Trader’s Narrative

Trying to peer into the fog of future price action, I looked at the advance-decline numbers for Nasdaq. Here’s a chart of the Nasdaq along with the daily A-D numbers smoothed over a 7 day moving average:

As you can see, sharp spikes down are usually good spots for a trend reversal (a bottom, either short lived or intermediate). In the past 3 years we’ve had the following spikes (reading below -700):

• mid-March 2004 - small bounce
• May 2004 - small bounce
• mid-July 2004 - small bounce
• August 2004 - intermediate bottom
• mid-Jan 2005 - small bounce
• April 2005 - intermediate bottom
• October 2005 - intermediate bottom
• May 2006 - small bounce
• June 2006 - small bounce
• July 2006 - intermediate bottom
• March 2007 - ???

So a spike in that territory usually defines some sort of oversold. But what determines if it is a bounce or a more solid bottom?

A good tell is the % of stocks above daily moving averages. In each case of an intermediate bottom, both the long term (200 day MA) and the short term (50 day MA) were quite low. This is just a back of the napkin calculation, so what I mean by low is anywhere between 30%-20% or lower.

The only time that this didn’t happen was in last summer (June 2006). Then we had both short term and long term % stocks above MA very low but we had to wait another few weeks for the definite bottom to be carved.

Right now, we just don’t have that. The % of stocks above moving averages is sitting quite high at around 50% and 35% (for long term and short term respectively)

My conclusion after all this is that we are probably seeing a short lived bounce here. We need more capitulation to launch another leg up. So be careful out there.

Utilities have been among the few sectors with high relative strength during this recent swoon that began in May. Even Chairman MaoXian recently made note of this. Usually this would make me like the sector because by swimming upstream against the current, it is showing that the ’smart’ money has spoken. But there is more to it when you look beneath the surface.

For one, the breadth in the sector makes the probability of a continued rally very low. Right now, 100% of the constituents of the utilities ETF (XLU) are trading above their 50 day moving average; as well, more than 90% of them are trading above their 200 day moving average. Much like a sprinter after a mad dash, the sector is out of breath having exhausted itself in this recent run up. The best thing that we can hope for is a pause. A fall from these heights is also possible since the sector is up to an old resistance that has pushed it back since August of 2005.

Another reason why I’m suspicious of the sector’s relative strength is that it is not the ’smart’ money that has been buying utilities. Looking to the Rydex utilities sector fund, its assets have swelled from a paltry $10 million from just a few months ago to almost $100 million today. Obviously the retail, Mom’n'Pop investors are crowding into this sector like crazy. Maybe their rational is to take refuge into ’safe’ stocks, maybe they are mo-mo investors who are simply buying because it has gone up, maybe they think the interest rate cycle has peaked… who knows.

All I know is that they are the crowd to fade not emulate. In fact, the last time the Rydex crowd got this excited about the utilities sector fund was back in July 2005 (first red circle). The other times were September 2000 and February 2001. Both great long to intermediate sell signals.

Although I don’t think the utilities are an automatic short here, if you’ve got any, it is prudent to look for exits and tighten stops. This would be especially wise considering that the sector and almost all of the individual stocks within it printed a very bearish wide range dark engulfing candlestick today. This is a very powerful reversal pattern, especially after a significant run up in price as we’ve had in utilities.