A Yin and Yang Market

By Arthur B. Hill - Fri 28-Sep-2007

The Tajijitu below symbolizes the Chinese principle of Yin and Yang. According to wikipedia, the dual concepts of yin and yang describe two primal opposing forces and these forces are at work in today's stock market. The bulls are pushing part of the market higher, while the bears are pulling part of the market lower. The Technology and Energy sectors are strong, while the Finance and Consumer Discretionary sectors are weak. The Nasdaq 100 ETF (QQQQ) is leading, while the Russell 2000 ETF (IWM) is lagging. The Networking iShares (IGN) and Software HOLDRS (SWH) are leading, while the Retail HOLDRS (RTH) and Regional Bank HOLDRS (RKH) are lagging. The broader market is caught in the middle and a lot is riding on the winner.

Which sector and industry groups wield the most power? The answer is pretty obvious from my standpoint. The Finance sector represents the biggest sector in the market and the Consumer Discretionary sector is the most economically sensitive. Technology is, of course, important and it is positive to see techs leading. However, it is not positive to see Energy leading because this reflects rising energy costs. Rising energy costs eat into profits and take money from consumer spending. Retail spending drives 2/3 of GDP and relative weakness in the retail ETFs points to weak consumer spending. Retail is the economy and the stock market moves with the economy. The bulls must overcome relative weakness in these key groups for the broader market to get on track. Until then, I expect the broader market to remain under pressure and I will err with the bears.

***Model Portfolio Update***

I took positions in the Russell 2000 Short ProShares ETF (RWM) and the S&P 500 Short ProShares ETF (SH) on Tuesday afternoon (25-Sep) and both went ex-dividend on the open (79 cents for SH and 66 cents for RWM). These dividends are payable to shareholders on record for 27-September. The cost of this position equals the entry price less the paid dividend. My original stop-loss was set just below last week's low and this is where it gets complicated. My data provider (Reuters) does not adjust for dividends and the chart shows SH moving below last week's low. However, stockcharts.com does adjust for dividends and SH did not move below last week's low. Moreover, the S&P 500 and S&P 500 ETF (SPY) did not move above last week's high (think opposite because SH is an inverse fund). The positions in SH and RWM remain in play. Once again, this is a top picking exercise in SPY and IWM or a bottom picking exercise for the inverse funds SH and RWM. The risk reward ratio is good, but the six week trends are up and the six day consolidation is likely to be resolved in the next week or two.

***Key Indicators***

~S&P 1500 AD Line~ The AD Line is not keeping up with the S&P 1500 ETF (ISI). While ISI challenges its July high, the AD Line remains stuck below its July support break. The indicator has been working its way higher the last six weeks, but is underperforming the underlying ETF and this shows relative weakness in small-caps.

~S&P 1500 AD Volume Line~ The AD Volume Line is keeping pace with the S&P 1500 ETF (ISI) and this reflects relative strength in large-caps. Notice how the AD Volume Line peaked with the ETF in July and bounced step-for-step with the ETF over the last six weeks. Both remain below their July highs.

~S&P 1500 Net New Highs~ The 10-day SMA for Net New Highs moved above +2% this week and the rally is gaining some traction. However, Net New Highs are still a far cry from their July levels and market strength is not as broad is it was from May to July, when the indicator regularly moved above +5%. Moreover, Net New Highs on the NYSE and the Nasdaq were actually negative on Tuesday.

~Small-caps Lagging~ I pointed out relative weakness in the AD Line above and the chart below confirms relative weakness in small-caps. QQQQ is far and away the market leader with a move above its July high. SPY has yet to break this high, but is trading close enough for a possible challenge. IWM remains well below its July high and has yet to move above the July support break at 82. Small-cap companies are like the canaries in the economic coal mine and relative weakness in this key group is not a good sign.

***Past Flags Versus Current Flags***

Once again, I would like to review past surges and breakouts for reference. Here are the similarities. First, SPY formed a double bottom. Second, SPY broke above its intermittent high. Third, a 1-2 week consolidation formed after the breakout. This consolidation formed as a flat flag in October 1998 and a falling flag in March 2007 and July 2007. The flag breakouts provided the second bullish signal. Give these charts another study and then we can go over the current charts.

~S&P 500 ETF (SPY)~ SPY does not show a double bottom like the prior setups, but there is a clear surge and breakout at 150 (green arrow). The ETF consolidated the last six days and the breakout is holding. I would treat this breakout as bullish as long as 150 holds. The normal 1-2 week consolidation period will end next week and we could see a continuation higher soon. A strong breakout should hold and a break back below 150 would argue for a assessment.

~Russell 2000 ETF (IWM)~ IWM surged above resistance at 80 and then consolidated the last six days. There was even a brief move below 80, but the ETF bounced back above the very next day. This breakout remains bullish until proven otherwise and the consolidation should resolve itself in the next week or two. Given the bullish breakout at 80, the odds favor a bullish resolution. A strong breakout should hold and a move below 79 would argue for a re-evaluation.

