ODDS SHIFT TO FIFTH WAVE RALLY… I addressed a couple of different ways to interpret the current Elliott Wave structure in Monday. The market is at an inflection point in Elliott Wave terms. Let’s briefly review what’s at stake and why. From the low of last March to this January, the S&P 500 rose in a three-wave sequence as shown in Chart 1. That leaves two different ways to read the wave structure. The more bearish view is that the three-wave rally is an ABC corrective wave in an ongoing secular bear market. That’s because corrective waves usually take place in three waves (see red letters). Bull markets, however, take place in five waves. The green numbers in Chart 1 show a more positive wave scenario. That view holds that the decline from January to February is nothing more than a wave four correction. That more positive view holds that the January high will be retested and probably exceeded by the S&P 500. Although the issue is still in doubt, the increasing number of indexes hitting new highs tilts the scale in favor of the more positive wave structure.

SMALL AND MIDSIZE STOCKS HIT NEW HIGHS… Last Tuesday, I showed the NYSE Advance-Decline line hitting a new high as shown in Chart 2. I pointed out that was a positive sign for the market since the NYAD usually peaks “before” the market. Its ability to hit a new high greatly reduced the risk of a market top. I also explained that new highs by small and midsize stocks were largely responsible for the strong breadth figures (Charts 3 and 4). That’s because there are more small stocks than large ones. [Large cap indexes like the S&P 500 are also capitalization- weighted, which means that larger stocks carry more weight than smaller ones]. That’s another reason why the NYAD line usually leads the major market indexes in both directions. The recent move to new highs greatly increases the odds that the major market indexes like the S&P 500 are also headed in the direction. There are several other market groups hitting new highs as well.

NASDAQ INDEXES HIT NEW HIGHS… The Nasdaq Composite has also exceeded its January high (see Chart 5). [The Nasdaq 100 is breaking through its January high today]. Two of the groups most responsible for that strong chart action are the Internet Index (Chart 6) and Network iShares (Chart 7). It’s usually a good sign for the rest of the market when the Nasdaq is leading it higher. The biotech group has also hit a new 2010 high.

MORE UPSIDE BREAKOUTS … I also wrote last week about the positive implications of new highs in the Consumer Discretionary SPDR (Chart and retail stocks (Chart 9). Here’s another one. Chart 10 shows the Dow Jones REIT Index hitting a new 2010 high.

TRANSPORTS RIDE RAILS TO NEW HIGHS… All of the leading groups shown so far are reflective of more optimism on the market and the economy. So is the next group. Chart 11 shows the Dow Tranports in the process of exceeding its January high. Although airlines are certainly helping to push the TRAN higher, even more impressive chart action is seen in rail stocks. That’s important because strength in the rails is usually an indication that companies are moving goods which is usually a sign of economic strength. All of these upside breakouts argue that the stock market has entered another upleg which would qualify as a fifth wave in Eliott Wave terms. There’s good and bad news in that. The good news is that the market is likely to reach new highs. The bad news is that the fifth wave is usually the last upleg in a bull market advance, which is usually followed by some type of corrective action. The message then is to enjoy the ride upward but don’t ride it too long.

by John Murphy

REACTION LOWS FOR IWM AND RSI… An uptrend is defined by higher highs and higher lows. With the Russell 2000 ETF (IWM) hitting a new 52-week high last week, we can assume that the overall trend remains up. Chart 1 shows weekly candlesticks for IWM over the last 16 months. The green arrows show reaction lows that coincide with RSI lows around 50. RSI found support at 50 as the ETF forged higher lows the last nine months. Momentum favors the bulls as long as RSI holds above 50. The most recent reaction low in IWM now becomes key support that defines the uptrend. An official downtrend would not begin unless IWM breaks below the reaction low at 57.5. In addition, I would also look for RSI to break below 50. This level offered support in early July, late October and late January.

S&P 500 ELLIOTT WAVE REVIEW… A reader asks if this week’s advance is enough to negate my Elliott Wave count for the S&P 500. The short answer is no. Before opening Pandora’s box here, just a reminder that Elliott Wave is part objective and part subjective. This is my interpretation of the theory. I opted for the count shown on Chart 2, which makes the current 12-month advance an ABC correction. I have seen other counts, including bullish counts, that make sense too. In particular, some Elliotticians view the advance from March 2009 as much too strong to be considered a corrective advance. They argue that such strength suggest that this advance is part of a five wave move. Chart 3 shows this version of events.

