The Futures / Inter Market Report

Trading the World's Markets

November 16, 2007

Matthew Caruso, CMT

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Stocks set up for potential fall

Stock indices have been correcting for about a month now and have erased almost all of the gains made since the summer lows. This week will take a deeper look at what has been driving the market in the recent rally and what the S&P 500 is likely to do in the coming months.

An important element exists in the stock market; it is the never ending battle between economic expansion and contraction. Investors are always faced with a choice; they can invest in stocks that benefit most from economic expansion, or they can invest in stocks that are likely to be hurt the least during economic contraction.  What I am getting at is the relationship between consumer cyclical stocks and consumer staple stocks. Cyclicals are stocks such as Walt Disney Co., Carnival Corp., and Home Depot Inc.. When the economy is weak and people’s discretionary income is reduced, they spend less on non-essential items such as cruises, home renovation and Mickey Mouse.  People will still need and purchase tooth paste, Coke, and buy clothes at every day low prices from Wal-Mart which is a consumer staple stock. Therefore, when the economic outlook is favorable, cyclical stocks outperform staple stock and vice versa.

Thanks to the rather new financial innovations of etfs, the staples and cyclicals can easily be compared. Consumer staple (XLP) ad consumer cyclicals (XLY) are plotted on a relative basis in figure 1 as represented by the red line. When the red line is rising, staples are out performing cyclicals. With a quick glance at this chart it is easy to see that when staples begin to be relative out performers vs. cyclicals, the stock market corrects. The reason for this is that investors are seeking safety in staple stocks because they are uncertain of the economic outlook. Such action means that investors will have less demand for stocks and as a result the stock market corrects. What is important about figure 1 is that after about 5 years, staples are once again become leader vs. cyclicals. The last major breakout of this kind preceded the 2000 market top. Of course that does not mean that will see a sell off of the same magnitude of 2000 - 2002 given that the same speculative excesses are not present at the given time. However, it clearly shows that a larger more serious correction may be developing for stocks.

Figure 1 chart by Metastock

Another factor that helps glean an insight to the health of the market is the relationship between the industrials and transports. This goes back to the very foundation of technical analysis and is called Dow Theory. As you can see from figure 2, the Dow Jones industrial average has made a new high in October where as the transportation made a lower high and now a lower low. This is called non confirmation of the new highs by the transports and has traditionally been a bearish sign for the markets. For a more in depth reading on this please refer to Technical Analysis of Stock Trends by Edwards and Magee.

Figure 2 chart by Metastock

Looking at the current market position in figure 3, we are at a major support level. The 65 week moving average has been a good support for the S&P 500 during the bull market. Also, we are at trendline support and the stochastic momentum oscillator is showing that we are oversold. Given this current support it appears that the market is due for a bounce higher. However given what we have discussed, it is likely to be a lower high that will lead to another leg down in the correction, possibly to the lower trendline in figure 3. However, if the current support fails to hold, that will be the market telling us that we will have a fast and strong move down to a 15% correction. What should an investor do now? Last week we looked at how the health care sector has begun to be a leader. A greater allocation to that sector is one option, raising cash on a market bounce is another option. Either way, stay with the leaders which now are health care, staple and to some extent technology.

Figure 3 chart by genesisft.com

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