Short Takes

Friday’s 13.78 point gain in the S&P 500 was not as impressive as it appeared at first blush. Large market participants, such as hedge funds and pensions, were not as interested as John Q. Public, as evidenced by the 23% drop in trading volume compared to Thursday’s down session. In terms of strategy, our stance has changed little since Friday morning. As we describe later, we need to see some more from this market before shifting from a short-to-intermediate-term defensive bias.

Warren Buffet’s annual letter to shareholders was released on Saturday. Since they deal in a wide variety of products and services, from GEICO insurance to Fruit of the Loom underwear, Berkshire Hathaway’s management team has a rare seat in which to view happenings in the global economy. The gloom and doom crowd may find it odd that Mr. Buffett wrote “our elephant gun has been reloaded, and my trigger finger is itchy,” meaning he is ready to buy more businesses. His letter to shareholders also included some optimistic statements that do not align with the “new normal” crowd. According to Buffet, “there is an abundance” of opportunity in America and our “best days lie ahead.” Today’s Wall Street Journal has more on Buffet’s letter.

In terms of investing, the news from Berkshire Hathaway aligns well with the longer-term outlook for stocks, in that we remain firmly in a bull market despite the current bout of short-term weakness. The CCM Bull Market Sustainability Index (BMSI) remains elevated and contributes to our current stance of being patient with cash and willing to reduce risk further if needed.

When the market finds some better footing, we will take a look at these ETFs as possible buy candidates: XLE (energy), IEZ (oil equipment), RJA (agriculture), XLB (materials), and IYR (REITS). These areas of the market have held up well, in relative terms, during the recent pullback. Below, we provide two examples of reasons to remain patient with cash - if this market is going to move higher, the technical indicators below will respond; until they do, there is not big rush to run back toward risk.

Typically, during a period of risk-aversion, the U.S. dollar attracts interest as a “safe haven” currency. It has not been the case in the early stages of the current pullback. This morning’s Wall Street Journal cites rising oil prices and the possible reaction from the Fed and ECB as the reasons for the greenback’s weakness (see below). With the Fed on a money-printing spree via QE2, flooding the global financial system with freshly-printed dollars, we need to respect that $130 oil could trip the markets and slow the economy.

The main reason is that oil is the Achilles’ heel of the U.S. economy. America’s energy intensity has declined in recent years, but still is higher than that of Europe or Japan, according to the World Bank. Toronto-based broker Brockhouse Cooper reckons a spike in oil prices to $130 a barrel would lower U.S. industrial-production growth from roughly 5% annually to about 4%. It would cost consumers upwards of $100 billion this year, wiping out much of the boost from the payroll-tax cut, according to Capital Economics…Such concerns have reduced already low odds the Federal Reserve will raise interest rates this year. Yet the opposite is true of the European Central Bank, Nomura Securities currency strategist Jens Nordvig points out. The ECB targets headline inflation. In contrast, the Fed focuses on core inflation, which excludes volatile food and energy costs.

Yesterday, from a strategy perspective, we had sell orders queued up and ready to go. We rarely trade early in the day, subscribing to the adage “amateurs in the morning and pros in the afternoon”. The five minute chart below shows the tone of the market changed somewhat dramatically in the afternoon with the S&P 500 closing 12 points above yesterday’s intraday low. We decided to be patient and made no moves yesterday. Our bias is to remain skeptical in the short-run, but in no hurry to raise any more cash until the market shows further weakness. If needed, we will cut back on positions in XLY (consumer discretionary), and EEM (emerging markets).

While it is too early to read too much into it, the S&P 500 does have some potential support close by in the form of the trendlines below, giving us another reason to see how things unfold before getting too aggressive with the sell button. Below is an updated version of a chart we presented on February 24. Should the markets stabilize, we would review the list of ETFs from February 10 for possible buy candidates, but we need to see more before that comes into play.

We head into Thursday’s trading session with an extended market that now has two negative fundamental factors to focus on; the Middle East and rapidly rising oil prices. Regardless of how long oil prices remain elevated, the market sees it as a reason to sell. According to today’s Wall Street Journal:

Oil futures touched $100 a barrel at the New York Mercantile Exchange Wednesday—the highest since before the financial crisis hit in late 2008—before pulling back. Pricier oil drives up the costs of everything from gas at the pump to the raw materials used to make nylon and food packaging. That could mean higher inflation and prompt consumers, who lately have shown more willingness to spend, to cut back their purchases.

