Continued Caution

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In the past two weeks I have had the word selective or cautious in the title of my weekly writing. Without a doubt, I continue to be cautious and very selective in the stocks I hold for clients. It is important to not become overly focused on the levels of the major stock averages. For me, it is important to be focused on key support and resistance levels for the individual stocks I hold in portfolios since many stocks can continue to provide superior returns even in down markets. Conversely, even when the averages are strong individual stocks can be mired in their own private bear markets.

Leading Economic Indicators (LEI's) were mixed last week. Two regional PMI's were released last week. Both of the numbers released in April remained in expansion territory but ticked down from recent levels. The important second derivative of change, the rate of change of change, is slowing. Is this a pause or the signs of real trouble ahead? I do not know. But, at the margin things have slowed and I have become more cautious.

The S&P 500 rose 0.6% last week in very volatile trading. It is not unusual to see volatility rise during earnings season. Globally stocks went down last week with concerns over European markets spilling over and leading to weakness here. There is no question that issues in Europe have an immediate impact on trading in U.S. markets. All of the issues regarding Europe are in the public domain in my opinion. When sentiment drifts to the positive side of the ledger regarding Europe, stocks here advance. When the powers that be feel Europe will be a bigger problem than current consensus, equities sell off.

Let’s look at the technical shape of the market. 73% of stocks in the S&P 500 are in sound shape technically, no change, and secondary stocks weakened by 1% as 68% of smaller stocks are in good shape technically. I have discussed several divergences in the market over the past few weeks. It is critical to keep track of developing divergences and how they could impact the markets. There have been too many recently to mention them all. There is a potential positive divergence developing as I write so let’s focus on the market in real time. The four indexes I have followed in this piece are the S&P 500, Dow, NASDAQ and Russell 2000. The four key area 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. So, you now have the key technical levels I will be focusing on this week. Look to see how the markets react when those levels are tested.

With the technical picture of the market strong but weakening somewhat, I am more cautious now than at any time this year. Also, the LEI data has displayed a slowdown from recent robust growth. In this environment I am going to reduce exposure to stocks that are not performing well. I will focus on names that continue to provide superior performance relative to the broader market averages. It is critical in my work to not become overly concerned with the broad indexes. I need to focus on each name in my portfolio to see if they warrant continued ownership.

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About Thomas J Smith CFA