Nasdaq 100 Jewels Beginning to Appear

I happened to catch Carter Worth of Oppenheimer & Co. on Fast Money tonight and I was amazed to hear him agree with me or, as he might see it if we ever had a chance to meet, that I agreed with him. It's fascinating how two experienced technical analysts can look at charts and arrive at identical or, at least, similar conclusions.

Carter anticipates a short, shallow correction followed by a continuation of the bull market. What was even more striking to me, however, were his specific stock recommendations: IBM and AMGN. Not only did he see some upside opportunities in those charts but, dare I say, he liked them from a fundamental perspective also. For example, he pointed out that while IBM is at the same price it was at its peak 10 years ago, today's P/E is around 11 as compared to the over 40 P/E back in 1999 (unfortunately, I failed to note the actual numbers). Amgen presented a similar technical and fundamental picture.

Carter may have been constrained by the broadcast schedule but, without those constraints, I had seen the same thing for some time and would even go father and say that the one area of opportunities in the next leg of the bull market (after the correction we both see coming in the coming New Year) is among nearly any of the large-cap Nasdaq stocks.

Scrolling through long-term charts (10 years or more of weekly and 9-day price/volume bar charts) of the Nasdaq 100 stocks and underscores one or more of the following common bullish characteristics:

• 54 of 100 are have "bull crosses" alignment in their moving averages (price>50>100>200>300-DMA)
• 74 have "golden crosses" in their moving averages (100>200-DMA)
• 41 of 100 have 300-DMA that are upward sloping
• about to break into new all-time high territory
• successfully testing recent past resistance levels as support levels
• breaking above extremely long-term downward sloping resistance trendlines
• stocks in the group have out-paced the S&P 500 Index in that: 29 exceed their levels when the S&P peaked in October, 2007, 64 have better performance than the S&P since the S&P peaked and 54 have performed better than the S&P since the March 9 bottom

Contrary to the views of some readers, I am not a perma-bear. Actually, I usually remain optimistic much longer than I should and actually have a difficult time of restraining myself from buying stocks. But there are times when caution is warranted and the market's recently being locked in a 2 percentage point channel is one of them.

But I would be remiss in not mentioning that the Nasdaq Composite has recently broken above a similar horizontal channel indicating that some NASDAQ 100 stocks have already begun climbing.

Some components of the Nasdaq 100 look awfully compelling, like ORCL:

and AMZNand IBM

It's exciting, about as exciting as it felt back in March with all those clear reversal bottom patterns (remember, "shooting fish in a barrel"?). So far, however, it's only a prospect, a possibility rather than a strong momentum ride on which to piggyback. After the correction Carter and I are expecting, however, this will be the place I begin mining for new opportunities.

More Evidence A Correction Is On The Way

I took time this weekend to read what other bloggers thought might be the Market's future and felt relieved to see that everyone is confused and pretty much sitting on the fence waiting for the winner of this Bull/Bear battle. Most see a convincing breakout, either way, from the narrow channel the market's been in since the beginning of November as the indicator as to whether the bull market will resume or we go into the long-awaited correction. You know my feeling but I thought I'd take another look and see whether I could find other clues in the Market's past.

The Market's dramatic, quick recovery hides something profound (love that word; it means "of deep meaning; of great and broadly inclusive significance") in the charts: the rate and extent to which the market has run ahead of the recovery. There have been bull markets in the past and I wondered how those markets compared this one since March. The metric I used were the ratios of the Index to its 200- and 300-day moving averages. To determine how typical this bull run was, I calculated the percentage that the Index was ahead of its moving averages:

Since March 12, 1963 (the extent of my database, there have been 11779 trading days, thousands of corrections, many bull and bear markets, several Market Crashes. In this volume of history, I thought we could find some precedents that would tells how typical this bull market recovery has been. Here's what I found (click to enlarge):

The current recovery has carried the Index to levels that are atypically ahead of its moving averages. In other words, the March-October move that repaired the damage caused by the financial panic was so powerful because the devastation that preceded was so deep (the Index had never been so far below its moving averages). When were those trading days farther to the left of today's positions (i.e., when the Index was farther above its moving averages)?