So which one do we believe? As far as I am concerned, the most important aspect is the current 12-month uptrend. It could be an ABC advance, part of a 5-wave advance or something else. Whatever count, the S&P 500 established a new reaction low with the Feb-Mar bounce. As noted above, an uptrend consists of higher highs and higher lows. A downtrend starts with a break below the last reaction low, which is now the February low. Therefore, a break below the latest reaction low is required to reverse the current uptrend. So, while I still have the ABC correction as my current Elliott Wave count, confirmation is dependent on a trend reversal with a break below the February low. A break above the January high would negate this count and favor the alternative.

FINANCE SECTOR CHALLENGES RESISTANCE… The Financials SPDR (XLF)has been featured in the Market Message the last two Mondays. The Market Message on Monday, February 22, showed XLF testing range support. The Market Message on Monday, March 1, featured XLF forming a pennant after the surge off support. With last week’s surge, chart 4 shows XLF moving towards the top of its six month range. XLF has been bound by support in the 13.5 area and resistance in the 16 area since mid August. An important resistance test is looming. A breakout in XLF would be bullish for the sector and the market overall.

Chart 5 focuses on the latest bounce and pennant breakout. The January high is coming into play and could offer resistance. In addition, the ETF is up over 10% in four weeks and getting short-term overbought. Short-term, Friday’s gap is the first zone to watch. This gap is bullish as long as it holds. A decline that fills Friday’s gap would reinforce resistance and keep XLF range bound. The indicator window shows the price relative picking up over the last few weeks. Relative performance for XLF was flat from early December to mid February, but picked up as the price relative turned up at the end of February.

SMH IS LAGGING THE BROADER MARKET… The Semiconductors HOLDRS (SMH) remains in a clear uptrend since November 2008, but the ETF has lagged the broader market over the last four weeks. Chart 6 shows SMH with weekly candlesticks over the last 18 months. First, notice that SMH bottomed several months ahead of the S&P 500 (Nov-08 versus Mar-09). This reinforces the status of semiconductors as a leading group. Second, SMH remains within a clear rising price channel since this November low. These are internal trendlines because they cross the February 2009 low and summer highs. Nevertheless, these trendlines capture the overall uptrend. With a bounce over the last five weeks, SMH forged a reaction low at 24. A break below this level would reverse the current uptrend.

Chart 7 shows daily candlesticks with a five month view. The current swing (four week trend) is clearly up, but SMH is showing some relative weakness recently. First, the current advance is hitting resistance near the 62% retracement mark (~27). In contrast, the major indices exceeded their 62% retracements and many exceeded their January highs. Second, the bottom indicator shows the price relative, which compares the performance of SMH against the S&P 500. A lower high formed in February and the price relative edged lower the last three weeks. SMH is underperforming the S&P 500. Semis are an important group for the technology sector and the overall market. Relative weakness should be watched carefully. On the price chart, a rising wedge is taking shape with support based on the late February low. A break below this level would call for a continuation of the Jan-Feb decline. The bulls have the edge as long as this support holds.

By Arthur Hill

BONDS ROCKED BY BETTER-THAN-EXPECTED PAYROLLS… The Labor Department reported that non-farm payrolls declined 36,000 for the month of February, which was much better than the consensus estimate for a decline of 68,000 jobs. Positive news on the jobs front sent bonds sharply lower and yields sharply higher. Bonds are especially sensitive to interest rates and Fed policy. While the economy has yet to show any job growth, the decline in non-farm payrolls is certainly slowing and this could affect Fed policy down the line. Chart 1 shows the 20+ Year Treasury ETF (TLT) hitting resistance from the January-February highs and declining sharply in early trading on Friday. Notice that broken support turned into resistance in the 92 area. Also notice that a triangle may be taking shape with support in the 88-89 area. Chart 2 shows the 10-Year Treasury Yield ($TNX) with a mirror image of the TLT chart. Yields found support near broken resistance around 3.55% (35.5 on the chart). This means the December breakout is holding and rates are in an uptrend as long as the February lows hold.

