Critical Time for Stocks and Bonds?

Every so often markets reach important tipping points where substantial breadth and volume action in either direction are likely to portend more action in that direction.  I suspect we are at such points in both stock and bond markets now.

Bonds have taken a rather large hit since late March as inflationary concerns have flared in response to higher food and energy prices.  Core inflation (x food and energy) rates remain fairly subdued but the fear is that such huge moves in energy and food prices might feed through more substantially than has been the case in decades.   Lower bond prices (meaning higher bond rates) have in turn helped fuel a dollar corrective rally.   It is rare for bond prices to fall materially while the US, Japan, and Europe are all slowing economically as is currently the case.  Headline inflation is often very late in the game to peak as recessions develop – although this time it is fueled heavily by Emerging Market demand that might not be a sensitive to G-7 slowdowns as in the past.  Our guess however is that bonds will not break down substantially, but will form a broad trading range instead.  However, let’s let the markets tell their tale.  A strong volume weak close by TLT’s (ETF long Treasury bond) below 89.6 would signal likely further problems for bonds and inflation that would begin to impact other markets more drastically.  Conversely a close by TLT’s over the down trendline shown in chart 1 would likely mean a prolonged trading range.

 
Chart 1:  Bonds approaching critical support juncture – trading range in place?  Courtesy StockCharts.com

The action in stocks is approaching critical levels as well.  We have suggested that the current rally lacks the breadth, volume, leadership, and demand indications that typically proceed a sustained advance underway, but that the rally was likely catchable for traders in top leaders.  The first resistance level has been passed by the market, but now a more critical one is leading to a potential more serious setback for the market if action continues to deteriorate.  Chart 2 shows the S&P hitting both down trendline resistance and 200 ma resistance this past week or so.  We got a distribution day (indexes down on high volume and weak breadth) off of this resistance zone and another weak breadth and strong volume distribution day will start to tilt the balance of likely movement to the downside should it materialize next week.  Conversely a strong breadth high volume close over both the 200 ma and down trendline, would indicate more life left in the bear rally since mid March.  A negative breakdown by both stocks and bonds would be particularly ominous if it developed.

 
Chart 2:  S&P at critical juncture as well – breadth and volume in either direction could tip off next move.  Courtesy StockCharts.com

Note also that since the mid March lows we have not had a period of 5 trading days or longer when our Top RS/EPS New Highs list outpaced our Bottom RS/EPS New lows list by 40 or more each day – which signals a good environment for adding net long exposure in leading groups and stocks.  We are still not there, and new highs have deteriorated quite a bit for such a shallow decline in the past week.  Steels, E&P’s, natural gas, fertilizers, rails, and export oriented big cap techs have had decent runs in this rally so far, but the leadership list has not expanded strongly to emerging other groups as much as normally would occur in a new bull market – at least not yet.  That means we continue to suggest lower degrees of allocation and potential short-hedging to net long stock exposure. 

Our long/short strategy is now long AGU (raise stops under the 75 level) and SID (raise stops to under 40.5 level), and short CKR (lower stops to just over 11.1).  These trades with stops moved are all nearly break even or very low risk trades now.  There were not valid trades or close calls in the action of the last week.    We now have to watch carefully to see if the leadership in our Top RS/EPS New Highs can recover and rebuild or if Bottom RS/EPS New Lows will begin to dominate and the market will rollover at the 200 ma resistance zone.  Next week’s action may be critical in this regard.

For those not familiar with our long/short strategies, we suggest you
review my book “The Hedge Fund Edge,” my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call “upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-and handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).

The chart below shows that Top RS new highs (available on www.midasresourcegroup.com) flirts with being 40 over Bottom RS/EPS New lows for a day or so but then drifts back.  This is disappointing action and the differential must grow to new high’s favor quickly for this market rally not to begin to deteriorate.