STOCK MARKET FOR BEGINNER | Stock & Option Guide

MATERIAL SPDRS AND BASE METALS ETF CONFIRM DOUBLE TOPS — HOMEBUILDER ETFS TEST NOVEMBER LOWS — XLK BREAKS NECKLINE SUPPORT — SEMICONDUCTOR HOLDRS SHOWS RELATIVE STRENGTH

VOLATILITY INDICES FORM HIGHER LOWS AFTER BREAKOUTS… The volatility indices held their breakouts and resumed their uptrends with the stock market slide over the last two weeks. Because the S&P 500 Volatility Index ($VIX) and Nasdaq 100 Volatility Index ($VXN) can be rather, well, volatile, I am showing the daily bars in gray and the 5-day SMA in red. This short-term moving average filters out the noise to get a better handle on direction. Chart 1 shows the 5-day SMA of the VIX breaking resistance with a surge in May.Broken resistance turned into support and held in mid June. With a surge over the last two weeks, the 5-day SMA broke above the May trendline to resume its uptrend. The May-June decline is viewed as a correction within a bigger uptrend. Support at 25 now becomes key to this uptrend. In other words, the 5-day SMA needs to break 25 to reverse the uptrend in volatility. Also notice that the 200-day SMA turned up in mid May. Rising or relatively high volatility is negative for stocks. First, volatility represents risk. Second, an uptrend in “fear” keeps investors edgy. Notice how the S&P 500 advanced when the VIX fell (July to April). As the VIX reversed its downtrend, the S&P 500 reversed its uptrend. There is clearly a negative correlation at work here. It may be a coincident indicator, but it is currently bearish as long as the 5-day SMA remains above 25. Chart 2 shows the Nasdaq 100 Volatility Index ($VXN) with similar characteristics.

MATERIALS SPDRS AND BASE METALS ETF CONFIRM DOUBLE TOPS…Unsurprisingly, the DB Base Metals ETF (DBB) and the Materials SPDR (XLB) have similar patterns at work: double tops. In fact, both confirmed their double tops with support breaks on the price chart and range breaks in momentum. Chart 3 shows the Materials SPDR (XLB) with an Adam and Eve double top, which is a term coined by Thomas Bulkowski, author of The Encyclopedia of Chart Patterns. According to Bulkowski, the Adam top forms with a short 1-2 bar/candlestick reversal. The Eve top forms as a wider top with 3-6 bars/candlesticks. Double tops are confirmed with a break below the intermittent low. XLB pierced this low five weeks ago, bounced and broke back below this week. Based on traditional technical analysis, the height of the pattern is subtracted from the support break for a downside target, which is around 23.3. RSI confirms the reversal with a break below 40 in early June. The right side of the double top looks like a falling wedge. We can watch this wedge unfold for signs of a failed double top. Yes, sometimes these patterns fail to reach their downside targets. Patterns and indicators are far from perfect. Technically, the trend is down as long as the wedge falls. A surge above 30 would call for a reassessment. A break above resistance at 32 would reverse the 10 week downtrend. For reference, chart 4 shows the Market Vectors Steel ETF (SLX) with a head-and-shoulders pattern working in 2010. It would take a break above the June high to negate this bearish pattern.

Chart 5 shows the DB Base Metals ETF (DBB) with a similar pattern at work. This is not surprising considering the connection between the materials sector and the actual materials themselves. DBB confirmed its double top with a break below support five weeks ago. The ETF rebounded for a few weeks, but fell back again this week. For now, the support break is valid as DBB established first resistance at 19. A break above this level would call for a reassessment of the current downtrend. RSI confirmed with a bearish shift in momentum. RSI ranges from 20 to 60 in a downtrend and 40 to 80 in an uptrend. The indicator broke its bull range with a move below 40 in May. For reference, chart 6 shows the DB Commodity Index Tracking ETF (DBC) with a falling channel in 2010.

