Tuesday, November 25, 2008

Long Term Treasury Yields

In recent commentaries, I suggested that long term treasury yields had the technical characteristics of an asset class where a long term secular trend change could be at hand. The prime fundamental driver would be that the U.S. government would need to make its sky rocketing and newly issued debt more attractive to its foreign buyers. So far this trade, which I had expected to last at least 18 months, has not worked out.

This past month, Treasury yields have dropped (as bonds have risen). This is essentially the flight to quality and liquidity trade. As stocks do poorly, bonds have defied the skeptics and risen in price. Or to put it another way: when folks wonder how low can stocks go, they also should be wondering how low yields on the 10 year Treasury can get. Yields are within a stones throw of their all time low.

The technical set up that has been reversed can be seen in figure 4 a monthly chart of the 10 Treasury yield. The indicator in the lower panel is our “next big thing” indicator that seeks to identify those times when a secular trend change is highly likely. Last month, Treasury yields closed above the 10 month moving average and above a down sloping trend line. This seemed to be confirmation that the trend for yields was reversing. One month later, yields have reversed lower to close below the 10 month moving average, the trend line and below a pivot low point (marked with red arrows) that should have served as support. This level comes in at 3.432% yield and now represents resistance. A monthly close above this level would mean that Treasury yields are likely to move higher.

Figure 4. Long Term Treasury Yields/ monthly

The only technical positive is the possibility for a double bottom, which I have highlighted before. Yields could reverse at this level, but confirmation of a reversal would only take place on a monthly close above resistance at 3.432% .

Extrapolating bond market strength to stock market weakness, one might suggest that lower yields (higher bond prices) continue to imply ongoing flight to quality and flight to liquidity. In other words, stocks aren’t expected to rise as long as money flows into bonds. As hard as it is to believe, bonds remain attractive. The yield is not attractive but in this deflationary environment they are attractive. Treasury yields are still on the cusp of a secular trend change, but it appears we will need to wait a little bit longer for yields to move higher. The price action does not suggest higher yields anytime soon.

Monday, November 24, 2008

To Have A Plan, To Speculate, And To Guess

Bounce? Bottom? Bear? Bull? Does anyone in the world really know where the market is headed? While the direction of the market may be unknown, there is one thing for sure: in the history of mankind, there has never been a time when so many people have had an opinion about the markets. Yet what is ironic is that most of these so called experts (and I would include myself here) are really just mediocre. The information overload we all experience really does not provide any sort of edge.

To Have A Plan
So in the absence of trying to predict the market’s direction, let’s at least put a plan together that should help us navigate the meaning of the price action. If there is one thing I can say about technical analysis, which is the analysis I espouse too, it is this: whatever is known or unknown regarding an asset is reflected in the price of that asset. Price and being on the right side of the trend are the only things that matter.

So where are we?
Last week, I wrote about price failures. Price failures are key areas where selling typically occurs, when we should expect buying. In other words, there should be buying at support levels. Instead we have selling and this typically occurs at an accelerated pace. As of last Friday’s close (November 7), the S&P500, NASDAQ, and Russell 2000 had experienced price failures. Five trading days later, these three indices were all down over 8 plus percent, and if it wasn’t for the 5% ramp in the last hour on Friday, these indices would have experienced losses in excess of 12% for the week!!! As I wrote last week, "Increasing Risks" indeed.

The Dow Industrials was the lone index not to experience a price failure, but last week’s price action took care of that. See figure 1 a weekly chart of the Dow Industrials. The red dots over the price bars are the key areas of buying. A weekly close below these levels is a price failure and as you can see, the Dow Industrials is below one of these key areas of support.

Figure 1. Dow Industrials/ price failure

So what does all this mean? The price action is telling us all that we need to know – price failures imply increasing risks. So what is our road map to navigating this market? A weekly close over 8350 on the Dow, 876 on the S&P500, 1565 on the NASDAQ, and 476 on the Russell would be bullish. These are our resistance levels. A bull market cannot start without these levels being taken out.

