Trader’s Narrative

Last week we looked at the head and shoulder chart formation which was evident on almost all major stock market equity indexes.

It looked perfect. The symmetry of the rallies making the shoulders and head, the volume, everything about it was picture perfect. Perhaps too perfect. I warned about failed head and shoulder patterns which cause prices to bolt the other way.

Right now, it looks like it was a false pattern. It trapped many giddy bears in the 8200 level and then put them through the meat grinder, taking the Dow Jones Industrial up 6% in 3 days flat. As the shorts cried uncle and closed out their positions (either because they hit their predetermined stop losses or because of margin calls), the rally started by the bulls gained even more momentum. While many will explain it by saying it was because of Intel’s (INTC) earnings release, tape readers know the real reason.

Not only are we back above the neckline of the head and shoulders pattern, we are once again above the long term moving average (simple 200 day). When something is obvious to everyone, then you shouldn’t treat it as an edge.

Here’s a short video from MarketClub from Adam Hewison on the recent action in the the Dow Jones Industrial index and what he expects going forward:

The quick bounce wasn’t out of left field since we looked at very short term indicators which told us that the market had quickly gotten very oversold.

An interesting factoid: after today’s strong close, 75.6% of the Standard & Poor’s 500 component stocks are trading above their 200 day moving average. That is the best breadth from this measure since June 2007. It is significant that it has been recovering relentlessly after falling to less than 5% for six months (almost continuously).

Also, Monday’s and today’s strength was actually almost back to back 90%/90% days. Today 93% of the volume on the Nasdaq and 96% of the volume on the NYSE was advancing. Then again, we’ve seen so many of these extremely positive breadth days throughout the bear market that they’ve practically lost all of their ability to command attention.

While this may have the feel of a classic bear trap, I’m not sure we’re going to just ramp up from here. Instead of either a cascade down or a rocket ride higher, we might just be climbing back into the previously established range bound trading. In other words, the lazy meandering action that is endemic of summer trading.

For economic and market news and to see what you may have missed last week, check out the list below. It is a small sample, to see it all go to news.tradersnarrative.com:

• Inside Ron Insana’s Time Machine
• Larry Summers: “I don’t think the worst is over”
• Morgan Stanley Plays Alchemist (Again)
• Fake Alpha
• Get a FREE Subscription to Financial Magazines
• How low can crude oil go?
• Worst Financial Gurus
• Everyone Talking about the Head & Shoulder Formation
• Rosenberg: Market Halfway Through Bear Cycle
• Smuggled $134 billion of bearer bonds fake or real?
• Smells like deflation
• The Wall Street White House
• Japan to Limit FX Trading

For the complete list, follow the graphic below:

And remember to check back regularly since there are interesting links added throughout the week.

The Week Ahead

Interactive Brokers Group (IBKR) went public a few months ago with a lot of buzz. Most of the attention was on the Dutch auction process they had chosen to go with, instead of the regular Wall St. investment bank route.

I’m not sure whether it was due to the process they chose, or the fact that the market got lethargic right when they debuted but the IPO sputtered.

A lot of people, had high hopes for IB but it ended up a disappointment. I even put in an offer but it didn’t get accepted because I was too stingy.

I took another look and noticed that it has carved out a fair head and shoulders pattern on the daily chart:

With today’s rumour of Warren Buffet’s involvement in Bear Stearns (BSC) the whole financial sector got a shot in the arm. I’m not sure if the rumour is true or not. There have been quite a few floating about.

In any case, I wouldn’t be surprised. BSC has all the hallmarks of a classic Buffet investment: beaten down sector, temporary dislocation, high barriers to entry, valuable name brand, loads of value, and loads of cash flow.

I’m seeing a lot of attention directed towards the weakness ni the US REIT sector:

• the CBOE Dow Jones REIT Index (DJR) weak relative strength
• DJR formed a clear “head and shoulders” pattern
• the weakness in the real estate market in the US
• DJR just fell through long term support at the 200 day moving average

So the REITs are finished at this point, right?

Not quite.

At the bottom of the March 2007 low, I shared a study by Lowry’s which looked at percentage of stocks above their 10 day moving average. It was wildly bullish at a time when others were panicky and fearful. Like everything I’ve come to expect from Lowry’s, it was top notch analysis.