With respect to the 300-DMA, they were the 1982-3 recovery and the 1997 mini-crash resulting from the Asia financial crises (sound similar to today?). When the Index was exceedingly ahead of its moving average in 1983, it went into 7 to 8 month horizontal channel of about 10% followed by a further 8% decline over the next six months before resuming the bull market. The 1997 correction was a 10%, six-month horizontal channel followed by an upside breakout and continuation of the bull market.

The 1975 bull market (the market went up 45% over 6 months to July), saw a 15-17% correction to allow the 200-day moving average to catch up to the index. The Index actually saw support in that moving average and bounced off of it twice before continuing its upward momentum.

The market was very much ahead of itself this October and it will take 6-8 months until either it corrects closer to the moving averages or remains in a horizontal channel allowing the moving averages to catch up to the index. Until evidence proves otherwise, I'm sticking scenario painted earlier in "Reversion to the Mean Still On Track" at the beginning of December.

This Damaged Market Is Ready for the ICU

I haven't taken its pulse, the market's vital signs, for some time. Given its inability to advance above 1120 on the S&P 500 and being caught for the past four weeks in narrow channel, an ever tightening coiled spring ready to bust out in either direction, it's time. What are individual stocks doing while bulls and bears are battling it out for control of the next momentum move?

The picture is not a comfortable one for the bulls. More and more stocks are jumping ship, abandoning the effort to push the market to higher levels and more and more are succumbing to the weight and beginning to join the bearish camp:

Ever since reaching a peak around October 19, when the S&P Index was at approximately the same level as it closed today, the number of stocks making 12-month new highs has declined from 510 to 141, the number of stocks over their 100-day moving average has declined from 77% to 52% and the number of stocks able to retain the "Golden Crosses" in their moving averages has declined from 70% to less than half.

On the flip side of the ledger, what's the story among stocks that have rolled over?

Although still a small number, more stocks are making new lows as compared with the number on October 19 when the Index was at the same level. Even more alarmingly, the number of stocks that have rolled over their various moving averages has nearly increased since two months ago showing that downside momentum is growing stronger among average stocks (as contrasted with the large cap leaders).

Today, nearly half of stocks are now below their 100-day moving average, and more than a quarter are under their 200-day moving averages. As important as it was when we were watching the Bull Market emerging last spring, it is just as alarming to now see a continually growing number of stocks (currently 12%) to have made Black and Bear Crosses (the mirror images of Golden and Bull Crosses).

On December 3, in "Reversion to the Mean Still On Track", I showed a possible flight path for the market modeled on the 1974 recovery. On November 22, in "Protect Yourself Against An Imminent Market Correction", I spelled out a strategy using call options on the 2x S&P 500 Ultrashort ETF. And on November 20, in "One Reason the US Dollar Index Might Increase" we anticipated a reversal in the $US followed by a strategy based on a reversal of emerging market stocks with "Positioning for Year-End and Speculating with EDZ".

I may have been early and you may not have understood or bought into the strategy I outlined but that's o.k. since there are many other equally good ways of playing a market correction. But seeing the market's vital signs continuing to erode, the time may be near to send this patient to the ICU.

Those Other "Banks"

While we're all sitting around waiting for the wind to pick up (if you don't know what I'm referring to you didn't read yesterday's posting) you might want to take a look at a little corner of the financial world, some of the companies on the Credit Services Industry Group. If we were on Wall Street's sell-side (those are the guys who go out and pitch stock ideas to institutional investors) we might make up favorable stories about:

• the improving economy allowing these stocks to be on the verge of making a comeback, or
• these companies stepping into to fill the gap that's opened as a result of the real estate lending problems of the banks, or
• the continually increasing slope in the yield curve offering these lenders' profit margin improvement for the first time in several years.

But if we're technical analysts who look at the charts, we might see accumulation taking place. We might see that the excess supply of stock is being absorbed into stronger hands and enabling these stocks to show some signs of emerging upward price momentum.

