A couple of weeks ago we wrote that a bottom appeared to be forming in the stock market and a rally was near. We did not expect most of the major indices to rally 7%+ in eight trading days. We went on to say that the earnings season beginning in mid-July would dictate the extent of the rally. This past weekend sovereign debt issues out of Italy dominated the headlines and overshadowing a dismal jobs number on Friday. Our portfolio mantra of vigilance and flexibility is welling up when we look at the current status of several intermediate term charts.
We believe this is one of those times to ask tough questions of your advisor regarding capital preservation strategies. The current news backdrop is not that negative, but the current chart formations are of concern to me. Remember the stock market tends to be a leading indicator that that is often 6-9 months ahead of the good or bad news in the system. What we am seeing right now suggests that at best a consolidation period is ahead and at worst a steep correction. we are going to get a little deeper into the weeds using technical analysis more than we usually do, but feel this is the type of information that can help you make more informed investment decisions. We’ll try not to be too confusing.
The signals we commented upon a couple of weeks ago were from daily charts. The signals we are currently responding to are from weekly charts and they look eerily similar to patterns occurring in late 2007 and early 2008. We’ve written about the MACD before as one of the indicators we use in our work. In the weekly chart of the S&P 500 below, the rally of the last couple of weeks back near to May’s high (some indices did make new highs) while the MACD barely budged higher (red arrows). This is known as a negative divergence and often, not always, leads to a correction. A similar pattern occurred in 2007 that denoted the ultimate top. The negative divergences were combined with head and shoulders patterns, which are also considered to be negative.
If you look closely you can see the right shoulder that formed in late 2007 led to a quick 15% correction. The market tried to rally midyear 2008, but we all know the failure that followed. The similarities in these patterns are clear and I believe caution is key here. Moving to a more conservative position and/or raising cash could be a constructive strategy. A couple of key points to consider; if we take out last week’s highs (S&P 500 1360 area), the rally will probably continue; if we take out the June lows (1250 area) the probabilities of a steep correction expand. Nothing is sure in technical analysis, but preventing a significant loss in a portfolio is always a good thing.
The chart of the US dollar is also flashing a warning with our work. Since the stock market bottomed in March of 2009 the dollar has had a fairly strong inverse relationship to the stock market. Most believe the reason for this is that when the dollar falls it helps our large multinational firms export more products at lower prices due to the weaker dollar. The chart below shows the Dollar Index broke a thirteen month downtrend this week. That combined with a positive divergence on the MACD suggests that the dollar could rise for the next several weeks to a few months. If the inverse relationship continues this move would confirm the negative divergence and sell signal that stocks are currently flashing. Looking back to late 2009 the dollar broke a similar downtrend and rose almost 20% in six months. Stocks were down while the dollar rose during that period.
As we mentioned previously these signals indicate probabilities/possibilities as they do not always play out. In our minds what increases the probabilities are the collective nature of this signal. Most domestic indices, sectors, leading stocks, and foreign indices have similar patterns. The chart below is of the German DAX, which is clearly a leader in Europe economically and from a stock performance standpoint. Because the chart is only a couple of years long (the S&P 500 above is five years) the head and shoulders and negative divergences are easier to see. Strong support for this index is at the break out point last November (green line) and that is about a 12% haircut from current levels. Several European indices have already broken through their June lows.
Our take from these charts is that there is bad news coming and stocks are warning us about it. We started earnings season Monday and for the next couple of months, several key stocks on a daily basis will report their second quarter earnings. Our guess is those will be okay, but the outlook for the second half of the year will be more challenging than previously anticipated. That would dovetail with the mostly poor economic numbers that have made headlines the last two months. Maybe the issues in Italy and Greece become a domino contagion situation, compromising the large money center banks of Europe and pushing the region into another recession? Maybe it is something that is not on the radar currently? In the fall of 2007 we did not know what sub-prime was. We don’t believe we were alone there.
We have no interest in being a Chicken Little here and this analysis may prove wrong. Again if the S&P 500 breaks through the 1360 level as other indices make new highs we will jump back on the bullish bandwagon Fed head Bernanke and other policymakers want us riding. Until then we are looking out below.
Did You Know
CAN THEY TAKE ALL OF IT? - To rank in the top 2% of all US taxpayers required an adjusted gross income (AGI) level of at least $253,197 for the 2008 tax year (i.e., the last year that tax data is available). This high-income group paid 46% of all federal income tax paid by individual taxpayers in 2008. If every individual taxpayer in this group paid federal income taxes equal to 100% of his/her AGI, an additional $1.633 trillion of federal income tax would have been raised. The Treasury Department estimates a $1.645 trillion budget deficit for fiscal year 2011, i.e., the 12 months ending 9/30/11. Russia implemented a 13% flat income tax rate for individual taxpayers in 2001, why not us? (source: Internal Revenue Service, Treasury Department).
Final Thought
“A man is never more truthful than when he acknowledges himself a liar”
- Mark Twain (probably for politicians)
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