Trader’s Narrative

You’ve probably already noticed this since the pattern completed in late July and early August. In case you haven’t, the Philadelphia Banking index (BKX) has carved out a fairly decent reverse head and shoulder formation:

Of course, the technical pattern in the above chart mirrors the one visible in other sectors as well as the general S&P 500 index itself. No surprise there since most stocks take their cue from the major index, rising and falling like the tide.

The one fly in the ointment is the left shoulder (see red exclamation mark on chart). Although the left shoulder is fully formed, I’d prefer to see a more symmetrical one to the right shoulder. That would have only been possible if the year end rally would have taken the Banking index a bit higher to reach the neckline. So it isn’t a picture perfect inverse head and shoulder pattern.

Back in June I mentioned that the financial sector was losing relative strength and the baton had been passed to the Semiconductor Index (SOX). Since then the banks have continued to lag the S&P 500 and the tech sector has been the engine of the stock market.

We’ve got considerable resistance ahead at the 50 level (on the BKX). But the measured move target is 74 - which takes us to the next significant support/resistance level. Needless to say, the reverse head and shoulder formation is the quintessential reversal pattern in technical analysis.

The semiconductor index (SOX) is a high beta sector which can be a leading indicator of the health of the market. It found a floor in late November of last year, much earlier than the S&P 500 index. From there it continued to power ahead with consistently better relative strength:

But in August, while the general market powered ahead, the semiconductors started to lag. That by itself wouldn’t be a major negative for the market. After all, there are naturally short periods of time when the SOX gives up leadership. What stood out at that time was that the trend line starting from November’s bottom and stretching for months and months had been broken.

I wasn’t the only one who noticed. Dave, a reader, contacted me then:

I just realized yesterday that my canary-in-the-coal mines, my lead husky SOX is out-of-sync with SMH, XSD, PSI, IGW, & USD, vis-a-vis their June highs.

Again, by itself, that wouldn’t ring any alarm bells. But considering everything else that we’ve covered which paints a picture of a market dangerously overextended, this just adds to the many other reasons to be positioned for a correction.

We know what the US market is doing, shrugging off every single negative news and floating higher almost effortlessly. But what about the emerging markets?

One of the strongest emerging markets before the recent bear market was Brazil and it has come roaring back with a vengeance. If you think the recent gains, whether a bear market or the real thing, are impressive, then consider Brazil’s gains.

Similar to almost all world markets, the Bovespa started the last bull market in late 2002 and went almost non-stop until late May 2008. As a sign of the impressive relative strength, it shrugged off any signs of a top in October 2007 and went sideways as other markets around the world weakened and fell. Then in early May it surged to new highs, to then reverse and form a top.

Using simple Weinstein stage analysis, it was easy to see the trouble signs. But even after such a strong showing the index still fell 60%. It reached its low in October and in the following months, every single low was higher than the previous one.

While the US market struggled, falling lower still in March, Brazil was already trading 19% higher than its October 2008 low. As of today, it has made an astonishing 70% gain from the extreme low of last year.

I don’t know enough about the fundamentals to make a case but I imagine it would refer to the fact that the Brazilian banks were, for the most part, left unscathed by the financial mess that enveloped US and European banks. And also the turbo boost provided by Brazil’s commodity wealth can’t be ignored. They produce everything from soybeans to precious metals.

But all that can be encapsulated in the relative strength of BOVESPA to the S&P 500 index. It has already surpassed the previous high it set in 2008.

There are a few ETFs for the country:

• iSHARES Brazil ETF (EWZ)
• WisdomTree Dreyfus Brazilian Real Fund (BZF)

As well, there are many ADR’s like:

• Petrobras (PBR)
• Itau (ITU)
• Banco Bradesco (BBD)
• Brasil Telecom (BRP)
• Brasil Telecom (BTM)

While continued heady gains are improbable in the short term, a pull back would bring prices back to the 150 day moving average (in red) which is slowly flattening out. This would then provide a platform from which it can realistically challenge the previous highs.

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While the general market, tracked by large indices like the S&P 500 (SPX), fell to lower levels than late last year, there are pockets of strength in some sectors. One sector that is showing surprising strength is the seminconductors:

Not only has it put in a higher low, it is close to breaking out in its relative strength chart (compared to the S&P 500) - not to be confused with RSI. As well, the 50 day moving average is flat, with prices well above it. The only downside is that the longer term, 200 day moving average, is still barreling down at a good clip and about to smack it around the 255-260 price level. Also, according to the internal measures of the sector, it is just too extended.

Here’s a closer look at the breadth within the Philadelphia Semiconductor Index (SOX):

Notice the cluster of data points where 90% of stocks in the sector have closed above their 10 day moving average. Not only is this very rare, it is unsustainable. Especially as the general market is similarly over extended and catching its breath. While things look much better here, as prices levitate out of the abyss and extend up and away, it isn’t a good idea from a risk/reward view to start buying here. This is where the smart money starts to unload the positions they built during the darkest hours.

There are a few other sectors in a similar technical position. For example, take a look at the AMEX Broker Dealer Index (XBD). From an optimists perspective, all of this points to a gradual rebuilding of the market - not a new bull market! But when the generals that lead the charge are tired, it is time for a pause. From a pessimists perspective, the bear market rally has exhausted itself and the brutal reality of a continuing bear market is about to reassert itself.

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While this bear is busy mauling everything in its path, there are some pockets of strength. One of them is right under our very noses: the Nasdaq composite index.

The individual charts of the Nasdaq composite and the S&P 500 Index, each show a crushing bear market. But the relative chart shows that out of the two, the Nasdaq is surprisingly strong.

Going as far back as 2006, Nasdaq’s relative strength has been putting in higher highs and higher lows.

But before we can get excited, the ratio of the Nasdaq to the S&P 500 ratio has to break 1.90 - that’s because since 2004, it has been in a holding pattern below that level. The last time it broke through was in early 1999, and you know the rest of that story.

Financial Sector
Of course, the sector that has everyone’s attention is the financials: banking, investment houses and brokerages. Although technically, a bull market doesn’t need the financial stocks leadership, this market has been primarily driven by the bank stocks because they have been the protagonists in this tragedy (or farce, depending on your point of view).

Today, the financials make up only about 10% of the S&P 500 index. So in a twisted sense, this sector has fallen so much that from here on in, it has much less weight to influence the general index. And that might be a good thing because while it may take decades for the US banks to come out from under the shadow of government intervention into some semblance of normalcy, the rest of the market can push forward.