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Technical Tuesday - End of the Mega Trend?

By Chris Rowe May 10, 2011 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Every Tuesday (the day I write for The Tycoon Report), before the article, I will list one or two "test your knowledge" technical analysis questions and after the article I'll list the answers.  I hope you find this fun and I hope it helps you make more trading profits.  Sometimes small bites can have a huge impact.

Technical Analysis Question of the Week:

In the 4-year presidential election cycle, which is statistically the strongest year?

a.  Post-election year
b.  Mid-term election year
c.  Pre-election year
d.  Election year

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If you have a favorite editor of The Tycoon Report, I'd like to hear about it in the comments section by clicking the "rate this article" link below the article.   Especially since it's largely "Chris Rowe fans" that read when I write on Tuesdays, and that might make it appear that I'm favored. 

But why wait for your favorite editor's day in The Tycoon Report to hear what he has to say about the market?  Do you want more than the one topic he decides to write about that week, or do you want more variety from your favorite money managers and floor traders?

If so, you should listen to our daily morning audio market commentary to get your daily edge on the market.  Stop thinking like an individual investor! 

If you haven't done so already, sign up for Morning GPS, free to Tycoon Report readers, and hear what Teeka, Costas, Ed and I have to say about that day's market.  Then come back and read this incredibly exciting article, below!

When Dylan and I founded Tycoon in 2004, the number one mission we set out to accomplish was to help individual investors avoid costly mistakes, and to simply make you a better trader or investor.  That's what the following article is intended to accomplish ...


End of the Megatrend?

I've been sitting at my desk for THE LONGEST TIME, trying to decide whether or not to title my article "Sell in May, Go Away" or "Buy in May, Here's the Play".  It's a deadlock!

Why?

One of the greatest gifts a trader can have is the ability to make both a bullish case as well as a bearish case for any given situation.  And right now, I can make a pretty strong case for BOTH.  The tie breaker will probably happen soon, and today I'll tell you what the tie breaker will be, so you are ready to pounce when you see it. 

I'll REALLY simplify this market's story when so many pundits are trying to complicate it for you.  Do they think it makes them sound smart?  If you get a chance to interact with them, next time just stop them from telling you what WILL happen and ask them to spend 80% of the time explaining what IS HAPPENING RIGHT NOW, and you'll know right away if they're worth listening to. 

Don't forget that 80-95% of the battle is understanding the market we are in at this very moment.

Shall we?

The question right now is whether or not the sector that has led this bull market higher -- commodities, most notably, energy --- has topped out, or is in the process of doing so.  Because when bull market leaders top out -- like technology in mid-1998 - 2000 ... like financials in mid-2007 ... like energy in mid-2008 -- the general market tends to follow suit (unless, of course, the last leaders can "pass the baton" to a new group before a market collapse, which rarely happens).

Right now, commodities look like they may be in the process of topping out, and if the dollar can break the down trend, we will almost certainly have a commodity massacre on our hands (worse than what we've seen so far).  And as Teeka Tiwari pointed out in his April 6 article "Tech Wreck Warning Signal", 42% of the S&P 500 gains in Q1 came from the energy sector.  (I should note that he also said back then that it's a warning sign, and NOT to exit energy yet.)

Take a look at the table below and notice that, while Energy has lead the way higher, they got hit the hardest in the first week of May. 

S&P Sector Performance as of May 5, 2011 (the day of the commodity "mini-crash")

 
S&P sector 12-month 6-month 1-month
Energy
27% 19% -7%
Telecommunications 26% 7% 1%
Materials 24% 8% -5%
Consumer Discretionary
19% 11% 2%
Industrials 18% 13% 0%
Consumer Staples 14% 7% 4%
Health Care 14% 12% 6%
Technology 13% 5% 2%
Utilities 10% 3% 3%
Financials 1% 3% -3%
 

Gains concentrated in one sector are seen near tops.  When leading sectors reverse, it's usually at a top.  When everyone believes that the bull market in the sector can't possibly be over, that the big sell off is a buying opportunity, it's a sign of a top. 

