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Looking back, planning ahead

January 2, 2007
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HAPPY NEW YEAR!!! I’ll start this one off by sincerely wishing you and yours a very healthy and happy year ahead.

It seems a good time to take a good hard look at where the markets have been, where they are, and where the charts seem to indicate they might be going. As I am not formally educated about the economy or really anything business or money related, I will attempt to stick to objective technical analysis of what has happened and what is happening. I will not get any closer than the weekly charts as they tend to factor out the “noise” of day to day movement and give a clearer view of the big picture. For the sake of simplicity, I will use either a plain chart with naked price action or the Investools study set with MACD and Stochastic because most of us are comfortable with them and I think they are as good as any. It’s really not about which indicators you use. It’s how you use them.
There are seemingly thousands of year end reviews with recaps of what made what happen and what might happen in the coming year. I enjoyed this quite level headed take on things from Investor’s Business Daily, After Smart ’06 Bets, Fed May Enjoy Rest. For a less market-centric forecast of things to come, Yahoo columnist Jeremy Siegel gives a straightforward and digestible Outlook for 2007.
As I think has become the norm, I’ll focus on the SPX (S&P 500) as “The Market” and generally disregard the Dow Jones Industrial Average. The reason for this is that the DJIA is an index of only 30 Large Cap stocks, therefore showing far less representation. But more importantly, the biggest beef with this index is that it is price weighted rather than value weighted. This means that a $1 move in a $20 stock affects the index exactly the same as the same move in an $85 stock despite a drastically different percentage move for each stock. Somewhat problematic, no? That said, it is worth noting that the DJIA with its 30 mega-cap stocks beat both the NASDAQ Composite and the SPX in 2006. Noteworthy also is that the Russell 2000 small cap index nudged ahead slightly as the the winner. I’m far from truly knowledgeable on the distinctions and performance of different capitalizations and classifications(growth/value), but it seems reasonable to me to guess that with the ever more rapid development of technology and the growing use of the Internet, the playing field may be leveling ever so gradually, offering small cap companies more feasibility to compete with the big boys.
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If this were the year chart for any stock, what would your first impression be?

Mine would be: Long term uptrend. Very strong rally mid year followed by a somewhat dramatic correction. 4th quarter rally recovers nicely and is surging into the old resistance level. Looks ready for a rest for consolidation before going higher if not a bounce down off old resistance.

Well, perhaps it’s a bit silly to make such a flippant reading on it, but this is a 20 year look at the SPX(S&P 500).

I prefer to look at the monthly chart without indicators, as it seems that beyond a certain time frame(I don’t know what, exactly), it seems ridiculous to use them.
Looking at the 10 year, monthly candlestick chart for the SPX, we see something along the lines of a double bottom reversal to begin the recovery from sell off in the wake of the tech bubble bursting and the tragedy on 9/11/01. 2003 shows a fairly remarkable comeback with the market easing back in early ’04 to establish a more sustainable trend for the coming years. From 2004 to late 2006, the market was in an quite orderly channel, though the lines are not exactly parallel. Considering that rising channels are more inclined to break to the down side, the final months of 2006 bursting through the resistance line is an impressive show of strength. In the absence of oscillating indicators, I’ll reference the ShadowTrader, Peter Reznicek, in saying that a movement above channel resistance can be considered moving into overbought territory. This confirms what we would see if we did look at the Stochastic indicator. It is also worth mentioning that though it is not drastic, the resistance line of that period was ever so slightly less inclined than the support line, creating what might be looked at as a Rising Wedge, a bearish reversal pattern. But it didn’t break to the downside.

So what are we to expect now? Well, we have about 100 pts. above us before we reach old resistance. So there is plenty of upside potential for the near future. We should also remember that overbought is what leads to more overbought. With the strength in the last 6 months, it’s hard to imagine that momentum just dying overnight. But with 6 straight bullish months, it would be reasonable to expect a bit of a rest somewhere soon. Whether it be profit taking after the run up and quarter/year end, redistributing positions or whatever, it would not surprise me to see a pause in this run to begin the year. Coming in to retest that old resistance as new support would probably be a very healthy occurrence. In any case, I read the monthly chart as bullish with a bit of caution, particularly for the start of the year. But if that old resistance line is tested and doesn’t hold as new support, I’d read that as a bad sign.