On Tuesday and Wednesday, we took some profits off the table based on the “incremental approach”. In terms of strategy, we sold or lightened-up on copper (JJC), agriculture (DBA), technology (QQQQ), mid-caps (IWP), transports (IYT), consumer discretionary (XLY), Malaysia (EWM), and emerging markets (EEM). We still own some of these positions, but our exposure has been reduced and our cash position increased. Depending on how we finish up today, we are open to raising a little more cash, continuing to step away incrementally from risk until the risk-reward profile of the market improves.

In How High Can Stocks Go?, we suggested the market may have trouble surpassing the range between 1,313 and 1,326. We are now back below those levels, which means the market has reversed from a fairly logical region; something that needs to be respected given the recent extended readings of our models (see red area in table).

It always pays to take a step back to a longer timeframe and check on the market health. A high percentage of market participants look only at daily charts. Obviously, a daily chart of the S&P 500 is going to look weak after the last two days, but what about a weekly chart that speaks to the longer-term outlook? We examine two S&P 500 weekly charts below.

If you understand basic support and resistance, then you also can understand how to use basic trendlines. If the S&P 500 fails to find its footing near the dotted blue trendline below, it may allow for a move back toward 1,275.

This weekly chart of the S&P 500 does support our risk-reduction moves over the last two days (we also cut back on emerging markets a few weeks ago). The relative strength index (RSI) has moved below 70, which is bearish for the intermediate-term (see 1). Price at point A diverged in a bearish manner from the ultimate oscillator (ULT) at point B. And if you care about trends, as we do, the most concerning thing on the weekly chart of the S&P 500 is the black ADX line turning down from an elevated level (see 2).

How does the chart above relate to our possible strategy going forward? It tells us to be open to further risk reduction should the markets remain weak. If the current pullback morphs into a significant and prolonged correction, the incremental approach will limit the damage. If the market rebounds, we can still participate since we did not make a radical move by going to 50% cash. Most likely, we would cut back further on mid-caps (IWP) and consumer discretionary (XLY) should another step away from risk be needed in the next few days.

Like yesterday, we raised some more cash today based on the incremental approach described this morning. If this pullback continues, we will consider raising more cash. If the market can hold near this level, that is fine with us – we have longs that will participate. Advancing vs. declining volume on the NASDAQ is very weak today, indicative of selling by large institutions, such mutual funds, pensions, and hedge funds.

As of 7:50 a.m. ET, the markets are stable, which is a good sign for now. The situation with Col. Moammar Gadhafi needs to be monitored closely. This morning’s Wall Street Journal (WSJ) provides a good visual of the unrest:

On the ground in the eastern chunk of this oil-rich desert nation, the signs of rebellion are plain to see in the armories of a military base near Baida: Weapons crates lie busted open and empty. Rifles are missing from their racks. Left behind are helmets and gas masks and cleaning kits—things that can’t shoot.

Based on the combination of (a) problems in Middle East, (b) weak housing data, and (c) an unfavorable risk-reward environment, we did some selective selling yesterday. We took some profits off the table and reduced exposure to copper (JJC) and agriculture (DBA). We still own both positions, just not as much. Selling a small amount allows us to step away from risk incrementally, which has a few benefits:

• If Tuesday’s slide extends into today, and possibly morphs into something bigger, we have broken “mental inertia” with the sell button. Hypothetically, if we see big declines today, our mental set is “we sold some yesterday and we can sell more today if needed”.
• If yesterday turns into a one-day pullback, mentally, we are fine with that since we only sold a small portion of our portfolio yesterday. We would be happy to make money if the market can hold.
• One of our biggest enemies in trading and managing money is indecision, or the inability to take action when the situation calls for it. If you sold nothing yesterday, and the S&P 500 is down 30 points again today, you may shift into “it is too late to sell mode”, which can be a dangerous place to be.

The CCM Bull Market Sustainability Index (BMSI) hit 4,195 last Thursday. As the table shows below, markets with similar profiles have been difficult to make money in (not impossible). For this condition to be cleared, the markets need a pullback (Tuesday) or a period of sideways consolidation.

From a strategy perspective, we will continue with the incremental approach. If the markets can move higher, we are happy to stay with our longs in gold (GLD), silver (SLV), and energy (XLE) to name a few. If a pullback does become a correction, we mentioned some possible buy candidates in Bears May Be Taken To The Woodshed During Next Correction, including VTI (broad U.S.), XLI (industrials), and XLE (energy). The article (Woodshed) also shows a possible range of major support for stock prices, which may come in handy sometime in the next few weeks.

CCM Clients: We did some moderate selling in some accounts today. If we see follow-through selling tomorrow, we will raise more cash. One day of selling does not mean too much, but given other factors (extended market, Middle East), we will err on the side of reducing risk over the next few days. It is too early to overreact to the selling today, but it is not too early to (a) do some selective selling, and (b) more importantly, have a “correction plan” in hand for tomorrow’s trading session.

