Indicators May Signal Bull Market Blast-Off

Blast-Off Indicators

ETFs: A Way to Play the Rally

Commodities Show Promise

When it comes to market timing, I prefer to keep it simple, and that’s exactly what my Letters do.  For the most part, my timing is based on two things–the trend of the overall market, and the action of leading stocks.  One pertains to the overall market’s health, while the other tracks the stocks I usually focus on.  Simple.

However, there is one category of indicators that I do track … though they generally give signals only every few years!  Thus, you can’t use these indicators to tell you when to get in or out of the market, and they’re unlikely to be much benefit in your daily investing routine.

So why follow them?  Because when they do flash green lights, it tells you something unusual is happening–something unusually bullish!

I’m talking about blast-off indicators (I haven’t thought of a snazzier name for them), and the concept revolves around a “super-overbought” market.  Overbought is a term that refers to a market that’s run-up for a few days in a row, and thus is commonly thought to have come too far, too fast.  A pullback often ensues.

Most of the time, overbought-type indicators work pretty well for the overall market.  (FYI: They generally work poorly for leading stocks.)  Yet when a market gets EXTREMELY overbought, instead of signifying a market that’s in need of a pullback, it’s actually telling you there’s a sudden, dramatic, powerful change in perception among investors … and such a change usually persists for months.

These “super-overbought” readings have historically occurred near the start of major bull markets (hence the blast-off moniker).  Instead of pulling back following these signals, the market either consolidated briefly, or simply pushed higher … and did so for many months!  Thus, while blast-off indicators are rarely of use, when they do turn bullish, they are VERY useful.

One blast-off indicator I follow is the A-D Line ratio; specifically if on average twice as many stocks advance as decline on the NYSE over a 10-day period, you’ve witnessed a rare surge of buying power.  The blast-off indicator gave a buy signal in late March, and soon after in Cabot Market Letter I wrote that “overall, following these signals, the S&P 500 was up more than 7% three months later, and up more than 15% six months later.  More important is that many of these dates kicked off sustainable new bull markets that lasted more than a year–other pinpoint buy signals came in January 1987 before a huge run, August 1982, as the mega-bull market began, and January 1975, marking the end of the 1973-1974 bear.”

Since that time, of course, the market has headed straight up, despite a bunch of “we’ve come too far, too fast” calls from pundits.

Last week, we might have received another rare blast-off signal.  (I’ll explain the “might” part of it in a moment.)  This one tracks the percent of all NYSE stocks that are trading above their 10-week moving average.  Again, when the readings get up to 70% or 80%, the market is usually ready for a pullback.

But when the readings get up to 90%–that is, nine out of 10 stocks on the NYSE are trading above their respective 10-week moving averages–it signifies a kick-off of major proportions.  On average, the S&P 500 was up about 15% six months after these signals.  Most impressively, during the next nine months, corrections in the index have been limited to 5% in general.  So not only were there hefty gains, but the ride was relatively smooth.

The only hitch with the “90%” indicator is that different data sources are giving us slightly different readings.  One trusted source tells us the figure hit 92% last week; another source, which has been around for decades, said the reading only got to 88%.  So we can’t say for absolute certain if we got there, but it sure looks like it.

Now, in terms of the current market, I did see some signs of institutional selling last week.  A couple of times the market opened higher on good news, only to fade as the day wore on.  And the Nasdaq Composite is bumping up into its downtrending 200-day moving average, a natural place for some investors to take chips off the table.  Thus, I wouldn’t be surprised if we’re finally going to get more than a two-day pullback … possibly much more.

But longer-term, these blast-off indicators tell you that the odds are strongly in favor of higher prices in the months ahead.  So look to buy on weakness, be it individual stocks, or even exchange-traded funds (ETFs), which I’ll touch on below.

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Probably one of the best ways to have played the market’s recent rally would have been through ETFs.  The leading stocks I focus on simply haven’t gotten it done quite yet (more on that later), but the market has been a bargain hunter’s paradise, and one way to play that was through ETFs.

If the blast-off indicators are right, then the indexes have some more gas left in the tank.  So I want to give a few helpful hints about this still-evolving world of ETFs.

First, the so-called leveraged ETFs (Ultra S&P 500 ProShares (SSO), which moves twice the S&P 500 and Ultra QQQ ProShares (QLD), which moves twice the Nasdaq 100) are a solid way to play the market … but only if the market’s going to make a consistent move.  As it turns out, these leveraged ETFs see their value decay somewhat over time–so if the market fluctuated for a few weeks, but on balance went nowhere, you’d actually see SSO or QLD down a bit.  Thus, these leveraged ETFs are better for shorter-term trading than long-term holds.
    
Second, when buying ETFs, you’re usually better off sticking with very liquid securities.  If you’re buying an ETF that only trades 10,000 or 20,000 shares per day, as many do, then you’re more likely to get bad prices if you try to buy or sell in a fast-moving market.

Third, if you’re going to play a sector-specific ETF, you probably want to trail some sort of stop behind it.  Sector-related ETFs can move quickly, but when the group comes under pressure, they can take away lots of your gains.  So don’t be afraid to take some chips off on the way up.

Finally, I know some of you are going to ask, “What ETFs do you like, Mike?”  One I’m watching is iShares China 25 (FXI), which tracks the performance of 25 mostly large Chinese stocks traded here in the U.S.  I am big on China, as that country’s stocks are performing very well.  The ETF just completed a nice two-week pullback, spiked to new recovery highs and has consolidated this week.  The 32-33 area would be a solid buy point, with a stop under 30.

In the same (but broader) theme, I also like the iShares MSCI Emerging Markets Fund (EEM).  It’s actually a bit stronger than FXI, but has generally the same pattern.  You could buy a little here, but to me, a shake down toward 29 would be much better, with a stop at 26.

Another ETF that’s been acting better is the DB Commodities Tracking Index (DBC), and the main reason for this is energy–heating and crude oil make up about 60% of the fund.  I like that it trades more than 1.5 million shares per day, and that it’s been trying to emerge from a bottoming formation for some time.

While oil ETFs are nice, the stock picker in me went hunting for the strongest, most fundamentally sound energy firm I could find.  The result:  Southwestern Energy (SWN), a major leader from the commodity boom earlier this decade.  Not only did the stock hold up better than most energy plays (SWN is actually all about natural gas), it consolidated for many months and recently moved to within 20% of its peak following a great earnings report.

Fundamentally, I’m very impressed that the company churned out 16% earnings growth last quarter, and is projecting a hike in earnings for all of 2009.  Remember, this growth is happening despite natural gas prices that are down more than 50% from a year ago!  That means production is going nuts–in the first quarter, Southwestern Energy cranked out 64% more product than a year ago, and expects production for the full year to grow 49%.  

Obviously, if natural gas prices continue to sink, SWN isn’t going anywhere.  But with oil and most commodities showing signs of life, I think there’s a good chance natural gas will follow suit.  Considering Southwestern Energy has the best growth prospects in the group, I think nibbling in the high 30s could work out well over time.

All the best,

Michael Cintolo
For Cabot Wealth Advisory

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