BACK TO BASICS WITH HIGHER HIGHS AND HIGHER LOWS… Let’s step back with some very basic charts and a basic momentum oscillator. Chart 3 shows the Rydex S&P 500 Equal Weight ETF (RSP) as a 5-day SMA, which smooths the daily fluctuations. A 65-day SMA is overlaid for two reasons. First, dips below the 65-day SMA are deemed significant enough to be called reaction lows and qualify as support levels. Second, the direction of the 65-day SMA confirms the underlying trend. The trend is up when the 65-day SMA turns up and rises. The trend is down when the 65-day SMA turns down and falls. Notice that the 65-day SMA turned up in mid April and remains up. The green arrows show the last three reaction lows with the last low marking current support at 38. With nothing but higher highs and higher lows since April, the trend is clearly up. A move below 38 would break support and argue for a trend reversal.

A 65-day Aroon oscillator is shown in the indicator window to measure momentum. Developed by Tushar Chande, Aroon means “dawn’s early light” in Sanskrit. The Aroon oscillator is constructed by subtracting Aroon(down) from Aroon(up). It fluctuates above/below zero. A new uptrend emerges with the move above zero, while a new downtrend emerges with the move below zero. More details can be found in the ChartSchool. Notice that Aroon turned positive in mid April and remained positive until mid February, when Aroon moved to its lowest level since April. This makes the Jan-Feb decline the sharpest since Feb-Mar 2009. Aroon is flashing a warning sign, but we have yet to see confirmation with a downturn in the 65-day SMA and a break below the February low. One strike here. Two to go.

Chart 4 shows the same indicators for the S&P 500 ETF (SPY). These two ETFs are good for comparing the performance of large-caps and not-so-large-caps. SPY is based on the market-cap weighted S&P 500, which means large-caps dominate. RSP treats every stock equal, which means smaller stocks dominate because there are more smaller stocks. Like RSP, chart 4 shows SPY trending higher with higher highs and higher lows since April, which is also when Aroon turned positive and the 65-day SMA turned up. Based on this chart, the overall trend is still up with key support based on the February low. There are some concerns here as well because Aroon turned negative for the first time since April.

EQUAL-WEIGHT QQQQ VERSUS QQQQ… We can also compare the Nasdaq 100 ETF (QQQQ) against the Nasdaq 100 Equal-weight ETF (QQEW) to compare large-cap techs against not-so-large-cap techs. QQQQ is dominated by Apple (AAPL), Google (GOOG), Microsoft (MSFT), Intel (INTC), QualCom (QCOM) and other tech heavy weights. QQEW treats all 100 components the same. Charts 5 and 6 show both QQQQ and QQEW are in uptrends overall, but QQEW is holding up a little better than QQQQ. First, notice that Aroon turned negative for QQQQ. Second, notice that QQQQ is further below its January high. The February lows mark key support for both.

NET NEW HIGHS EXPAND TO PRIOR HIGHS… Net New Highs survived their third corrective period and surged over the last few weeks. Chart 7 shows Nasdaq Net New Highs surging back above +200 this week. Prior surges in October and early January hit the +200 area. Notice that there have been three corrections over the last eight months. Net New Highs dipped into negative territory in early July, late October and early February. These red areas are small as Net New Highs moved back into positive territory soon thereafter. In fact, notice that Net New Highs found support at or above -50. This means we should expect a trend reversal if and when new 52-week highs break below -50.

Chart 8 shows NYSE Net New Highs. Notice how this indicator bounced near the zero line in early July, early November and early February. Also notice that cumulative Net New Highs have been rising (above the 10-day SMA) for over 8 months. Even though Net New Highs are considered a lagging indicator, they have captured the current uptrend by staying largely positive. SharpCharts subscribers can click on these charts to see the settings and save to their favorites list.

OIL CHALLENGES RESISTANCE… Chart 9 shows West Texas Intermediate ($WTIC) challenging resistance in the low 80s for the third time in five months. Note that this is the 5-day SMA. Oil first hit 80 in late October and edged above 80 in early January. Even though the overall trend is up, some signs of weakness are starting to appear. First, Aroon moved into negative territory for the first time since mid March. Second, the 65-day SMA turned down over the last two months. There are two strikes so far, but West Texas Intermediate itself has yet to break support in the low 70s. A break below the Dec-Feb low would be strike three.