Looking a touch closer at the weekly chart, we can see the impressive bull run since July with a very orderly ascent. Though that trend support line was breached 5 weeks ago, it was only broken on a weekly closing basis two weeks ago. Interesting to note that this past week shows the upper shadow for the week as having kissed the underside of that line and backing away from it. Looking at it from another perspective, however, there is a more gradual channel that has appeared since November which includes almost all of the daily action intraweek. Even with the slight retreat at last week’s close, the index is comfortably in the middle of that channel.

While we do have 3 green arrows still in tact on the Investools study set, the MACD is about to cross over, giving a red arrow and showing an easing off of momentum. Stochastic is very high in the upper reversal zone and seemingly rounding downward, if only slightly.
Looking strictly at trend, the SPX has not yet broken its uptrend with a slightly lower high being made last week, but not yet a lower low. A close below the prior week’s low would begin a near term downtrend. At that point I’d look to the round
number of 1400 and the long term channel resistance at just under 1390 for potential support. I read this chart as cautiously bullish.

Okay, so I lied. I am going to use the daily chart to read the Market Forecaster study. Simply put, with the green Intermediate line having passed out of the upper reversal zone (below 80), this should be read as bearish for the intermediate term. In fairness, the it appears to be lurking sideways at the moment, but it has not turned back up. The two shorter term lines are also heading down, though the short term momentum line(red) is very low and likely to bounce upward. The much longer term “Sentiment” indicator has very gradually turned over in the upper reversal zone and is headed toward crossing below 80.
The chart shows the 20 MA, which has acted as relatively good support over the last 6 months continuing to hold and the 50 MA. It is worth noting that the 200 MA is 100 points below the current price. I am cautiously bearish on the Market Forecaster for the SPX.

For the final piece of the puzzle, we look at the VIX volatility index. The 5 year chart is decidedly downtrending. As a contrary indicator, this is bullish. While the actual numbers are not too important, the relative price action is what counts here. If it is low, there is complacency and comfort in the market. If it is high, there is fear. We watch it to see it turn up and down from these relative lows and highs for signals that sentiment is changing.

Looking at the latter half of 06, as the SPX rallied strongly the VIX settled into all time lows. But at the end of November, the VIX jumped to break the downtrending resistance. The next couple weeks were somewhat benign and then it fell sharply to test the old line only to bounce up off it forming a piercing pattern, which argues for a bullish reversal. Since that’s bullish for the VIX, it’s bearish for the market. But as of yet, it hasn’t followed through. I am neutral on this index but watching it for a move upward for signs of market bearishness. Until this index breaks above the 12.5 and 13 level, it will be hard to be bearish on the market.

In summary, I am reading the SPX as pretty bullish for the market in the intermediate to long term, though it seems like there is a bit of consolidation or healthy pullback necessary before another leg upward is made. How long that might take is anybody’s guess. With the very low volume activity for over the holidays in December, it will take a bit of time for the market to find its feet again.

Now for a look on the other side of the tracks, let’s consider the tech. heavy and more volatile Nasdaq Composite. It is said to lead the other indexes, which it certainly did in turning downward in 2000 first and again in selling off this year in April about 3 weeks before the SPX began its slide. However, it has lagged the other indexes in the late 2006 rally.

In comparison to the SPX, the run up to the peak and the fall from grace in 2000 is far more dramatic. The recovery, however, is quite similar to that of the SPX and relatively orderly. That it has yet to recover even half of that fall is interesting. For you Fibonacci followers, there is still over 200pts. up to the 38.2% retracement of the fall from the peak in 2000. Either things in techdom were just off the charts of overvaluation in 2000, or there’s still plenty of room to go higher at this point. Here is a Yahoo finance article that is bullish on tech.