So lets take a page from their playbook and look at the REIT sector as defined by the CBOE Dow Jones REIT Index and see how many are above their 50 day and 200 day moving averages.

As of Friday last week, only 21% closed above its 50 day moving average and 45% above its 200 day moving average. That tells you things are very oversold in the short term and will probably bounce rather than keep going down.

Keep in mind that quite a few REITs in the index are only above their 50 day and 200 day moving averages because they are being bought out. For an example, see Eagle Hospitality Properties Trust Inc. (EHP). So realistically we are even more oversold than that measure shows.

The REIT sector broke out in the summer of 2003 and entered into an uptrending channel. It has stayed within that channel and everytime it has dipped below, it has been to trap more shorts and zoom higher (the yellow line is the 50 week moving average):

And about that ominous technical formation: when something is obvious to everyone, especially a well known pattern such as a “head and shoulders”, then it probably will not complete as expected. This reminds me of the massive head and shoulders formation on the S&P 500 index which formed in the summer of 2002 at the 950 area (neckline). Everyone and their uncle was expecting it to complete. Had it done so, it would have meant a measured move to 400 on the S&P 500 !!

Obviously, it didn’t. Instead, the market bottomed towards the end of that year and then started on its bull run, which is still ongoing. The market has a tendency to make mincemeat of those who think they’ve “figured it out”. Especially when what they’ve firgured out is blatantly obvious.

Finally, take a look at the 90 day T-Bill rate:

As I mentioned when I wrote about the yield curve flattening, we are seeing a topping formation which may be presaging a cut in Fed funds rates. If we do see a rate cut, that would, once again, breathe new life into the REITs bullish run.

Here are the top 10 REITs in the US - representing more than $136 Billion in capitalization:

Simon Property Group Inc. (SPG)
Vornado Realty Trust (VNO)
ProLogis (PLD)
Equity Residential (EQR)
General Growth Properties Inc. (GGP)
Boston Properties Inc. (BXP)
Host Hotels & Resorts Inc. (HST)
Archstone-Smith Trust (ASN)
Public Storage Inc. (PSA)
Kimco Realty Corp. (KIM)

There are also a few ETFs:

Real Estate iShares (IYR)
Vanguard REIT VIPERs (VNQ)
streetTRACKS Dow Jones Wilshire REIT Fund (RWR)

Before I delve into this, let me go back to my previous call in this sector (blog accountability and all that jazz). Last year, at the beginning of July, I wrote that the gold sector was in for a rough patch. At that time, the AMEX Gold Bugs Index was trading at around ~340. I drew a neat little head and shoulders pattern, implying that it would head down to form the right shoulder.

The HUI did carve that right-hand shoulder but it didn’t complete the measured move, instead it bounced off the neckline. All in all a pretty good call. I’d say it deserves atleast an A- — but I’m biased

Today, the picture isn’t any brigher. If you’re a gold bug, I’m afraid you’re in for some (more) disappointment.

Although gold futures have bounced a bit, they’ve bumped their heads on serious resistance in the $700-$725 level. If you look at the relative performance to the equities market, you notice that things have been very lukewarm for gold bugs. As well, there is the recent matter of a massive short position by the commercials . According to the latest commitment of trader’s report, they’re as short as they have been at previous intermediate highs: late February 2007 and May 2006. One thing you do not want to do, is to bet against the commercials in any commodity. Unless you actually want to lose money.

The gold equities (as shown by the AMEX Gold Bugs Index) have been pretty much mirroring the commodity. Unless we see a decisive breakout from this range, money in this sector is wasted. Again, notice the relative performance compared to the S&P 500 Index.

If we combine the two graphs we get the k-ratio (not shown). And it is telling us the same story. Not a good time to be in the gold market. The breadth of the sector also confirms this with 60% of gold stocks being above their 200 day moving average. The best thing we can look forward to is more meandering.

But gold bugs are nothing if not tenacious. So while the equities are partying like its 1999 — with the Dow blasting through 13,000 today — a select few will choose to be “smart” and sit on their long positions in gold or gold shares, sneering at the equity bulls. Oh well, I guess that’s what makes a market.