Clues for Market Direction

Volatility is back with a vengeance. The market is witnessing extreme swings in both directions, but primarily the market has been going down – fast. Support is at 1040 on the S&P (Tuesday’s intraday low) and resistance is first at 1104, then 1110 – 1140. The NASDAQ has major support at 2140 (also Tuesday’s low) and resistance at 2370.

Whether or not the recent market lows hold is the key for the markets next primary move. If the S&P breaks down below 1040, the bulls better run for cover! The Dow had an 800 point swing last week and a 500 point swing this week. That type of volatility is not normal for a traditional market correction. Many are calling for the bull market to resume and that a new high for equities is in store. If that does happen, it will take a little time for the market to build a new base to launch from.

Now it’s about follow through. The market hasn't recorded back-to-back positive days since April 28-29. From the April 25th high to the May 24th low this year, the S&P 500 corrected 14.7%. If you look at any chart pattern for the major market indices and the most of the major subsectors you will easily notice that a pattern of lower highs and lower lows exits. That is called a downtrend and until that trend is broken to the upside investors need to be careful. Also of note is that the uptrend from last year’s lows has been broken to the downside.

Many of the overbought and sentiment conditions that I have been concerned about recently have abated. It also seems that much of the negative emotion surrounding Europe has subsided. Today, Fitch downgraded Spain's long-term foreign and local currency issuer default ratings to AA+ from AAA, while maintaining a stable outlook. While the market reacted negatively, Armageddon did not break out as it might have earlier in the week.

We could rally for a while but whether or not we go to new highs, given the current environment is yet to be determined. This week’s release of the AAII poll showed that bearishness rose dramatically to 50.9% from 33.7% the previous week. That is the highest level of bearishness seen this year. These sentiment polls are contrary indicators. Usually when the majority of investors feel one way about the markets, the opposite occurs. For now, bearishness abounds.

On Thursday the markets melted up 3%, albeit on lighter volume repeating the pattern the markets had all last year. Historically price action needed to be confirmed by volume for that direction to be sustainable. But like most MBA books, some forms of technical analysis are not holding long established truths either. Currently, it seems that price alone is truth! The market’s ability to get so much of a bounce on so little news Thursday was a classic sign of a market that was extremely oversold on a short-term basis and desperate to launch a technical rebound.

On the economic front we have both good and bad news available. First some bad news: Now that the homebuyers tax credit has expired mortgage applications for new purchases of homes has dropped to a 13 year low according to the Mortgage Bankers Association. That means mortgage applications are lower now than anytime during the credit crunch of the last three years!

The most recent Case Shiller Home Price Index showed another monthly price decline. That is the sixth decline in a row, and 70% of the cities monitored posted a falloff. Long term, housing remains the key to US economic stability. In the past couple weeks many austerity programs for European countries and US states were outlined. These cuts in government jobs and services will not help create a V shaped recovery for the economy. Instead they will act as a drag and lower GDP expectations and quite possibly corporate earnings.

Consumer confidence, measured by the Conference Board, improved 5.6 points in May to 63.3. That is the best tally since March 2008 and the third increase in as many months. It must be noted however, that during times of economic expansion normal confidence numbers stand at around 102. In past recessions, consumer confidence averages 71. In fact, right after 9/11 consumer confidence was at 85.3 and that was immediately after the terrorist attacks and an economy that was eight months into a recession. So before anyone uncorks the champagne over this improvement in confidence, it may be wise to put the current situation into historical perspective.

Now for some positive news: We have a holiday shortened week with Memorial Day on Monday. Several summer rallies have started soon after Memorial Day. We will also have many positive economic reports due next week. The jobs number on Friday is expected to show 500,000 new jobs created for the economy last month. That could act as a strong catalyst for an upward market move. The average workweek is expected to increase demonstrating demand and the ISM Manufacturing and Services numbers should also show continued economic expansion. Next week also marks the monthly strength period for the markets. This is the time that automatic flows of money to fund retirement accounts from workers around the country hit the markets. This can lend strength to the markets.

I was not surprised by the huge rally Thursday since many indicators were screaming oversold. We went short at the beginning of May and captured profits as the market declined. We still have our gold and silver ETFs. But mostly we are in cash even though that can seem unsatisfying and unrewarding to investors as the market swings about in both directions. Sometimes it’s better to be safe than sorry. We feel it appropriate to wait for the clues that will clearly define the next major market directional move.

I’ll close with this final note of caution supplied by Dave Rosenberg of Gluskin Sheff. There have only been two other times when the stock market ran as quickly up from a low in barely over a year, as was the case this time around (+80% from March 2009 to April 2010): the 112% surge from June 1, 1932 to September 7, 1932; and the 116% run up from March 2, 1933 to July 18, 1933. In the first case, there was a 40% correction and in the second, the correction was 34%. So, using history as your guide, we are talking about the prospect of a pretty significant reversal that could take the S&P 500 down to as low as 850.

The clues are the support and resistance levels. If support is broken it is imperative to raise cash as that would signal a breakdown of a triple bottom. If we break above overhead resistance (1150 on the S&P) positions could be added, but use tight stops as things can change very quickly in this volatile environment.