7/2/2010 - Something's Afoul...

7/2/2010 - Something's Afoul...

Written By: Matthew Xiarhos
Categorized in: NEWSLETTERS

Equity Market Overview

I wrote in both a Special Report of late May and in my last report of June 4th that the technical and sentiment indications suggested an intermediate-term rally of significance. While the market was able to develop a rally into mid-June, the decline and subsequent technical damage over the past two weeks has negated much of my optimism for a sizable summer rally. Additionally, my long held view that 2010 would be contained within a large trading range is being supplanted with more bearish perceptions.

Near-term, a rally seems possible if not likely. This week AAII reported an large surge in bearishness (fear/concern) to over 42% with bulls (optimists) dropping to a very low 25%. That extreme one-sided view and the ratio of the bulls to bears has historically coincided with market bottoms. Caution is warranted, however, because high levels of bearish sentiment can and do persist during bear markets.

At the previous bottoms of late May and early June, the number of 52 Week New Lows remained contained and even dried up. In a bull market, this is typically a strong technical indication of an imminent rally. However, the paltry and short duration of the rally into mid-June and subsequent plunge to new price lows suggests a larger and longer term bearish dynamic to the markets. If the market were healthy the recent decline should not have occurred. Certainly, new lows should not have occurred for the decline from April.

The decline of the past two weeks has created a surge in the number of 52 Week New Lows. In a healthy bull market this should not occur. If the market were simply defining the lows of a trading range the number of new lows would remain contained, if not actually receding as the ultimate low was reached, and thereby suggest an imminent rally. The fact that the new lows have grown considerably of late suggests that the market is unhealthy and risky in the intermediate-term at least.

Put/Call ratios and the Rydex Cash Flow ratios have also remained at levels that are higher than they should be at a significant bottom. In other words, even though prices have gone to a lower low compared to late May / early June these indicators have remained at elevated levels evidencing a persistence of optimism/hope. Usually at major market lows all optimism must be wiped out and replaced with outright fear. Such a condition would be reflected by very low reading of these sentiment indicators; a condition which is remarkably absent today, however.

In summary, though the market does seem poised for some type of short-term rally the intermediate and longer term trends are much more questionable. Given the nearly 20% market decline from the April high and the extreme readings on some indicators I won't abandon all hope that a summer rally is possible but I'll need to see some improvement in the market's internal condition before I could give an "all clear".

The penetration of the long-term moving averages by all major indexes and subsequent rally failure in mid-June has ominous portent. In healthy bull markets, the long-term moving averages can be violated by a small measure and short duration. In this case, however, the degree of violation is too large to be considered "normal" for a bull market. Bear market rules apply.

US Equity Markets (Equity Style Model)

Until recently, the more aggressive small and mid-cap components of the style boxes had remained the leading group. This was a bullish indication that investors were willing to assume more risk. However, in the past two weeks the focus has definitely shifted towards the "growth" axis of the style boxes. This is fairly typical defensive move by investors.

International Equity Regions

International equities have fared much better than their domestic counterparts as I predicted in late May. Not only did they rally more into the mid-June highs but they held their gains better in the subsequent decline of the past two weeks.

In part, this was due to the nearly 3% decline in the US Dollar since early June. The extremely oversold nature of overseas markets, which were really beaten up going into the late May / early June lows, also played a part.

Investment Grade Bonds

We are long domestic investment grade bonds. Any lengthy decline in the US Dollar is likely to lead to a switch to international bonds.

High Yield Bonds

High Yield Bonds are on a SELL.

Real Assets / Inflation Hedges

Commodities and other inflation hedge have been in unified retreat globally. The tenor of all risk markets globally is retrenchment and risk aversion.

Currencies

The Euro has broken upwards from consolidation over the past two weeks. At present, it could not yet be defined as being in anything more than a short-term uptrend. Whether it can develop a long-term uptrend remains to be seen but we are still long the Euro.

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