Here's what I'm talking about:

• CACC (Credit Acceptance Corp): An auto loan provider that has just broken into all-time new high territory. [in full disclosure, I just purchased the stock]
• EZPW (Ezcorp): small consumer loans through pawn shops (also sells merchandise forfeited by borrowers). Stock has been in a horizontal channel for nearly 3 years. An upside breakout would put stock in all-time new high territory.
• FCFS (First Cash Financial): another pawn shop operator. Stock is also about to break into all-time new high territory
• NEWS (Newstar): provides debt financing solutions to middle-market businesses and commercial real estate borrowers. Stock is close to completing an ascending triangle reversal bottom pattern.
• SLM (SLM, the old Student Loan Marketing Co., or Sallie Mae): loans to .... students
• STU (Student Loan Corp): competitor in student loan market

Needless to say, I selected these stocks strictly because of their interesting charts; further research and discrimination among them I leave up to you.

Becalmed, Waiting For New Tailwind

If there's one piece of advice I can offer right now is that you not focus on any individual stock. Look instead at the market. It doesn't matter what you hear on CNBC or read in (other) blogs and newsletters about one stock or another because all are moving in unison to one extent or another.

Think back to March, when all we could see were stocks forming reversal bottom patterns. There were inverted heads-and-shoulders, upward sloping triangles, cups and handles, double-bottoms .... you name it and you saw it. Some of the formations began six months prior, some four months. Some were broad and encompassed 70-100% fluctuations from trough to peak, while others were narrower and only covered 20-40% moves. You could have played that volatility but uncertainty reigned since no one was sure where the bottom was and whether any of the moves up were dead cat bounces, suckers' rallies or the real thing.

The talking heads were out selling their wares (stocks) telling you why it should be bought because of a strong balance sheet, good cash position, no toxic assets, relatively immunity from the financial crises because of a large export business or the opening of burger joints or coffee houses in China. But only a few rare special situations were able to ignore the base-building phase.

What I'm telling you is that if you were looking for a stock that's different and will succeed in breaking away from the crowd you're going to be disappointed. After scanning hundreds of stocks, the situation today feels similar to that period back in spring: there's a common denominator running through nearly all stocks and it's the spring that the market's tightly winding.

Nearly ever stock I see is struggling to either cross a significant long-term resistance trendline (overhead supply), cross a key moving average (a downward-sloping 300-day moving average) or escape from a relatively narrow channel. This struggle began in late July to early September, sometime around Labor Day. It was just about the time that the 200-day moving average of the S&P 500 Index turned positive, just after the 100-day moving average crossed above the 200-day (the "Market's Golden Cross") and when the Index itself crossed above its 300-day moving average.

Just as most were beginning to believe a bottom was in, that green shoots were popping up all over, the wind that had been behind our backs started to die down. Since mid-September, we've been becalmed, waiting for a whiff of wind to tell us which direction we'll be going. There's no question that the market's internals have improved. The market's 300-day moving average has turned up for the first time in over a year; 27% of stocks now have an upward sloping 300-day moving average while an equal percentage now have charts with "Bull Crosses" (where the price > 50DMA > 100DMA > 200DMA>300DMA and all are pointing up).

So we may have been experiencing a consolidation beneath the surface since September, a "stealth correction" you might call it. Take TEVA as an example, a great move up from the October low only to be becalmed in July in a horizontal consolidation channel:

How about SNDA (Shanda Interactive), China's big online entertainment and gaming site:

SNDA more than doubled between December and July only to hit a brick wall and go into a 7 month pennant consolidation formation. Or what about ANR (Alpha Natural Resources):

ANR had a clear reversal formation at the beginning of the year, broke out into a pennant shaped "buyers' remorse" correction back to successfully test the support and has been in a channel consolidation since September.

I'm not clear which way the wind will blow when it picks up again. I still have my longs and hedges in place but I'm beginning to have second thoughts about the correction I was looking for in the 1125-1150 area. Because of the strength in the market, we may already have had it in 1060-1110 area and not even known it.

Large or Small, A Correction

Last week, in a comment about a New York Times article, I wrote:

"The S&P 500 Index, the solid blue line is hard to see when overlaid on the bar graph of the OEF, the S&P 100 Index because they're almost identical. Granted, small-caps marginally outpaced large-caps during July-October but that advantage has eroded since."