To Speculate
Can we speculate on buying at lower price levels if they come about? Absolutely, and this is somewhat the premise of buying on bearish extremes in investor sentiment. Lower prices will bring out the bears and this is typically bullish. Currently, the Investor Sentiment Composite Indicator has just turned slightly bearish. Interestingly, the Smart Money remains bearish. Both indicators are shown in figure 2 below a weekly chart of the S&P500.

Looking at 18 years of data, such a dichotomy occurs about 10% of the time, but usually favors the smart money. In other words, we will not see higher prices until the Smart Money indicator turns more bullish. Of note, the Market Bias Timing System is likely to turn bullish next Friday provided investor sentiment remains bearish. We will evaluate this possible signal within the context of all the data available to us.

Figure 2. Investor Sentiment

To Guess
In the short term, the market is oversold and it would not surprise me to see buying in the week ahead. A daily chart of the S&P500 is shown in figure 3 (next page) with the McClellan Oscillator shown in the lower panel. The McClellan Oscillator is based upon the advance decline, and it is much oversold. With the Thanksgiving holiday and end of the month buying on light volume, there is very little reason to think there will be downside pressure on the market.

Figure 3. SPY/ daily

What I have tried to provide you with this commentary is a plan. It is my guess that the markets will have a short term bounce. It is speculation to bet against the prevailing sentiment when there are extremes in sentiment. Now is not a time to speculate.
This is a plan of action to follow when the price action meets certain criteria.
That's TheTechnicalTake!
I hope you have found this commentary insightful and profitable.

Sunday, November 16, 2008

Increasing Risks

It has been two weeks since my last commentary, and in this market environment, that seems like a lifetime. The Market Bias Timing System has turned neutral, and despite the widespread belief (hope?) that a trading rally is in the offing as the 2002 -2003 lows are approached during this seasonally positive time of year, the data suggests otherwise. The markets remain weak, and as hard as it is to believe (as I would be the first person to buy into a declining market), I think the risk is skewed to the downside.

The Market Bias Timing System (MBTS) turned neutral at the close of the week ending on November 7, 2008. What caused the change? The Investor Sentiment Composite Indicator is no longer extremely bearish (i.e., bull signal), and the price action remains poor. So can we count on ongoing bearish investor sentiment to propel prices higher? It does not appear that way. So it is the combination of neutral investor sentiment and poor price action that suggests caution.Why did the MBTS turn only neutral and not outright bearish? There is a time component to the system that essentially gives the market 5 weeks (once sentiment turns neutral) to get off the bottom and move higher. This won’t be fulfilled until November 28. This criteria or filter is combined with market breadth, and this part of the MBTS will generate a sell signal as market internals continue to lead the price action lower. This can be seen in figure 1, which is a weekly chart of the S&P500 showing the NYSE advance decline line and NYSE cumulative volume. Both are leading price lower and this is not good.

Figure 1. S&P500 v. Market Internals/ weekly

So we have the MBTS turning neutral and in all likelihood, it should be a bearish signal as market internals remain poor. What else gives me caution? It is this notion of price failures that I have been discussing over the past couple of weeks. I think this is important so I want to try to explain to you in greater detail the significance of a price failure, and why these areas are important areas to focus on. We all can agree that a bullish trend is a series of higher lows and higher highs. Typically what happens in a bull market is that prices make highs, and then prices sell off. Investors become worried on the sell off, and investor bearishness rises. At some point, investor bearishness becomes extreme, and prices find a low as buying ensues, and prices pivot higher. It is the combination of bearish sentiment and the pivot point that forms this important low. This is the “line in the sand”. Figure 2 is a weekly chart of the S&P500, and the boxy looking graph in the lower panel, is a “digital” representation of the Investor Sentiment Composite Indicator. So when this indicator is up, it has a reading of 1, and investor sentiment is extremely bearish. This is a very bullish signal. When the indicator is in the down position, investor sentiment is not bearish.