~Nasdaq 100 ETF (QQQQ)~ QQQQ remains the king of the major index ETFs. It is the only one to break above its July high and shows excellent relative strength. The ETF formed two doji over the last two days and this shows some indecision that can sometimes foreshadow a short-term reversal. With the ETF up 13% since mid August, it is ripe for a correction or a consolidation. Broken resistance around 50-50.75 turns into a support zone (blue box) and a move below 50 would set the corrective forces in motion.

~Finance Still Holds the Key~ I have focused on the finance related ETFs for the last few weeks and I remain focused on this group. My concern this week is with the sharp pullbacks over the last six days. A strong ETF should hold its surge or at least most of it. This is the lesson from the prior SPY breakouts in 1998 and 2007. A short shallow pullback is OK, but deep pullbacks undermine bullish resolve.

The Finance SPDR (XLF) and Regional Bank HOLDRS (RKH) surged with the Fed cuts on 18-Sept, but gave back most of these gains over the last six days. This is the second time in two months that Finance related stocks surged on a Fed cut and then gave almost all of it back (gray ovals). Evidently Wall Street is not convinced the cuts are enough. The trends since mid August are still slightly up. A move below 147 in RKH and 33.3 in XLF would reverse these uptrends and weigh on the market overall.

~Relative Weakness In Retail~ I am also concerned with relative weakness in the Consumer Discretionary related ETFs. These include the Consumer Discretionary SPDR (XLY), Retail HOLDRS (RTH) and the Retail SPDR (XRT). All three gapped down on Tuesday after weak reports from Lowes and Target. Like XLF and RKH above, these three ETFs gave back most of the big gains seen on 18-Sept, the day the Fed cut rates. The inability to hold these gains is negative and I find the gaps bearish. All three show relative weakness and all three are on the verge of a breakdown. XLY has a rising wedge working and is about to break support. RTH needs to move back above 102 to fill the gap and revive the bulls. XRT needs to move back above 40 to fill the gap and revive the bulls.

~Tranports Feeling the Heat~ Continued strength in oil will keep energy related ETFs strong and put downward pressure on the Transport iShares (IYT). West Texas Intermediate Crude ($WTIC) moved above $83 today and remains in a clear uptrend. IYT was also showing relative weakness because it did not break above its late August or early September highs. Broken support turned into resistance around 89-90 and the ETF consolidated the last few weeks. At this point, the odds favor a continuation of the Jul-Aug decline and it would take a move above 90 to revive the bulls. Stocks in this ETF cover airlines, trucking, rail and freight forwarding. Goods and people move when the economy grows and the breakdown in this ETF reflects less movement.

~Semis Dragging~ While the Nasdaq 100 ETF (QQQQ) trades at new highs, the Semiconductor HOLDRS (SMH) and the Semiconductor PowerShares (PSI) remain well below their July highs and continue to show relative weakness. SMH is dominated by the big semis: Intel (INTC), Texas Instruments (TXN) and Applied Materials (AMAT). These three make up over 50% of the ETF. PSI is more equally weighed and represents a broad selection of semiconductor stocks. The top 11 stocks account for around 50% of the ETF (NVDA, AMAT, KLAC, WFR…). SMH broke flag resistance with a surge last week, but stalled and remains below the 4-Sept high. The flag breakout is holding for now and this bullish signal is still valid. A move below 37.5 would negate this breakout and also break the August trendline. PSI is meeting resistance around 19 and remains within a rising wedge. Last week's surge is holding, but follow through has been weak. A move below 18.4 would be negative and a break below 18 would reverse the six week rise.

I will cover the inter-market ETFs in Tuesday's report on 2-October.
Until then… -–Arthur Hill

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Disclaimer: Arthur Hill is not a registered investment advisor. The analysis presented is not a solicitation to buy, avoid, sell or sell short any security. Anyone using this analysis does so at his or her own risk. Arthur Hill and ETFInvestmentOutlook.com assume no liability for the use of this analysis. There is no guarantee that the facts are accurate or that the analysis presented will be correct. Past performance does not guarantee future performance. Arthur Hill may have positions in the securities analyzed and these may have been taken before or after the analysis was present.

ETF Outlook is a weekly newsletter that is usually published every Friday. Changes to the position table or model portfolio are sometimes necessary between publications and special portfolio alerts will be issued by email and posted to the website when necessary.

The S&P 1500 is used for breadth statistics because it is an excellent cross section of “the market”. This index covers the S&P 500, S&P SmallCap Index and S&P MidCap Index. There are around 1000 NYSE stocks and 500 Nasdaq stocks.

AD Line: This indicator represents small and mid-cap stocks. Regardless of market cap or volume, an advance counts +1 and a decline counts –1. Because there are many more small and mid-cap stocks than large-caps stocks, the AD Line reflects the performance of the small and mid-cap indices.

AD Volume Line: Volume is added for all advancing stocks and subtracted for all declining stocks. Stocks with the greatest volume carry the most weight and these tend to be large-caps. As such, the AD Volume Line reflects the performance of the large-cap dominated indices and ETFs.

Net New Highs: Regardless of market cap or volume, a new 52-week high counts +1 and new 52-week low counts –1. Net New Highs is the difference and I apply a 10-day EMA to smooth the data series. The Net New Highs indicator often lags the AD Line and AD Volume Line. Signals are generated when the 10-day EMA turns positive or negative.