I find that I may not have been comparing sufficiently dissimilar indexes. Because the S&P constructs their indexes by capital weighting them, the S&P100, a subset of the 500 stock index comprised of the largest stocks looks identical. But when you compare with a true small cap index you find a more interesting divergence.

Investors use any of a multitude on indexes to monitor the market's action. There's the granddaddy of them all, the Dow Jones Industrial Average, an index of stock prices of the country's 30 largest stocks. A broader gauge is the S&P 500 Index which combines the stocks of top 500 public companies. An even broader index is the Russell 3000 Index. Furthermore, the broader indexes are subdivided into subsets of like companies, like companies considered small-cap, mid-cap, growth or value.

I usually focus my market monitoring to the S&P 500 Index to the exclusion of all the others but something caught my eye this weekend and I need to correct what I wrote last week: participation in the market's advance was actually becoming narrower over the past several months. Large-caps have continued to forge ahead while small-caps and, to a lessor extent, mid-caps have consolidated.

The "dash for trash", when money was flowing into the stock of almost any small to mid-sized company forcing their single-digit prices to double and sometimes triple off their market crash bottoms, ended in September. If there's going to be higher income tax rates next year as Congress moves to close the Federal budget deficit, then it makes sense to capture those small cap profits this year, at the lower rates. Here's a chart of the S&P 600, an Index of small caps (click on images to enlarge):

Small caps broke above the neckline of the market's inverted head and shoulders bottom in July with a two and a half month, 25% bull market spurt. Since mid-September, these 600 small cap stocks have been forming a symetrical triangle. By the way, the Russell 2000 Index, a broader index of smaller capitalization stocks looks the same.

By comparison, the Dow 30 Industrial Average hasn't shown any indication of a consolidation: The chart of the Russell 1000 Large Cap Index shows a similar pattern:

Interesting, but what does it mean, how do you play it? I guess the answer rests in whether you're looking for a market correction in the new year or a resumption of the bull market. As I've written before, I see both happening next year .... a correction first followed by new highs later in the year. The small caps, since they've had the greatest gains this year may have consolidated already and will lead the market higher next year. A quick and not overly steep consolidation after New Years will be concentrated in the large caps.

That's my guess. What's yours?

HMO Stocks: AET, UNH and WLP

Even the best in sports needs coaching from someone who can give them objective feedback and playing the stock market game as an individual investor is no exception. A long-time reader and someone I've been mentoring since the last summer's start, let's call him Eric, alerted me to an industry group with charts that have many of the same characteristics as the general market had when we saw the inverted head-and-shoulders in the S&P 500 Index. One knows they've done an excellent job of mentoring when the mentee teaches the mentor.

This was recently brought home to me when Eric suggested I take a look at WLP (Wellpoint), a member of IBD's Medical-Health Maintenance Organization Industry Group. The last time I wrote about medical stocks was on February 4, when I wrote:

"Will market participants see all this resistance overwhelming or will traders large take a move towards and above each one of these obstacles (along with favorably received Government action) be a signal for more money to be moved out of Treasuries and into riskier equities.

While still mostly on the sidelines myself (80% in cash), I have edged out into some equities. I'm always on the lookout for more stocks with good charts that also have met or are close to meeting the additional criteria of have a "golden cross". Many of these stocks happen to be in the defensive healthcare industry groups like pharma, drugs and biotech."

Charts included in the post were

• MTXX (then 18.19 but trashed in June due to having to pull Zycam from the market),
• SIGA (then 4.02, yesterday 8.66, or 215%),
• CMN (then 14.68, yesterday 19.45 or 133%) and
• SXCI (then 20.00, yesterday 52.02, 260%)

Oh, if I had just followed my own advise and stuck with those recommendations. But there may be another opportunity (albeit, with the market's completely different backdrop ... anticipating a correction rather than anticating the recovery) among the 15 HMO stocks. Some have experience significant appreciation since March 5 like CVH (178%), CI (160%) or HNT (108%). But these three (including Eric's WLP) caught my eye as group members that have a good chance, with what appears as debate on the healthcare approaching some closure, to begin finally to follow the herd:

• AET (Aetna)
• UNH (United Health)
• WLP (Wellpoint)

Far From Random

I don’t usually do book reviews but decided to make an exception for this one I just ran across. I strongly recommend it if you're interested in getting a better understanding of how and why you, as an investor, make the decisions you do and why stock charts perform the way they do. The book, “Far From Random” by Richard Lehman, was published by Bloomberg Press earlier this year.