Chart 10 shows the Energy SPDR (XLE) trading flat since mid October, when the ETF first crossed above 56. There are similar signs of weakness appearing in XLE as Aroon turned negative and the 65-day SMA turned down. As with crude, XLE remains above support in the 54-55 area. A break below this level would reverse the uptrend. Chart 11 shows the Oil Service HOLDRs (OIH) holding up better than both crude and XLE. Notice that Aroon remains positive and the 65-day SMA has yet to turn down, though it has flatted in the last two months. Watch key support at 115 for a trend reversal here.

By Arthur Hill

WEEKLY EMA COMBINATION IS STILL UP … I’ve always advocated the use of the weekly EMA crossovers for “longer-term” signals. The daily signals are for “short-term” trading purposes. Weekly signals are always more important than dailies. Chart 1 overlays the 13-week (blue line) and 34-week (red line) EMA lines on weekly bar chart of the S&P 500 for the last three years. The last bullish crossing took place last July (blue arrow) and is still positive. The black line below Chart 1 is the spread between the two weekly EMAs. Crossings above and below its zero line correspond to the EMA crossings (see circles). Although the weekly bullish crossing didn’t take place until last July, the EMA spread (black line) actually turned up during March, which gave an early hint that the major trend was improving. The black line has dipped during the first quarter of 2010 as the two EMA lines have converged. So far, that signifies nothing more than a downside correction in an ongoing uptrend.

DAILY EMA LINES TURN POSITIVE… On Tuesday, I wrote about how the ability of U.S. stock indexes to close back above their 50-day averages had improved the market’s short-term trend. I also mentioned that a couple of daily EMA combinations were turning positive. I was referring to the 20-50 day EMA and the 13-34 day EMAs. Chart 2 shows the 13-day EMA (blue line) crossing back above the 34-day EMA (red line) this week. [The daily S&P 500 prices are plotted above]. That reverses the short-term sell signal given in late January. Unfortunately, upside volume has been relative light during this week’s price advance which detracts from the stronger price action. That suggests a couple of possibilities. One is that the correction is over and prices are starting a new upleg. A second possibility is that prices have entered a trading range between the January high and the February low. Moving averages need a sustained trend in order to function properly. While weekly averages are still bullish, daily averages have been “whipsawed” over the last month. That’s often a sign that the market is entering a period of relatively flat (and trendless) price action for awhile.

RETAIL STRENGTH IS A GOOD SIGN … One of the factors working in the market’s favor is the move to new highs by the Consumer Discretionary SPDR and retail stocks in particular. Chart 3 shows the XLY hitting a new 52-week high today after exceeding its January peak, while Chart 4 shows the S&P Retail SPDR (XRT) having broken out of “triangle” formed between October and February (see converging trendlines). Both consumer-oriented ETFs show rising relative strength lines (below charts) since mid-January. Given the importance of consumer spending to the economy and the stock market, the absolute and relative strength shown by both ETFs is a positive sign.

RETAIL LEADERS … Three retail leaders are showing a bullish combination of strong chart action combined with rising relative strength. The monthly bars in Charts 5 and 6 show promising bullish breakouts in the making by Big Lots and Family Dollar Stores. FDO is now trading at the highest level in six years. Chart 7 shows Target hitting a new 52-week high after having risen above a two-year resistance line. Its relative strength line (below chart) is trading at the highest level in three years. Target also happens to be the most heavily weighted stock in the S&P 500 Retail SPDR (XRT).

WHY I’VE AVOIDED INVERSE ETFS … The main reason is that I wasn’t convinced that the recent market dip was serious enough to warrant bearish positions. So far, that view has been justified. Chart 8 shows the ProShares Ultra Short QQQs (QID) nearing a test of its January low. It’s also back below its 50-day average (blue line). Inverse funds are not meant as long-term holdings. Their use is only justified when the market is in a serious downward correction or a bear trend. Some short-term profits could have been made in the QID from mid-January to mid-February, but only for very nimble traders. For everyone else, it’s back where it started the year. The QID is designed to trade in the opposite direction of the Power Shares QQQ Trust (QQQQ). Chart 9 shows that technology-dominated ETF trading a couple of points from its January high and well above its 50-day line. At the moment, the QQQQ is acting a lot better than the QID.

By John Murphy