Wednesday Winddown?

Two key events this Wednesday could give investors an excuse to book some profits:

• Federal Reserve Chairman Ben Bernanke will speak before Congress.
• Fed minutes are due to be released.

There appears to be little evidence to suggest Bernanke will drift from his recent guarded optimism stance on the economic outlook, which means his comments may be stock market-friendly. On the Fed minutes front, the release is based on the meeting when the statement “The Committee is prepared to increase or reduce the pace of its purchases…” was added. The key term was “increase”. Therefore, the minutes may prove to be dovish or stock market-friendly as well.

Hard To Predict Market’s Reaction

Even if we had advance copies of Bernanke’s speech and the Fed minutes, it would be difficult to predict the reaction of the fickle financial markets. Therefore, the best way to handle Wednesday’s Fed-related events may be to see how traders react and make allocation tweaks if needed.

Bulls Have Tight Grip

With unprecedented and simultaneous intervention from central banks in the United States, Europe, and Japan, one of the best ways to stay aligned with money making opportunities is to simply pay attention to what is happening and what is working. As demonstrated in the video below with various charts, ratios, and markets, what “is happening” is the bulls are in complete control.

Aston Martins and Acquisitions

The bull/bear debate always comes down to the risk tolerance and confidence of investors. Bloomberg reported a 1961 Aston Martin Jet took in a record $4.85 million at auction last weekend, which tells us someone is confident. Similarly, Yahoo’s reported acquisition of Tumblr shows companies are willing to trade cash for what they see as growth opportunities.

Weak Dollar Script Not Working

In recent weeks, we have been favoring U.S. stocks over emerging markets (EEM), precious metals (GLD), and commodities (DBC) due in part to ongoing strength in the U.S. dollar (UUP).

The “risk-on” script over the past several years has been for “weak dollar” assets, such as emerging markets, to lead during periods of increasing risk appetite. With a strong U.S. dollar in play, emerging markets continue to lag the S&P 500 rather than lead (see below).

Materials: The Most Important Sector?

As we will cover shortly, stocks recently broke out in a bullish manner relative to bonds. Materials stocks, a recent market laggard, are trying to complete a similar push higher. When laggards begin to “catch up”, it is typically a good sign for the entire stock market. As shown in the chart below, the materials ETF (XLB) was turned back at several points of logical resistance over the past two years (see red arrows). The green arrow highlights a breakout above a typically bullish chart pattern know as a “triangle”. If materials continue their ascent, the S&P 500 could push significantly higher.

Risk-On Beating Risk-Off

The monthly labor report released in early May gave many investors renewed economic confidence. A logical and often pondered question is would I rather be in stocks or in bonds. The stock/bond ratio below [(SPY) vs. (IEF)] rises when stocks are in greater demand relative to bonds. Conversely, the ratio falls when investors have a greater desire to buy bonds relative to stocks. The red arrows below show numerous occasions during the last two years where stocks failed at logical points of resistance. The green arrow highlights a breakout above a typically bullish chart pattern known as a triangle. The chart below also represents a bullish breakout by risk-on relative to risk-off. As long as the chart below maintains its bullish look, we will favor stocks (VTI) over bonds (TLT).

Investment Implications

As noted in the charts and video above, the bulls have a firm grip on the markets (as of the close on May 20). Using the “pay attention to what is happening” approach, as long as conditions continue to favor bullish outcomes, we will favor stocks over fixed income instruments. If emerging markets and materials stocks can begin to show leadership, we would also be more inclined to favor economically sensitive or cyclical ETFs, such as financials (XLF), over more defensive sectors, such as consumer staples (XLP).

In the video above:

1. CCM Big Four - 2:20 mark
2. Helpful Twitter charts - 3:04
3. S&P 500 12-year base - 5:16
4. The most important chart - 6:17
5. U.S. Dollar changing script - 7:25
6. S&P 500’s bullish trend - 9:05
7. Longs vs. shorts - 12:14
8. Stocks vs. bonds - 13:22
9. Credit Spreads - 15:17
10. S&P vs. Treasuries - 16:48
11. Stocks vs. VIX Fear Index - 17:56
12. Small caps look healthy again - 19:03
13. Risk-on vs. Risk-off - 19:46

Bullish Charts on Twitter: On Friday, we added a few links to bullish charts on Twitter (click here).

New Video Coming Sunday: We will be posting an updated video this weekend - look for a link here or on the CCM Twitter Feed.

The chart above is described in detail at the 8:46 mark of last weekend’s video (click to view the segment).

It remains important for cyclical assets, such as materials stocks, to attract enough buying interest to complete bullish turns.

