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Dangerous Signals June 21, 2011 The following article was extracted from the June 7th 2011 Market update
Long term break down Money continues to move into defensive stocks and this usually takes place when the market is plagued with uncertainty. In addition it is the energy sector that carries the market up during its last leg and that’s exactly what took place; the energy sector was the driving force behind the highs the Dow set this year and it is what could potentially push the Dow to test its highs one more time. A healthy financial sector is one of the necessary ingredients for a bull market. In 2009 shortly after our smart money indicator generated a buy financials exploded upwards. In 2010 their rate of ascension was mediocre to non existent in comparison to 2009; coincidently this was around the same time we turned neutral on the market. At present this sector is underperforming. This underperformance can clearly be seen in the 1 and 3 year charts of XLF (the financial ETF).
In the 1 year chart of XLF, the up trend has been violated and it is now testing important short term support at 14.75. XLF topped out in Feb, while the Dow rallied until May before putting in a top. If the financial sector was healthy then it should have rallied in Unison with the Dow. Historically for a market to move higher the financial sector or the housing sector has to be in good shape. The housing sector is in the doldrums and the financial sector is far from healthy.
. The 3 year chart clearly reveals how bad things really are. XLF topped about roughly the same time the buy signal issued from our smart money indicator turned neutral. As of April 2010 XLF has done nothing but trend sideways. A weekly break below 13 will be a very strong warning signal that the market is close to breaking down.
If you look at the chart of JPM the pattern is actually worse. It topped out towards the end of 2009 and since then it has been trading in a very tight range. This is telling because JPM is the nation’s second largest bank and this chart clearly illustrates that the market does not think JPM is out of the woods yet. The chart of Bank of America the largest bank in the nation looks even worse. Last week we had a 9-1 down volume day; the down volume was 9 times that of the up volume. If the market has experienced a strong correction this is a bullish development as it is a sign that the last players are panicking. As the market is far from oversold and trading relatively close to 2 year highs this has to be viewed as a bearish development. The only way it can be neutralized is if we have a 9-1 up volume day; here the up volume leads the down volume by a factor of 9. Finally for the first time in many, many months, our V Index has experienced a small drop; V readings dropped from 2140 to 2135. It is too early to tell if this is a trend change but until they drop to or below 2000 the markets are going to remain very volatile.
Intermediate outlook
The Dow is at a precarious point; it needs to turn around shortly or risk breaking down. There are a few factors that indicate the Dow is getting ready to mount a rally from these levels. If the SP 500 and the Dow are unable to stabilise at current levels, then they could test their march lows, 1250 and 11500. If this takes place it will confirm that the market has already topped and that any rally from these levels is going to lead to a lower high.
Dumb money has started to become increasingly negative, the premiums of puts are rising, and the market has still not closed down on a very high volume day. For example the market closed in the red on volume of only 4.02 billion shares. Volume continues to rise slowly on down days but there has been no spectacular surge in volume yet. Finally, the dollar could potentially test its lows, and if this takes place it would provide the fuel the Dow needs to rally. Traders who opened up long positions and are getting nervous can close all the positions that are showing a profit. We would like to stress that we have not changed our long term views on the markets; we are still bearish. We are only somewhat bullish on the intermediate time frames because price action suggests that the market could surge higher. A full confirmation comes only when both price action and volume confirm, but this has not been the case.
Conclusion From a long term perspective, the Dow has hit all its targets and long term traders should be out of the markets; they should be only getting into Strangle plays, short positions and maybe selling put options. If the economy is on the mend the news that is pouring out certainly does not indicate this. This so called economic recovery has been completely illusory in nature; QE 1 and QE 2 provided the illusion that everything was getting better. Unemployment remains at very lofty levels and only looks like it is falling because they do not count individuals that have simply given up looking for a job. The housing market is still in a free fall and will remain unattractive as long as jobs remain illusive. Government at the state and federal levels are aggressively cutting back services; all this does not take place if the economic outlook is improving. Getting a government Job was considered one of the safest bets before but roughly 20,000-30,000 government jobs will continue to be slashed until 2012. If revenues drop, more cuts will be made. There are already talking about cutting the Federal work force significantly; some are proposing a 10% cut. All this does not occur when an economy is performing well. The US has been repeatedly threatened with a debt downgrade if things are not put in order soon. Sooner or later even harsher austerity measures will need to be implemented. We cannot go on printing money forever and living beyond our means; Greece is a perfect example of what happens when you live on a hope and a prayer. The financial sector is one of the main drivers of the market and economy looks far from healthy; the financial sector is indicating/ suggesting that it is just a matter of time before it experiences a complete breakdown. Until a full sell signal is generated, we believe the best strategy is to open up strangle positions. When a sell is generated, we can start to scale into put options only. So far, we have 5 strangle positions and are actively scouring the markets for more plays. Remember that these plays will start to bear fruit after the market experiences a huge move; the direction is not important. As we have over 1 year of time on these options it seems highly unlikely that the market is going to trend sideways for over 12 months. With such high V readings, a strong move is bound to occur sooner or later.
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