The monthly chart shows a surprisingly orderly uptrending channel for the past few years. While the SPX finished 06 with a bullish December, the COMPQ closed lower with an almost obedient respect for long term trend resistance. It is also worth noting the slight resistance back in ’99 at the 2,500 level. As a significant round number, it seems a reasonable level to expect some resistance. Nevertheless, the trend is still clearly up, so I read this is long term bullish with an expectation of short term weakness.

The weekly chart makes a slightly more bearish argument, though it hasn’t cracked yet. Three green arrows in the air, though the MACD and Stochastic have red arrows likely coming soon. The index has failed to make a higher high in the last month and has a big bearish engulfing candle pattern two weeks ago. Since July, it went straight up and now it’s going sideways. Healthy consolidation perhaps. But if it breaks below the current short term support at 2,400 and just below, this won’t be a very good sign for the short term. There’s not a lot of obvious support on the way down. I read this chart as neutral. Not bullish, not yet bearish.

What worries me more, though, at least in the short term, is the NDX (NASDAQ 100). These are the big dogs of the NASDAQ and looked at as its leaders. They have already buckled beneath short term support by closing below it after a bearish engulfing pattern and shown the first major bit of weakness among the major indexes. Last week, though on light volume, was a failed attempt at getting back above that support line. The MACD has already crossed the center line and the Stochastic is very close to giving a sell signal. Again, there’s not a lot of obvious support on the way down. I read this chart as bearish.

The Market forecaster doesn’t speak any better for the COMPQ. The longer term Sentiment line in orange has crossed out of the upper reversal zone, arguing for a longer term bearish bias. As it moves further, the stronger it will get. The Intermediate term line in green is well on its way downward and with a reading of about 40 still has room to go. The red mome
ntum line is very low and ready to bounce higher. If it were high with room to fall with the blue near term line as it is, this would be an intermediate term confirmation signal, one of the stronger signals to look for on the Market Forecaster. Though it is not fully there, it is worth paying attention to.
The daily candles have now tested the underside of the 20 MA twice and bounced down from it. Will the 50 hold for a second time? I read the market forecast for the NASDAQ Composite as bearish.

Finally, the VXN is very similar to the VIX in having broken the downtrending resistance line, but it shows more conviction in moving upward in last week’s candle. It needs more confirmation, but for now, I’ll read the VXN as a bearish as long as it stays above 18.

In summary, the Nasdaq Composite is showing much more imminent signs of weakness. The long term trend is still bullish, but the intermediate trend may well be on the brink of bearish. I will look for this index to show weakness and fight it out in the beginning of 2006, but closer higher by the end.

To wrap it up, the two major indexes tell more or less the same story in the long run, but in short term, the NASDAQ looks much weaker. Their support/resistance layouts are also quite different. While the SPX has a good 100 pts. overhead until resistance, the NASDAQ seems to be currently bouncing down from resistance. The SPX has likely support not far below us. The NASDAQ is on the verge of breaking support obvious levels close below. Considering the Indexes’ push/pull relationship to one another, I expect the beginning of 2007 to be somewhat more volatile than we’ve seen in the past 6 months with a likely pullback of some degree before regrouping and trying to go higher. Barring major tragedy or economic shocks, I would think we’ll see another bullish year in the end.

Perhaps it is overly simplistic to make predictions like this solely on the analysis of the indexes. There are obviously concerns of a slowing economy, Fed surprises, oil possibly moving higher again, the housing market not recovering nicely, etc. But at the very least, this gives me something to work with. As technical traders, we do not need to pretend to know it all. Regardless of what we think will happen, we can manage our risk and spot the rising tide by watching the charts. To quote Thinkorswim trader/instructor Joe Kinahan, “When you realize you’re a dummy, life gets really easy.” Makes sense to me.

This has taken much longer than I expected. I hope it was worth the read. I will try to complement this post with a look at some of the sectors in the coming week. As always, thanks for peeking your head in to see what I have to say about things.
Here’s to a profitable 2007!

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