Short Takes

Our levels were exceeded near the close on Germany (EWG), foreign (SCHF), Simon Property Group (SPG), materials (XLB), and emerging markets (EEM, SCHE). We sold portions or all of these positions today. We will enter next week with a continued defensive bias. If needed, we will continue to raise cash until the markets find their footing.

Noon update: We are ready to raise more cash if needed today.

The chart of the S&P 500 shows the market stalled below 1,344 (orange arrow). The purple arrow (top) shows RSI resistance, which leans bearish as it sat as of the close on May 19. The blue arrow shows price broke below the upward sloping trendlines, which too leans bearish.

We are ready to raise more cash if we get closing prices below our lines in the sand.

While all comments in Washington have a political component, the quote below is a sign of the times, and a sign of the possible risks the markets face in the short-to-intermediate-term. From Reuters:

“It would not be good for the economy,” said Austan Goolsbee, chairman of the White House Council of Economic Advisers. If the ceiling isn’t raised before early August, the government would have to default on its bonds, social security, Medicare or military pay, though he added it was impossible to say which one the United States would choose. “Which of those do you default on, what kind of question is that?” he said.

As of 2:45 p.m., all our major positions remain above the next set of lines in the sand we have drawn, but are close enough to merit close watch.

When the market is looking for direction, market breadth can help you determine how the rest of the day may unfold (emphasis on may). While breadth is far from strong today, new highs & new lows are much improved over yesterday. The net is breadth is neutral-to-positive today as of 12:50 p.m. ET.

Visiting clients in Boston this week (with laptop in tow) - so comments may be limited for next two days. The important news for us Wednesday was the Fed’s possible exit strategy. According to Bloomberg:

The central bank should first end its policy of reinvesting proceeds from maturing securities and later raise interest rates and sell assets, majorities of policy makers said at their April 26-27 meeting, according to minutes released yesterday. The caveat: Talks about the exit strategy don’t mean that tightening “would necessarily begin soon,” the report said.

We have been and will continue to watch the markets closely. We have numerous sell orders saved and ready to go (always good to be prepared). As mentioned over the last few days (post one, post two), it looked like the markets were trying to find some short-term footing. They did with the S&P 500 gaining 26 points in last two days from recent low.

We do not like this market and our bias remains to be ready to raise more cash. However, even a weak market can rally for a few days. We also have to keep in mind that from a big picture perspective we still remain in a bull market for risk and inflation-protection assets, which means you have to be careful not to let your cash levels get too high.

Yesterday, we mentioned that numerous markets were near a point where they could logically find some support. Today, we look at the U.S. dollar, which is also telling us to exercise some patience in the short-term until we see how a few things play out.

While the intermediate-term outlook for the dollar appears to be becoming more bullish, the short-term outlook hints that the greenback may take a break from its recent gains (see orange arrows below).

On a weekly chart of the dollar, potentially, the most important development is the bullish divergence between price and the MACD Histogram. Comparing points D and F reveals price made a lower low while the indicator made a higher low, indicting waning selling pressure. This is a divergence we have been aware of and it played into our decision to raise cash and pare back on energy and commodities. Points A and B in the chart below are possible areas of resistance for the dollar. The horizontal lines near point C represent important levels of possible resistance and support.

The monthly chart of the dollar also shows signs of a bullish turn. RSI turned up recently near point A, but has not yet cleared the blue trendline (orange arrow). Point B highlights some levels to watch. Point C is potentially the most important. Notice how the trend of the dollar changed when the MACD Histogram reversed (blue arrows) – a similar move may be taking place now (green arrow lower right), which would become more significant if it can hold through the end of the month.

How does all this help us? With an intermediate-term bullish bias seemingly taking root in the dollar, we should be ready to cut back further on commodities and energy-related issues. With the short-term bias showing some signs of weakness in the dollar, we may see commodities and energy rally for a short-time. If they do, in an unconvincing manner, it may present an opportunity to sell into strength. A more convincing bounce in commodities would allow us to hold our current positions.

We enter the trading day on Tuesday with negative news from HP via Bloomberg:

Hewlett-Packard Co. (HPQ), the world’s biggest personal-computer maker, cut a billion dollars from its sales forecast for the year and said profit is falling short as consumers hold back buying PCs.

Our bias remains defensive, but it makes sense to see how some things play out over the next few trading sessions. Many markets are near points where they logically could find some buying support. We could have picked numerous charts to illustrate the concepts below since similar situations exist.

We would like to see how market participants react to the long-and-short-term horizontal support near point A, the trendlines shown in blue (see B), and the possible RSI support (point C). RSI, which is an overbought/oversold-type indicator, has held at similar levels in recent months (see green arrows to left and right of point C). All of the set-ups below may be taken out in a bearish manner, but it makes sense to be patient until we have more information. We have adequate levels of cash given what we know at this time.

Problems in Europe continue with the news moving past debt and into the outlook for earnings. From Bloomberg:

“There’s nothing close to a resolution” for Europe’s government debt crisis, Norval Loftus, the chief investment officer at Allegra Investment Management Ltd., said in a Bloomberg Television interview with Francine Lacqua in London. “There’s a lot of risk in the system. It’s a very important time to maintain a slightly risk-averse outlook.”

Analysts are cutting European earnings forecasts by the most in almost two years.

Friday we showed negative divergences on the daily charts of the S&P 500, mid-caps, and small-caps. At the close of last week, a divergence (potentially bearish) was present on the weekly chart of the S&P 500.