THE MEGATREND

If you follow the megatrends, the money will come.  I learned this from Dylan and Teeka in the mid 1990s, and it's the Achilles heel of the financial market monster. 

The latest leaders -- commodities -- have been the result of the underlying megatrend, which is the decline of the U.S. dollar. 

So the megatrend in commodities can be broken down into two parts:

1. The decline in the dollar (inverse effect) adding upwards pressure to commodities. 
2. The global demand for commodities. 

The megatrend in commodities has largely been based on the dollar decline, as Bernanke prints his way out of economic trouble. 

In a recent article by our very own Ed Pawelec, "What are the commodities markets telling us", he pointed out that, while gold and silver were rallying (two metals that are considered quasi currencies being used as a hedge against the dollar decline) the DEMAND driven, or global growth driven commodities, copper and lumber, have been in the dog house.  This, even in the face of a declining dollar, which is supposed to add upwards pressure.

So again, separate the declining dollar effect from the demand effect here.  The currency hedge has been advancing while the global expansion in commodities has been declining.  That tells us that the commodity advance is running on only one of the two engines. 

Also, consider that Treasuries have been rallying.  So?

Investors buy bonds when they aren't worried about the significantly reduced buying power of the principal that they will be paid back in the future.  Said differently: bonds are bought when inflation isn't much of a concern.  Demand for bonds tends to increase even more when deflation is the main concern (because perhaps principal will be paid back to the investor when that money can buy more stuff).  What I'm pointing out here is that the recent advance in treasuries might mean that markets are saying inflation is less of a concern.  (Less need to hedge inflation by purchasing commodities.)

I know this is "technical Tuesday" and I try to stay away from the jibber jabber from the media, politicians, government, etc., but consider for a second how nonchalant Bernanke and Geithner were in the recent press conferences when responding to concerns about the declining dollar.  Either they're crazy, or they see something everyone else doesn't.  I speculate they are not crazy.  (SIDE NOTE: I do admit I go back and forth on that.)

When Bernanke is asked about the inflation in food and energy prices, the most volatile of the inflation numbers, he responds with a "40-yard stare" by saying that the food and energy inflation is "transitory" and he implies that prices will correct themselves. 

PUTTING IT TOGETHER

It sounds like Bernanke and Geithner are telling us there is trouble ahead, and that there will likely be less growth and less demand for commodities like energy.  I'm thinking austerity measures that will have people traveling less, spending less, and worrying more about deflation down the road.  It seems that, so far this year, the bond market has been telling us the same thing. 

Who is right? 

The inflationary camp - like investing legend Jim Rogers? 

His ex-partner George Soros who just sold the majority of his gold and silver holdings from the accounts of his investment fund, the Soros Fund Management, over the past month?

The deflationary camp?

I don't know.  You don't have to know the answer either, because 99% of the people reading this will play the intermediate-term markets (weeks to months) even if they start out saying they are long-term investors. 

The "story" is important -- yes.  The "fundamentals" are important -- yes.  But it's the technical action that is most important and that matters the most to us.  So we watch the first two, and trade based on the latter.  The most important story is the one that prices are telling us. 

We've separated the demand story from the inflationary hedge story so far.  We've heard the story that demand due to global growth based commodity prices are telling us.  Demand isn't so strong.  We've heard the story that inflationary hedge commodity prices are telling us.  But it's not as clear...

YES -- A lot of the selling we saw recently was margin selling.  A lot of the money in those metals was speculator money -- largely people trying to ride a strong trend, more so than hedging against the decline of the dollar.  

But what about the rally in treasuries? 

One more thing to point out is that hedge funds see a trend and play both sides of it.  That means they not only buy commodities, but they short the U.S. dollar at the same time (adding upwards pressure to the commodities they own).  When margin requirements were raised, there was "margin selling" (selling one asset to raise enough money to hold the rest of a position on margin).

