Tuesday, August 07, 2007

Tough Love

In the face of its self-inflicted credit problems, Bernanke gave Wall Street some much-needed tough love on Tuesday.

The FOMC offered a token nod to "tighter credit conditions", before reminding professionals for the bazillionth time that the greater policy issue is still inflation. As difficult as the credit crunch may be for some, it stems from poor choices made by professionals who should have known better. Unlike his predecessor, Bernanke remains intent on letting the marketplace heal such overindulgences on its own, and isn't predisposed to tempting further moral hazard.

The stock market seems to like this new therapy, as the indexes all closed with decent gains on solid volume. The two current leaders -- the Dow and the NDX -- both reclaimed their 50-day. Internals were also much improved, although New Lows continued to smother New Highs, 963-171.

Daddy taking the T-bird away certainly inspired leading stocks. The IBD100 shot up 2%, although internals still came in just good, not great. While 25 stocks saw accumulation vs. just 11 under distribution, two-thirds of stocks on the IBD100 had lower volume than on Monday. Institutions remain cautious about charging back into the good stuff.

The NASDAQ is trying to be on its best behavior, but it's still no candidate for sainthood. The high-volume action off the 200-day is positive, but the Composite is still a damaged chart mired in a thick band of resistance. Overhead supply doesn't thin out for another 70 points, so if stocks move up, expect a bumpy ride.

However, the bigger issue is that in TA, few things are more rare than an untested bottom. Statistically, this pullback won't be over until 2490 gets sat on again, and the best double-bottoms overshoot lower on their retest. History is filled with examples of retests taking weeks -- even months -- to finally develop.

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With the FOMC meeting now in the books, two important and related questions are still searching for answers:

1) Is the credit problem going to poison the broader economy?

2) Has the stock market now seen the worst of it?

Debate has a habit of raging on endlessly, but parsing the market for objective, evidence-based data is a better basis for making investment decisions. The two sections below use a few charts to help work through the questions above.


Regarding credit issues contaminating the economy, it's worth noting that the short end of the yield curve (3-month/10-year) flipped negative over the past week. While this is an unwelcome development, the 2-year/10-year remains unperturbed. This gives the yield curve "recession" indicator a lukewarm reading at worst. Below are charts of both curves.

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While specific mortgage and derivative metrics have imploded over the past two weeks, the Treasury and corporate bond markets have remained more rational.

Below is a chart of the 10-year Treasury bond, along with LQD (an investment grade corporate bond ETF), and HYG (a junk bond ETF). Over the past two weeks, as the Bear Stearns fiasco hit the tape and financials plunged, Treasuries, high-grade paper and junk bonds all moved higher. Things can change, but so far this is not the sign of "credit contagion."

Junk bonds (HYG) are particularly noteworthy. During a week that we learned we're in "the worst fixed income market in 22 years" HYG actually moved higher. There's no doubt that Bear Stearns and other non-banks have issues. However, If the crisis was truly widespread, high-grade paper would be falling and junk would be tumbling out-of-control. Things could get worse, but for now this is no Armageddon, and the broader credit market is still functioning.

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Regarding the stock market: if all that remains for this pullback is for it to retest the lows, this is one heck of a bull market. The jury is still out, but a couple of interesting developments are worth noting.

The McClellan Oscillator is a breadth metric that smoothes and distills advance-decline data into a single line on a chart (for more info, click here or here). NAMO is a stubborn indicator that is not easily impressed, but in an unusual TA event, it's developed a positive divergence with the NASDAQ over the past two weeks.

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Interestingly, Up Volume vs. Down Volume (NAUD) is printing a similar divergence. Both NAMO and NAUD printing positive D raises the odds for higher prices soon, possibly in the form of sharp, strong rally.

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With not even the most basic timing indicator printing a Buy yet, it's premature to get ahead of oneself. However, this market is displaying remarkable tenacity against a steady drumbeat of problems.

If this bottom does hold, it's worth acknowledging Bill Luby's thus-far prescient bottom call he made at 11am on Monday. For the record, this is currently the precise market low. Bill also gave fair warning a bottom was near on Sunday in a post on VWSI, his proprietary volatility metric. Nice going, Bill.

This has been an interesting summer, which will no doubt be continued on Wednesday.

See you then.




Bill Luby said...

Thanks for the kudos, dk...and for flagging the advance-decline divergence. While the new lows seem to get the most attention, I think the advance-decline/McClellan data is more timely and forward-looking.

Good trading,


dk said...

No prob, Bill. Your bottom call was a tasty, data-dependent assessment that so far has proved as accurate as it was dramatic - lol.

I've been stalking the NAMO and NAUD divergences for at least a week, and two consecutive up days meant it was time to mention them. I'm curious to see how useful they turn out to be.

Danny said...

dk, I had to shout you out because you are a must read. I am glad you appreciated the head nod.