The market’s recent shift back into economically sensitive assets tells us stocks could continue their surprising march higher despite the ongoing calls for “sell in May”. As shown in the chart below, the S&P 500 made no progress during the last twelve years. The “no progress” pattern was recently broken, which could lead to head-scratching gains in the months ahead.

Market Has Responded To Economic Data

The financial markets were pleased with the widely-anticipated monthly employment report that was released in early May. Monday’s session was greeted with a better than expected number on the retail front. From Bloomberg:

Sales at U.S. retailers unexpectedly advanced in April, helping ease concern of a sustained pullback in consumer spending that would stifle the economy. Retail purchases climbed by the most in four months minus receipts from service stations, where cheaper gasoline prices depressed the dollar value of sales.

Confirmations More Upside Likely

In the world of chart reading, known as technical analysis, “confirmations” occur when two or more charts support the same conclusion. Breakouts can fail. Therefore, we would feel more confident about the S&P 500’s recent twelve year breakout if other charts and areas of the market seem to fall in the bullish line. This week’s video covers twenty areas of the market that align with or serve as a “confirmation” of the S&P 500’s recent march higher. Chart analysis begins at the 2:43 mark.

Volume Confirms Market’s Push Higher

When large market players, such as hedge funds, place a bet, they make large trades which are reflected in daily and weekly trading volume. When we track volume, we are indirectly tracking where the “big boys” are placing their bets. The chart below ($NYUD) shows more volume has been associated with advancing stocks relative to declining stocks, which is another way of saying the big boys have been more interested in buying rather than selling. Notice how $NYUD, like stocks, has broken above a multiple-year base.

Breadth Regains Bullish Footing

The period between late January and mid-April 2013 was marked by a defensive bias in the markets, despite the S&P 500’s advance. The defensive undertones can be seen in the chart of market breadth below. Market breadth speaks to the percentage of stocks participating in a rally. When a high percentage of stocks participate (strong breadth), it is a sign of a healthy market. Conversely, when breadth is weak, it casts doubt on a rally’s staying power. Notice how the concerns about weak breadth have been removed since the Summation Index ($NYSI) reversed sharply in mid-April.

Shift Back Toward Cyclical Stocks

Cyclical stocks tend to be more sensitive to the strength of the economy. One example is Harley-Davidson (HOG). Rational people tend to put off the purchase of a $15,000 motorcycle if they are concerned about job security. The chart below shows economically sensitive stocks (SPHB) were weak relative to defensive stocks (SPLV) during the ten week period between early February and mid-April of this year. Since then, the market’s tone has shifted noticeably in the bulls’ favor.

Small Caps Show Growing Confidence

Small caps are another area of the markets that is shifting back toward the “we’re confident” end of the spectrum. When investors migrate back toward smaller (read riskier) companies, it signals renewed hope for positive economic outcomes.

Intermediate-Term Outlook Positive

Even the under the most bullish conditions, stocks experience various forms of backfilling. Therefore, if the bullish signals above remain in play, we should still expect pullbacks from time to time. However, the odds favor a continuation of the longer-term trend, which is bullish.

Investment Implications

As long as conditions outlined above remain in place, we will favor cyclical areas of the market over defensive sectors. Cyclical ETFs include high beta (SPHB), consumer discretionary (XLY), retail (XRT), technology (QQQ), semi-conductors (SMH), home builders (ITB), energy (XLE), financials (XLF), small caps (IWM) and mid-caps (MDY). Defensive sectors tend to underperform under these conditions, meaning we would tend to avoid or underweight consumer staples (XLP), utilities (XLU), and healthcare (XLV).

Major Wild Card: Fed Policy

There is absolutely zero question the Fed’s aggressive money-printing and bond-buying programs have played a major role in the market’s recent advance. A not-so-subtle objective of the Federal Reserve’s use of quantitative easing (QE) is to boost asset prices. If the Fed dials back its bond purchases and the markets react in a negative manner, the entire investment landscape could be flipped upside down. A May 11 Wall Street Journal article paints a very uncertain picture relative to the Fed’s exit strategy, especially on the timing front:

Officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves. The timing on when to start is still being debated.

Should the markets have a Fed-induced return to “risk-off” mode, the charts above will experience an observable change in character. In a world where asset prices are heavily impacted by intervention from central banks, maximum flexibility is an ongoing requirement for investors.