Currency positions are leveraged 10 to 100 times more than commodity positions, so when the funds unwind the commodity trade, they are unwinding the short dollar trade BIG TIME!  They buy it back, adding upwards pressure to the dollar and pushing commodities even lower!

Now that we know that we can strip out the "commodity demand" pressure on commodities, and focus more on whether the inflation hedge is ending or not, let's focus on the wild card which is being pushed by the Middle East and North African uprisings:  Energy!

Coming Full Circle

We started by talking about the stock market, and whether the leading sector in the stock market is reversing.   Below is a 1-year chart of the S&P energy sector ETF, which is weighted by market capitalization.  You can see that it recently broke below some key levels that it's trying to push back above.  This is what you have to watch closely, because the strength in the energy sector is critical to the strength of the rest of the market. 

After making a double top with a two massive negative divergences in the MACD and RSI (momentum indicators), which are often a precursor to a bearish reversal, XLE moved below a key support level at $75.00.  (It has since moved back above that level, which is one sign of potential strength.)

You can also see it moved below the key 50-day moving average.  (It has done this two other times this year and recovered.  It's trying to recover once again but when a security slices above and below a key moving average numerous times after a big run higher it's often a sign of a topping trend.  We'll have to wait and see.)

(Click on image to enlarge)

You can also see, above, that there was a tentative up trend line that I drew.  This can be considered by some as a neckline in a variation of a head and shoulders formation.  The formations are almost never perfect, and almost always variations.  The concept is about the same, though.  In this case, the key point, the neckline, was violated and XLE is now testing that level.  Will it act as resistance?  Will XLE show enough strength to push back above it, possibly triggering lots of short covering pushing XLE much higher?  We will have to wait to see!

The point is that we have to watch energy, and the entire commodity sector closely here.  Copper, typically a leading commodity, has been telling us the growth/demand factor isn't strong.  The Treasury market has been telling us inflation isn't a big concern at this moment.  Energy, typically weak in the second quarter, has been rallying on fears of more violence and the dollar decline.  Therefore, we will have to watch energy and we will have to watch the dollar. 

Below is the equal weighted S&P energy ETF, which shows the same picture ...

(Click on image to enlarge)

So finally, let's focus on the dollar.  Below is a 5-year chart of the dollar.  I chose to show 5 years for perspective on how sharp the rallies can be when they happen.  The first sharp rally that you see happened when the stock market crashed.  The second one happened mostly in the first half of 2010, when the European sovereign debt crisis hit and the euro got crushed.

I circled the recent dollar decline (in red) which has largely caused the energy and metals stocks to lead this bull market higher. 

(Click on image to enlarge)

Let's zoom in (below).  You can see that we have been trading in a channel.  The green line is the down trend line and the red line is the "return line".  As discussed in a December article, as well as my recent articles on silver, when a return line is violated it is a test.  If the security -- in this case the dollar -- can stay on the other side of that return line (in this case, below) then it's a signal that the trend will accelerate.  In this case, that didn't happen.  The dollar moved back above the return line (purple).

(Click on image to enlarge)

When this happens, the security is signaling that it will likely either consolidate for a while before continuing its move in the same direction, or that it will reverse.  Since this happened, as you can see above, we are watching to see if the dollar will also break above the green down trend line.  If that happens, then we just might have a bullish reversal on our hands, which may be a nail in the recent bull's coffin.

Why?

Reread the article above, if you dare.  The point is, a dollar reversal higher would mean more downward pressure on commodities.  Since commodities led the stock market higher, the stock market would likely have the same fate. 

If we get a continued down trend in the dollar and/or a bullish reversal in energy, then the general stock market will probably trade higher.  My guess is at least up to 1,430 on the S&P 500 (see below).  But perhaps that's a story for next Technical Tuesday.

(Click on image to enlarge)
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Answer (to TA question from above the article):

c.  Pre-election year.   The strongest two years are pre-election and election years.  The start of wars and bear markets most often occur in the first and second years of presidential terms.  We haven't seen one losing pre-election year of a presidential term since 1939.

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