been doing for weeks is Chris Puplava’s Bill of Health for the market which talks about market breadth, which is a fancy word for saying, “how many stocks are trending up.” If the breadth is narrow, then it’s unhealthy. If it’s broad, then it’s healthy. It’s simple right? Well how does the common investor know when the market is healthy? Check every Wednesday and we'll give you an update. Right now it's healthy. 

During this correction the majority of stocks in the S&P 500 held above their respective long-term moving average. If you recall from many of my instructional writings on the use of moving averages and oscillators, the best tool to use when a market is trending (like ours from the October low) is moving averages. Now if more than 70% of stocks are trading above the 200-day moving average, you’re looking at a very healthy and strong market. When that number drops off, you’re likely looking at a major correction like we saw last year and in 2010.

spxa200r

#2 Trend Reversal

Trendlines, false breakouts, topping patterns—these are all the signs we look for to gauge a market top. We saw them in 2011 and began raising cash in July. This week, the S&P 500 attempted to break its trend on Monday, but we’ve whipsawed that event within a day. That was the first indication that this correction was about to get a rally. In addition, the Nasdaq Composite on Monday was the only index to drop below the levels Tom Smith gave on his Monday Market Observation. Here’s what he said:

“The four indexes I have followed in this piece are the S&P 500, Dow, NASDAQ and Russell 2000. The four key areas of support for those indexes are 1356/12,700/2975/782 respectively. If all four levels give way on a closing basis it signals an acceleration of this recent sell-off. If some of the support levels are violated, but not all, it is often a sign of waning selling pressure and we can see a rally in the market.”

Yesterday, the Apple rally led the S&P 500 back above the Monday support breakdown, and back above the intermediate trend line established from the April 2nd top. This was a short-term buy signal and today’s close above 1390 confirmed that signal.

spx hourly

So, right now, we have a buy signal. We didn’t break 1340 support on Monday and the market held 1358 on better market internals despite horrible numbers from Europe. If the S&P was going to put in a top here, the pattern would have looked a lot better for a correction had we not broke above 1393 today. On the hourly chart, over the past two months you could have imagined a H&S top, but today made that likelihood drop significantly. That probability will drastically drop if we take out the 1422 high.

#3 Momentum

One of the indicators I like to use is the RSI, called the relative strength index. It is an oscillator bound by 0 and 100 that basically measures momentum during a period. It can indicate whether a security has moved too far down (oversold) or too far up (overbought). It also tells us when momentum is waning versus previous reversals. Finally, it can tell us something about trend too (aha! I told you to use moving averages and not oscillators when a market is trending). The RSI tends to top out at lower values when the trend is down compared to uptrends. Vice versa, the RSI tends to bottom at higher values during uptrend corrections, than it does in downtrends. I call this shift. The RSI just bottomed near 40 during the recent correction for the S&P 500. This is typically where we find support in an uptrend using a 14 period as recommended by the designer, J. Welles Wilder. An RSI bottom near 40 was a bullish indication the trend is still intact. Now if we were to lose momentum on a rally from here, you’d see the RSI top at 60. That’s something I’m watching for.

spx 26 apr 2012

So if the trend does not resume, and we are faced with the Sell in May trade, I’ve given you an idea of what to watch for; however, as I started this article, I wanted to help you observe the positive catalysts facing commodities and commodity stocks. In addition, I wanted to clearly show that we are not seeing the same conditions in the euro like we did in 2010 and 2011. Also recall last year that the Chinese and the Europeans were restricting monetary policy to curb inflation. That’s not the case now, just the opposite. My view is that the energy, materials, and industrials should begin to outperform. That’s still a big "should" because there’s a lot left wanting in both the euro and the Shanghai Index with no confirmed reversal and establishment of a bullish trend, but both have shown real encouraging signs that these conditions may be arriving soon.

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