HOMEBUILDER ETFS TEST NOVEMBER LOWS… Weakness in the homebuilders and related industries played an important role in the demise of the consumer discretionary sector over the last few weeks. There are two ETFs related to home building. Despite some differences in their components, the Homebuilders SPDR (XHB) and the Home Construction iShares (ITB) track each other pretty well. Both capture the ups and downs of home construction and the related industries. Even though actual homebuilding may be a small part of the economy, therelated industries amplify the affect. New homes mean moving, new appliances, painting, selling old homes, renovations etc… XHB averages over 7 million shares volume per day, while ITB averages less than 1 million shares volume per day. Chart 7 shows the Homebuilders SPDR with a large rising wedge from March 2009 until April 2010. XHB rose for 13 months and then formed a lower high as it broke the wedge trendline with a sharp decline the last 10 weeks. While this breakdown is clearly bearish, the ETF is currently oversold after a ~30% decline in 10 weeks. In addition, the ETF is nearing support from broken resistance around 14. The combination of support and oversold conditions could give way to an oversold bounce or consolidation. However, at this moment, a bounce would be considered a counter-trend move within a bigger downtrend. Chart 8 shows the Home Construction iShares with similar characteristics.

XLK BREAKS NECKLINE SUPPORT … After an outside reversal last week, the Technology SPDR (XLK) declined further and broke below support on Thursday. Chart 9 shows XLK with a head-and-shoulders pattern in 2010. In fact, the price action this year looks quite similar to that seen in the Market Vectors Steel ETF (go figure). XLK is current trading below the February-June low, but these are weekly candlesticks and a big rally today could push XLK back above its support break. Let’s see it first. For now, the head-and-shoulders dominates the price chart and it is bearish until proven otherwise. The pattern is around 3.5 points high and neckline support is near 20.5, which targets a decline to around 17. Also notice that a 50-62% retracement of the March-April advance would extend to the 17-18 area. As far as proving otherwise, the right half of the pattern forms a falling wedge. No uptrend here as long as the wedge falls. A break above the upper trendline would call for a reassessment and a move above the mid June high would reverse the 10 week downtrend.

SEMICONDUCTOR HOLDRS SHOWS SOME RELATIVE STRENGTH … Despite a support break in XLK, chart 10 shows the Semiconductors HOLDRS (SMH) consolidating above the February low. SMH has yet to even test this low. Chart-wise, SMH shows less weakness by holding above the February low. This is also known as relative strength. Most of the major index ETFs and sector ETFs have either broken or tested their February low. Despite relative strength, SMH was still hit pretty hard over the last two weeks. It is not totally immune to broad market weakness. SMH is at a moment-of-truth as it tests support from the May-June lows. Chart 11 shows daily candlesticks as the ETF formed a large spinning top in its support zone. This candlestick shows indecision. StockRSI is also oversold as it trades at 0. 14-day StochRSI equals 0 when 14-day RSI is at its lowest level of the last 14 days. 14-day StochRSI equals 100 when 14-day RSI is at its highest level of the last 14 days. StochRSI needs to pop above .50 (centerline) and SMH needs to break above 26.5 to keep this range alive and hold support.

By Arthur Hill

GOLD STOCKS BACK OFF FROM OLD HIGHS — SHORT-TERM TREND HAS WEAKENED FOR PRECIOUS METAL ASSETS

GOLD AND SILVER BREAK 50-DAY LINES… Gold and silver prices took a hit today for the first time in awhile. So did precious metal stocks. Chart 1 and 2 show the Gold ETF (GLD) and Silver (SLV) falling an average of 4% today on very heavy volume. Both commodity ETFs also broke their 50-day lines. Chart 1 shows the 14-day RSI for GLD falling below the 50 level for the first time in three months. That’s obviously not good chart action. Part of the reason for selling precious metals may have been a similar breakdown in the U.S. Dollar (and a sharp rally in the Euro). Chart 3 shows the Dollar ETF (UUP) falling below its 50-day line for the first time since April (on rising volume). Since the dollar and gold have been rising together, it makes sense that they would correct together as well. Not surprisingly, gold stocks also had a bad chart day.