Figure 2. Price Failures

The pivot points (red dots) on the price chart are those times when investor sentiment is bearish and prices make a pivot. These pivots are unique in that they have become key areas of support or where buying is most likely to take place. And in essence, this is supported by the data. But let me just take you through the graph and show you empirically.Point #1 is the July, 2006 low. Prices traded below the first red pivot and then 2 weeks later traded back above. This was a fake out, and led to a nice 6 month bull run. Pivots #2 and #3 were just points of buying, and note how these points acted as future support. Point #4 failed, and this essentially kicked off the bear market. Point #5 is March, 2008, and is at the time of the Bear Sterns failure. At this point, I suggested risk was increasing as prices had broken below support or this key pivot point. The very next day, the Fed announced its bailout plans, and the market reversed course. But like all Fed interventions over the past 18 months, the bounce was short lived, and within months, prices were trading below these key support levels. Point #6 is July, 2008 and we can see what happened when this area gave way in October, 2008 (down arrows).

The bottom line: breaks of support should be noted. They typically lead to lower prices, but reversals also have to be monitored. And as we noted in the prior commentary, breaks of key support levels or price failures in bear markets are more ominous than in bull markets.

So let’s move to the present situation and this is pivot point #7 in figure 2. This pivot point is at 875.83 on the S&P500 and the weekly close is at 873.29 and below this “key” level. On the NASDAQ, the pivot point is at 1565.72, and the weekly close is significantly below at 1516.85. The Russell 2000 has also closed well below its pivot too. The Dow Industrials is the only major index above its prior pivot low. On the Dow, the pivot point is at 8348, and the Dow closed the week at 8497.31.Ok, to my point. It is clear that the points I have identified are important areas of buying and selling. The fact that a majority of the major indices have breached these areas with last week’s close suggests to me increasing risk. When you combine this with decreasing bearish sentiment and poor market internals, I think risk increases even more.

In my March 24, 2008 commentary, I discussed “Those Four Letter Words”. In particular, I made the point that risk (our four letter word) was increasing, and I based my findings on similar analysis. Of course, the Fed came out with its Bear Sterns’ announcement and the market reversed sharply higher. Could something similar happen again? Certainly. But in the absence of trying to predict the market, let’s just acknowledge that risk is increasing. We know where our important buy and sell points are. If you are feeling uncomfortable at selling at the lows, I don’t blame you. But as the market appears to be weakening (despite being near the lows) I would be a seller into any strength. Furthermore, I would not tolerate too much downside as a breach of support has already occurred in all the major indices except the Dow. Things could get uglier before they get better.

What would make me turn bullish again? Investor sentiment will need to turn bearish again. Therefore, we will need to see lower prices or a long drawn out trading range. This will essentially wear investors down.

Lastly, I want to give you the numbers for the recent signal in the MBTS. The NASDAQ had a draw down of 31.58% with a loss of 24.55%. The S&P500 had a draw down of 30.77% with a loss of 23.25%. The Russell 2000 had a draw down of 37.32% with a loss of 28.27%. As it turns out, the draw downs were about 2-3 times larger than previously experienced by the system and the losses are about 3-4 times larger. Prior large draw downs in the system have typically been met by buying and all that was necessary was to ride out the draw down. In these extraordinary and unprecedented times, this did not happen. Therefore, the increased losses.

Obviously, this is not good market timing. But in my defense, this represents one of those 10% of the times where things just don’t work. Unfortunately, I cannot predict when things won’t work, and I have always made this very clear. The only thing I can control is my risk, and this is why I rely upon money management to reduce the risk of going against the prevailing winds.

For now, the prevailing winds – investor sentiment, market internals, and the price action – suggest increasing risk. This is not a time to go against the prevailing winds. This is not a time to stray too far from the data as price failures can lead to accelerated price moves lower. If this turns out to be a fake out, this may mean selling at the lows and buying back into a rising market. This is unpalatable but it may be necessary to protect yourself against what I believe is increasing risk.

For now, the MBTS has a neutral bias, and I would be a seller into strength.

That's The Technical Take!!!

I hope you have found my commentary insightful and profitable.