Video Contents:

1. NASDAQ’s break above resistance - 2:43 mark
2. Volume confirms move in stocks - 3:15
3. S&P 500 above long-term resistance - 3:49
4. S&P 500 weekly breakout - 4:32
5. Bullish weekly trend - 4:49
6. No demand for hedges - 5:15
7. Stocks vs. intermediate Treasuries - 5:46
8. QQQ relative strength turns - 6:05
9. Aggregate bonds lagging stocks - 6:29
10. No spike in VIX yet - 6:55
11. Home builders regain traction - 7:16
12. Small caps important higher high - 7:44
13. Materials bounced at logical support - 8:00
14. Credit spreads realign with stock bulls - 8:46
15. High beta vs. shorts - 9:11
16. Risk-on vs. risk-off - 9:48
17. Three stock vs. bond charts lean bullish - 10:09
18. Defensive staples start to lag - 11:26
19. Defensive utilities lag as well - 11:50
20. Discretionary vs. staples regains footing - 12:13

One Example – Stocks vs. Bonds

Looking at stocks (SPY) relative to bonds (AGG) is one way to monitor the market’s acceptance of or aversion to risk. The green box in the chart below shows eight weeks of consolidation, which pointed to an uncertain outlook on the risk-taking front. The resolution thus far has clearly favored the stock market bulls. Retests of breakouts are not uncommon, but even if the chart below revisits the green box, the odds would favor a bullish bounce from there.

Links On Twitter

The CCM Twitter feed has links to a few more charts that paint a similar “acceptance of risk” picture. Things can change at any time, thus, we will monitor the markets with a clear and flexible mind.

The video below opens with a reminder of what happens when buy and hold stops working (see 2:03 mark). At the 5:04 mark, we cover some tweaks we have made to our models to account for outlier scenarios similar to the one we have experienced in recent weeks.

Chart analysis can be found at the following points in the video:

• 08:12 - S&P 500’s weekly trend
• 12:53 - Short vs. long
• 14:26 - Stocks vs. bonds
• 17:27 - Tech stocks breakout
• 20:25 - Bonds still lagging
• 24:02 - VIX Fear Index
• 25:26 - Credit markets
• 28:22 - Small caps trying to turn
• 30:30 - Small caps vs. Treasuries
• 31:28 - Divergences between stocks and bonds

Markets Hinted At Bullish Employment Report

As we noted on Friday, the charts were tilting back toward the bullish camp before the monthly employment report was released.

Employment Data Aligned With Markets

The bullish employment report may have come as a surprise to many, but as we describe below, the markets were dropping bullish hints prior to Friday’s announcement. The recap of the employment data from Bloomberg:

Payrolls expanded by 165,000 workers last month following a revised 138,000 increase in March that was larger than first estimated, Labor Department figures showed today in Washington. The median forecast of 90 economists surveyed by Bloomberg projected a 140,000 gain. Revisions to the prior two months’ reports added a total of 114,000 jobs to the employment count in February and March.

Trend Still Favored Stock Bulls

The conditions described below allowed us to enter Friday’s session with long positions and no exposure to the short side of the market. How can these charts help us going forward? They still favor bullish outcomes for stocks. Until something “flips” on the charts, the odds will favor risk assets over defensive assets.

On April 30 we covered three areas of the market that were starting to turn back toward the bullish stock market camp. One of them examined the weekly trend in the S&P 500 Index. Moving averages help us filter out some day-to-day volatility and focus on the longer-term trend. The most favorable conditions for stocks occur when the following are in place: (a) price (black line) is above both moving averages (blue and red), (b) the faster moving average is above the slower moving average (blue above red), and (c) the slopes of the moving averages are positive. A “bearish look” from a trend perspective is described via the red text in the chart below. Below is a version of the chart the day before Friday’s widely-watched employment report. Notice the chart looked healthy and bullish.

The Fear Trade Was Still Lagging

After Wednesday’s 14 point drop in the S&P 500, we stated the declines were not all that meaningful in terms of impacting the bullish trends. We also tweeted an updated version of the bond (AGG) vs. stock (SPY) chart below after Thursday’s close stating bonds had some work to do relative to stocks.

Below is a version of the bond vs. stock chart heading into Friday’s monthly employment report.

Breadth Was Also Improving

Another tell on the employment front was market breadth. We showed a version of the chart below on April 30. Market breadth speaks to the percentage of stocks participating in a rally. Healthy markets have broad participation. The Summation Index, shown below, is an intermediate-term measure of market breadth. All things being equal, bulls would prefer to see the line rise on the chart below. The Summation Index recently initiated an attempt at a reversal as ECB rate cut chatter increased.

Markets Improved After April 18 Low

The markets looked vulnerable the week of April 14. However, after the S&P 500’s low on April 18, things began to improve on April 23 when weak data from Europe increased the odds of an interest rate cut in Europe. Since then, the charts above also pointed to a more positive outlook. Asset classes and market breadth were dropping hints that a favorable employment report was coming on Friday. As we will find more often than not, the markets were right. If another leg up is in the cards, foreign (EFA) and technology stocks (QQQ) may provide leadership.