While today’s market is obviously weak with the issues in the Middle East, trading volume was running a little lower this morning, but it has picked up in the last two hours (as of 1:50 p.m. ET). The advance/decline line is weak. We are reviewing the markets and our positions. According to Bloomberg:

Libyan leader Muammar Qaddafi said he’s leader of a revolution that requires “sacrifice until the end of life,” defying a widening revolt that has left corpses on the capital’s streets and rebels claiming control of the second-biggest city.

It is only a matter of time before the market turns its attention to the possible implementation of the Fed’s third quantitative easing program or QE3. The QE3 chatter could begin as early as today with Ben Bernanke speaking at 8:00 AM ET. As far as the markets are concerned, QE2, and the possible onset of QE3, easily remain the most important drivers of asset prices. Any read from the markets that (a) QE2 will be completed, and (b) QE3 is a possibility could help extend the current bull market. We believe the full implementation of QE2 is a near certainty given stubbornly high unemployment levels in the United States. QE2 and QE3 banter impacts all asset classes from old-school industrials (XLI) to rare earth metals (REMX).

Friday morning brings another rate hike in China as they attempt to slow inflationary pressures. This news comes after the gold ETF (GLD) closed yesterday near two forms of potential short-term resistance (see chart below). Gold helps us monitor the “inflation-friendly risk appetite”, meaning indirectly it helps us understand the health of the inflation trade. Should gold break to the upside in a convincing manner, it would be good for many inflation-friendly assets, such as stocks (SPY), agriculture (DBA), and grains (JJG). From a strategy perspective, we would be more apt to hold, and even add to positions like XLE, should gold garner enough interest to move higher. At some point in the future, interest rates are going to spook the markets. The Wall Street Journal reports the rate hike in China may also be accompanied by changes in reserve requirements, above and beyond publicly stated levels:

According to banking sources, the central bank has in recent months ordered some banks to set aside additional reserves above and beyond the official reserve ratio. The PBOC hasn’t confirmed any specific reports of higher reserve ratios for individual banks, but has said it is implementing a differentiated reserve ratio policy.

Nothing immediately troublesome appears on the chart of the S&P 500 Index (below). As we outlined in How High Can Stocks Go? The S&P 500 had potential resistance between 1,315 and 1,326. The market stalled in the range only momentarily, which is not what we would have expected after such an extended run. A good trading rule is “when the market doesn’t do what you think its going to do, you better pay attention.” The longer we remain above those levels, the more bullish it is. The table in the How High Can Stocks Go? also identified 1,364 as an area to watch.

On a housekeeping note, the Bull/Bear ratio as of 2/17/2011 is 2.66, which is concerning, but not all that concerning. Our strategy remains the same – happy to hold our current positions, but we are not in a big rush to add to them.

As we mentioned on February 15, we never know what news or global event will spark a flight to safety. This WSJ story dated today as of 6:43 a.m. ET is worth keeping an eye on:

FRANKFURT—Use of the European Central Bank’s emergency marginal-lending facility skyrocketed Wednesday, hitting its highest level in over 19 months, the ECB said Thursday. .. The ECB declined to give any explanation for the high figure, which generally reflects acute, if mostly short-lived, liquidity problems at one or more banks… The banking systems of Greece, Portugal, Spain and Ireland account for over 60% of ECB lending, despite accounting for less than 20% of euro-zone economic output.

Overbought markets can be spooked rather easily. A story related to problems in Europe’s banking system could be the spark that lights a correction fire. Should a correction unfold, two of the positions in our February 10 ‘correction shopping list’, RJA (agiculture) and JJG (grains), are also referenced in today’s WSJ in a bullish manner (see below). In terms of strategy, we are not interested in taking positions now, but may be on a pullback depending on how things unfold. We are still happy to hold our current positions.

“The seeds of a sustained increase in food prices are about to be sown in Mississippi, Nebraska and other farm-belt states across the U.S. as American farmers prepare to plant their next crops, they must decide how much, and what, to plant.”

In terms of our market models, the CCM Bull Market Sustainability Index (BMSI), closed yesterday at 4,095, remaining on the low-end of an unfavorable risk-reward range looking out six months. On February 2 we asked Is the Market Extremely Overbought? – below are updated charts showing some of the market breadth indicators we put in the ‘worth watching’ category.

CCM Clients: We continue to take a hard look at all our holdings in terms of possibly needing to play defense in the coming days or weeks.