Under the Hood

May 18, 2009
Mike Doran

It is important to watch distribution days on the Major Indexes, and the general price and volume action to help determine the more immediate health of the market.

The Cause for Pause

The major averages finally took a breather after a 2 month rally. This week the market found little cause to sustain the upward momentum as the bank stress test results have been released, Q1 earnings season is mostly behind us, and summer is fast approaching.

All four of the major averages ended the week lower. The Russell was the worst performer, falling -7.0%. The S&P was down -5.0%, the Dow fell -3.6% and the Nasdaq went down -3.4%. Financials were the worst performing sector dropping -12.1% for the week, which is not surprising considering how the sector outperformed during the rally, particularly last week when they surged 23% on the bank stress test results. Industrials lost 7.6%, Consumer Discretionary fell 7.3%, and Energy decreased 6.8%. All ten sectors that make up the S&P 500 ended in negative territory this week.

This week, there are a few important earnings reports left with Home Depot (HD) and Hewlett-Packard (HPQ) coming out on Tuesday (5/19), and Deere (DE) and Target (TGT) coming out on Wednesday (5/20). It will be a much slower week on the economic calendar, however, with the only notable releases being Housing Starts/Building Permits on Tuesday and FOMC Minutes from the April 29 meeting on Wednesday.

Next week takes on clear importance to see if investors are willing to step up and buy the weakness or if we have more downside ahead.

Under the Hood

Our view on this blog continues to be that we are in a traders market and that may continue for a long period of time. The buy and hold philosophy that was so popular in the 80’s and 90’s is not a viable approach under current market conditions and volatility. We recognize that many physicians and medical practitioners cannot watch the market throughout the day. We believe that this is not an absolute requirement to do well in a trading environment.

We like to watch distribution days on the Major Indexes, and the general price and volume action to help determine the more immediate health of the market. In my 12 year career as a professional fund manager, I have learned that attention to price and volume is a helpful factor in determining the pulse of the market. A careful diagnosis of accumulation and distribution in the broader indices has helped me protect capital time and time again.

Careful examination of the current leadership of stocks and major sector ETFs will also help to provide additional clues to the tenor of the market. It is usually better to study the object at hand than to be pulled around by the vast amount of varying opinions of the market.

The markets have been selling off the last week and it is not always easy to know if a shallow consolidation may be taking place or if something more severe is on the horizon.

Let’s look at a few charts to see if we can make an educated guess at what will happen this week. In the weekly chart of the S&P 500 index below, notice there have been 9 weeks of strong upward movement off its lows (A) on heavier volume (C). There has not been one week of heavy distribution (shown by the red vertical volume bars at the bottom of the chart). There has not been a heavier lower weekly close on heavier volume since the initial rally from the March lows. The dotted line to the left of (A) represents one area of potential resistance. The S&P 500 is still trading below a key 200 day moving average, as shown by (B), which some technicians believe is also key resistance. It would be healthy and normal for the market to trade in a balance area range here and consolidate the gains, perhaps pulling back further into the 825 level around the 50 day moving average (the blue line) and retest another area of important support near the Nov-Dec lows.

(Click on image to view larger)

In the S&P 500 daily chart below, we have had only two heavier distributional days as indicated by (A, B). The overall volume to the downside is significantly less than the market bottoming process that took place back in March (E). If we were to see additional heavier volume days accompanied by further serious deterioration in leading stocks, that would be a concern and perhaps a reason to raise more cash. For now the market is pulling back and consolidating normally. As long as the index trades consistently below the 200 day moving average this signifies that we are still in a bear market rally (opposed to a new bull market).

(Click on image to view larger)

From our internal measurements including breadth and up/down volume on the major indexes, the market is long overdue for some kind of rest and possible correction.

In summary:

1. The overall market looks good, but resistance is looming.

2. Most stocks are pulling back with bullish undertones (low volume and orderly price movement).

3. Many stocks have “broken out” over the past 4 weeks.

4. In the short-term we are bearish (though this condition is being worked off), and in the intermediate term bullish, but in the long-term we are still in a bear market.

5. To actually call a bottom, I’d like to see more volume.

6. However, the price pattern looks good for bottoms, especially if the S&P mounts above the 200 day moving average

One final point regarding chart analysis - it is helpful to look at both the S&P 500, the Nasdaq, and the Russell 2000. The Dow Jones Industrial Average is only 30 stocks and not as representative of the broader market. As we have shown, the position of the overall market should be looked at from both a daily and weekly perspective.