As we mentioned on May 13, divergences on weekly charts are more meaningful than those on a daily chart. We sold a good portion of our stake in Simon Property Group (SPG) on Friday. We also lightened up on some other positions, including gold mining stocks (GDX). The daily chart of the S&P 500 below shows some reasons for optimism, but our bias is still toward being defensive.

Slowing economic growth and the fast-approaching end of QE2 are just a few of the concerns facing market participants. A recent Bloomberg poll highlights the divergent views on where stocks and bonds are headed after QE2. While the results show opinions favoring lower stock prices and lower bond prices, they were far from widely-held views. Forty-three percent see stocks moving lower, which means fifty-seven percent see something else happening. Fifty-four percent see bonds heading lower after the Fed pulls back on its purchases. Forty-six percent do not share the view that bond prices will fall.

Another concern that we outlined on May 6 is that commodities often lead stocks lower. On May 11, we mentioned that 1,354 was a key short-term level. The S&P 500 (SPY) is having trouble remaining above 1,354.

Just as the poll respondents were lacking conviction in their outlook for stocks and bonds, the markets themselves are painting a similar “lack of conviction” look at the moment. We have position in Simon Property Group (SPG), a real estate investment trust (REIT). The weekly chart of the REIT Index EFT (IYR) can be viewed with a bullish bias or a bearish bias. The proper way to analyze any market is with an open mind.

A bull on REITS might say, “Be patient a breakout above 61.59 and 62.19 could lead to further gains”. A bear’s view might sound like, “The chart has a rising wedge which tends to be a bearish set-up (point B below). Major resistance sits near the top of the wedge in the form of the highs made in 2008 (point A).”

We do not know where REITS are headed in the short-to-intermediate-term, but we do know a break from a rising wedge formation, either up or down, tends to be followed by a bigger than average move (either up or down).

How can this help us manage our existing position in REITS? We see enough bearish evidence to have some lines drawn in the sand in the form of “mental stops”. If these levels are exceeded on the downside, then we will consider selling all or a portion of our position. We have a nice gain in Simon Property Group (SPG) – a gain we want to protect. If the mental stops are not exceeded on a closing basis, then we are happy to hold SPG and IYR. Using a similar strategy, we recently had our last silver stops (SLV) execute on the exchange.

The rising wedge above is significant because it is present on a weekly chart. The rising wedges below are less significant since they appear on daily charts. Nonetheless, rising wedges tend to be bearish formations. It is important to include “tend to” in the sentence above, meaning rising wedges can be resolved in a bullish manner.

You can think of people coming and going to a party to paint a picture of why a rising wedge tends to be bearish. Assume you are having a party that starts at 7 p.m. The guests (buyers) arrive at a steady rate between 7:00 pm and 8:00 pm (price rising at steady rate). Since they are having a good time (making money), the people arriving at the party tend to stay for a few hours. There is no reason to leave (sell) because this is the place to be. As the night wears on, guests arrive (buyers) at a slower rate. Eventually, the room starts to get crowed (near the top of the wedge). At some point during the night the last guest (buyer) has arrived at the party, making the room even more crowded. The crowded room makes some guests uncomfortable (we are uncomfortable with SPG) and they eventually begin to leave (sell). Since there are no more arriving guests (buyers), the number of guests leaving the party (selling) dominates the activity at the door.

The party may end soon, so we have mental stops for all our major positions. If the stops are not exceeded on a closing basis, we are happy to stay at the party for a while longer.

On May 6 we wrote:

If you own stocks you should be concerned about the May 5 plunge in the commodity markets. Why? Commodities, especially silver and copper, have been the leaders of the current bull market in risk assets. When the leaders of a bull market become weak, it is prudent to become concerned about the entire market.

Our last holdings in copper were sold last week when the market triggered our stops. We picked three reasonable levels under the silver market to manage risk. All three levels have been broken and our remaining positions in silver were stopped out early on May 11. The takeaway is that bull market leaders could not hold above reasonable levels, which means the general market remains at risk of further declines.

Relative to the indicator below, William %R, we wrote on May 11:

How can this indicator help us in the days ahead? If the indicator fails to move back above -20 as stocks move higher, it will be a yellow flag. This is what happened at point R (on this chart). Notice the rally attempt in stocks failed after point R. Full confirmation in a bullish manner of the current rally attempt in stocks would come if the indicator can surpass -20.

The indicator (see top of chart below) was unable to retake -20, which is a sign of a weak market. Notice how near point A below: (1) the indicator dropped from overbought territory, (2) it broke back above the center line on a rally attempt, but (3) never made it back into overbought territory (> -20). The weak reading in the indicator was eventually followed by falling stock prices (see red lines). We have a similar situation occurring now near point B.

How can the setup near point B help us now? It, along with weakening fundamentals and numerous other factors, tells us to enter the trading day on May 12 with a defensive bias. On May 11, we sold all or portions of our positions in silver (SLV), energy stocks (XLE), mid caps (IWP), and commodities (DBC). We will consider cutting back further during the May 12 session, especially if the green trendline in the chart above is broken.

We will keep an open mind relative to better than expected outcomes, but we need to see some real improvement in the markets to justify a shift in our stance. On May 6, we presented a chart showing some similarities between recent commodity weakness and setups in the stock market. These setups are still of concern relative to stock prices.