GOLD MINERS ETF BACKS OFF FROM OLD HIGHS… The chart action in the Market Vectors Gold Miners ETF (GDX) was also bad, but makes a bit more sense. Chart 3 shows the GDX backing off earlier this week from chart resistance along its May and December highs. That’s a logical spot to expect some profit-taking. The falling RSI line (top of chart) also shows loss of upside momentum. The rising relative strength ratio (below chart) shows that gold stocks have been market leaders since the end of March (in fact, they’ve been the market’s strongest group). Today they were the weakest. Several reasons were put forward in the media to explain today’s heavy selling in precious metal assets. The most convincing I heard was that traders needed to take some profits in order to meet margin calls in other losing assets. The bottom line is that the reasons don’t matter. While the major uptrend is still intact for precious metals, their short-term trend has suffered technical damage.

By John Murphy

KONDRATIEFF WINTER HAS BEEN ON TARGET — GOLD STOCKS AND DEFLATION

GOLD AND DEFLATION… I’m going to be writing about deflation in this message, since that’s the only model that seems to have worked over the last decade. But first, I’d like to respond to one of our reader’s question about the performance of gold in a deflation. The question includes the following observation: “Since we have not had deflation in the U.S. since the 1930s, and gold was not freely tradable then, there’s no precedent to look to … for how gold might perform in a deflation”. Actually, that statement is only partially true. My 2004 book entitled “Intermarket Analysis” described the new deflationary threat that started in 1998 (during the Asian currency crisis) and wrote about the major upturn in gold prices as a result. Page 123 includes the following quote: “Some skeptics questioned the staying power of the rise in gold shares on the grounds that gold was an inflation hedge and there was more deflation than inflation. However, gold shares have done historically well during both inflations and deflations…Although gold bullion was set at a fixed price during the deflationary years from 1929 to 1932, the price of Homestake Mining (a gold stock) gained 300 percent while the stock market lost close to 90 percent of its value”. [The price of gold was revalued upward in 1933 and the dollar devalued in an effort to combat deflation]. In fact, the two top performing assets during from 1929 to 1932 were bonds and gold stocks. The two worst were stocks and commodities. That’s the deflationary model that I warned about in my 2004 book and which I believe is still in play.

DEFLATION SCENARIO… The Introduction to my 2004 intermarket book reviewed relationships that prevailed up to 1998 (which I had explained in my 1991 book on the same topic). One of the paragraphs containing the headline — “Then Came 1998 and Things Changed” — which explained that “deflation” played a key role from then on. A later paragraph (p. 52) entitled “The Deflation Scenario” explained that deflationary trends not seen since the 1930s were starting to take hold which would result in falling stocks and commodities with rising bond and gold prices. The biggest intermarket change was the major decoupling of bond and stock prices which has lasted until the present day. One sentence reads: “Market events of 1998 were a dramatic example of … how bonds and stocks can decouple in a deflationary world”. [Last Thursday's article on why falling bond yields were bad for stocks was based on that earlier deflationary theme]. Another explanation for deflationary trends over the last decade comes from Kondratieff Winter which was also described in the 2004 book.

KONDRATIEFF WINTER … The Kondratieff Wave (discovered in the 1920s by Nikolai Kondratieff, a Russian economist) is well known to most technical analysts and describes a “long cycle” of economic activity which lasts approximately 55 to 60 years. I bring it up here because it may explain why the last decade has gone so badly for stocks and so good for bonds and gold. I take no credit for the accuracy of its prediction made in my 2004 book since it was based on the work of Ian Gordon, editor of the newsletter “The Long Wave Analyst” (although I included it in the book because it coincided with my own views). Gordon divides the long wave into four seasons with each “season” lasting approximately 15 years. Autumn (which he says started in 1980) sees the greatest speculation in bonds, stocks, and real estate. Gordon put the start of “Kondratieff Winter” in 2000. The 2004 book summarized Gordon’s view as follows: “The main characteristic of the economic winter is deflation. Stock prices plunge (as do real estate values)…The two best defenses are cash and gold”. Gordon refers to the long wave as a “lifetime cycle” because it happens only once in a lifetime (the last time being in the 1930s) and each generation is unprepared for its onset and unfamiliar with its solutions. What’s worse, nearly a decade later, Wall Street and the economic community still doesn’t seem to recognize that we’ve been in the first truly deflationary environment since the 1930s. Once you understand that, most intermarket trends will make a lot more sense to you.

By John Murphy