The book is organized in three parts: the first part is an excellent critique of fundamental analysis and including its shortcomings. In the same way that the advocates of fundamental analysis ridicule and attempt to debunk technical analysis, Lehman dissects the academic concepts of Efficient Market Theory and Random Walk and why the various techniques fundamental analysts use to assemble their fair market valuations of individual stocks just don't work.

Lehman then turns his attention to the question of market timing. He underscores the inconsistency of Wall Street professionals (of which he was one for 30 years before switching to academia himself) who instruct individual investors to sell stocks when they become overvalued but never apply the same discipline to markets (time the market, sell stocks and move into cash) when they become overvalued as was the case at the end of 2007 and beginning of 2008, the beginning of the Financial Crises melt down.

The next part of the book, its guts and essence and the part I think is the best, deals with a form of stock market research that few individual investors are aware of: the study of behavioral finance, a discipline that began thirty years ago among behavioral psychologists and now includes countless research reports and findings. "Many aspects of human behavior, when aggregated over a large number of people, can be indeed be quantified", writes Lehman. He then proceeds to define many (investor) behaviors impacting stock prices and trends:

• Ambiguity Aversion: people will give something up in order to have something more certain....people underweight outcomes that are merely probable compared with outcomes that are certain.
• Anchoring: people put mental stakes in the ground on a reference point that forms the basis of quantitative estimates such as stock prices...for example, anchoring purchase price when considering what we are willing to sell for.
• Disposition Effect: causes people to be heavily biased in favor of disposing (selling) a stock or other asset to realize a gain and against disposing to realize a loss.
• Mental Accounting: people mentally categorize their money differently according to time horizon, levels of wealth, life changes, family changes.
• Gambler's Fallacy: wagering that after seeing a streak, that the gambler (investor) assumes there's a high probability that the streak (of black/up days) will end and reverse (to red/down days).

These are just five of 23 psychological factors impact investors' buying and selling decisions. If I'm honest to myself, I can find many in my own trading history. I realize that many of the rules and disciplines I'd created to guide my trading are aimed to neutralize the most damaging of these behavioral phenomenon.

The final part, what Lehman calls "Trend Channel Analysis", is the weakest and most narrow (no pun intended). He focuses on trading channels (movement between parallel trendlines) to track momentum in one direction to the exclusion of other tools that, I believe, better identify turns in momentum direction. As readers know, I use moving averages (simultaneously four different time horizons to confim each other) in conjunction with trendlines (support and resistance variety over channels).

The book is just over 200 pages and is a relatively easy read. It will improve your investing experience by helping you understand how and why you currently make the decisions you do.

Large or Small, That Is The Question?

"...the performance gap between the weak and the strong has rarely been as pronounced as it has been since March's market lows. The extreme outperformance of the more speculative stocks could make them vulnerable to another market shock.....'high quality stocks are about as cheap as they have ever been relative to shares of firms with weaker finances. It's almost a certain bet that high-quality blue chips will outperform lower-quality stocks over the longer term.'"

That's what Mark Hulbert wrote (and quoted from Jeremy Grantham, the chief investment strategist at GMO, a money-management firm) in yesterday's NY Times. The theme of the article was, according to Grantham, that the Federal government, by reducing interest rates, "effectively encouraged huge amounts of risk-taking in financial markets. The sizable disparity of junk over quality should not have come as a big surprise given how massive the government's stimulus has been." The conclusion was based on the following findings:

• The 20% of stocks with smallest market capitalization have on average outperformed the largest 20 percent by 72 percentage points.
• Since 1926, small-caps have outperformed large-caps during the first 9 months of all bull markets by 21 percentage points.
• Since 1926, only first nine months of the 1933 bull market, the middle of the Great Depression, produced a gap in the performance of small- and large-caps greater than this year's of 196 percentage points.

With all due respect to Grantham and Hulbert (who am I to question their experience, intelligence and integrity), I decided to do my own research and look at the charts. I wanted to see how the S&P 600 SmallCap Index compared with the S&P 100 Index (tending to be the largest and most established companies in the S&P 500). Based on the Hulbert article, I was expecting to see a wide disparity between the two indexes when one was overlaid against the other; interestingly that wasn't the case. See for yourself (click on image to enlarge):

The S&P 500 Index, the solid blue line is hard to see when overlaid on the bar graph of the OEF, the S&P 100 Index because they're almost identical. Granted, small-caps marginally outpaced large-caps during July-October but that advantage has eroded since.

Where's the truth here? What are the Hulbert and Grantham motivations? Are the two S&P Indexes not representative? Perhaps you know the answer because I don't see a significant enough difference to jump to the politically-charge assertion that monetary policy is leading to risky behavior in financial markets.

My take away from these graphs (at least for the period 2007-2009) is to go back to Benjamin King's truth that ""50% of a stock’s price movement can be attributed to the overall movement in the market, 30% to the movement in its sector and only 20% on its own." This was something I often wrote in the middle of last year's crash. My guess is that it's equally true during this year's recovery and, as I believe, up-coming correction.

Reversion to the Mean Still On Track

This morning's Labor Report was a shocker but I'm not convinced that "pleasant surprise" expectation hadn't already been baked into the market. Hasn't everyone been talking, month-after-month, about labor market improvements in terms of continually smaller increases in the unemployment rate? So, if the numbers remain unrevised, then the risk has flipped from upside on pleasant surprises to now finally risk of downside move from unpleasant surprises.

I'm going to stick with the report I had drafted before the announcement because I believe it's still relevant.

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We've arrived here at the Southern Command Post on the West Coast of Florida, I've set up the wi-fi network, installed a new wide-screen second monitor to my system and am ready to go.

I had a lot of time over the past several days while driving to ponder where this market may be headed and my thoughts often drifted back to where we have come from. During the depths of the Crash from October to April we continually looked for precedents to divine what the future. We looked to the 1929-32 Great Depression Market Crash and the 2000-03 Tech Bubble Crash. We also dissected the 12-year secular bear market of the 1970's looking for similarities between that era's oil shortages, politics, currency situation and stock market and the present situation.

Along with the Coppock Curve, a very long-term indicator that gave me some confidence in March that we had reach the bottom was something I labeled "Reversion to the Mean". The Indicator statistically determines through regression analysis of the S&P 500 Index since 1939, the market's growth and the upper and lower boundary (at two standard deviations) of its volatility around the mean. In a May 1 piece entitled "Measuring Market's Health: Moving Averages, Coppock Curve, Mean Reversion" I wrote:

"....while we're holding our breath that all these signals ultimately follow through with a promise similar to past experience, it could also mean that we're not going to see the all time highs of 1500+ for some time. If the market follows the track of the 1974-75 Bear Market, the highest we might see the market by Year-End 2009 is 1050-1075 and 1250-1275 by Year-End 2010. While that's a respectable 20+% gain for next year, it's not the sort of volatility we've grown accustomed to over past several months. But then again, who needs that level of volatility."

Flash forward seven months and we see that the market has actually followed fairly closely the trajectory of the 1974-75 Bear Market.

The high so far this year was today's intra-day high of 1119.13, marginally higher than the 1075 forecast on May 1 when the Index as 877.52. If the market continues on the 1974-76 track then we should look forward to a minor correction back to around 1000 followed by another upleg carrying the Index above 1225 by next year-end:

The projection is calculated simply by applying the ratio of the 1974-76 index to the extrapolated lower boundary of the long-term regression line so the Index's future path is a copy of the path it traced in the prior period:

Last May, I thought there was a slim chance that the two recoveries could follow nearly identical paths. It will be amazing to see whether the correction on in the forecast actdually materializes.