GROWING RISK AVERSION HURTS EMERGING MARKETS -- BUT HELPS STAPLES, UTILITES, AND BANKS -- BEAR FUND UPDATE -- RISING VIX SHOWS FIRST SIGNS OF FEAR IN FOUR YEARS

EMERGING MARKETS FALL WITH OTHER FORMER LEADERS... Last Monday I wrote about a number of sell signals that were being given in the market and in commodity-related stocks in particular. I wrote a paragraph entitled "Growing Aversion to Risk" in which I explained that former market leaders were probably going to be hit the hardest in a market downturn. That included basic materials, gold, and energy stocks as well small caps and emerging markets. I recommended profit-taking in all three groups. The breakdown in commodity stocks is now a matter of record as is the selling in small caps. Not surprisingly, emerging market stocks have also had a dreadful May. Chart 1 shows the Emerging Markets iShares (EEM) having broken their 50-day average last week and bearing down on the 200-day average today. [If you take nothing else from the recent market downturn it should be the rule of taking some profits in any market that falls below its 50-day average]. Over the last two weeks the EEM has fallen over 15% to make it one of the globe's weakest market performers. Most of the selling has come from Latin America (-18%) and Brazil in particular (-22%). Since the previous rally in that region was largely tied to rising commodity prices, it's no surprise to see it get hit especially hard during the current commodity selloff. Asian markets like Taiwan (EWT) and South Korea (EWY) have also been big May losers (-14%). While that growing aversion to risk has hurt the strongest (and riskiest) groups that had risen the most prior to May, it's helped defensive groups that had been at the bottom of the 2006 performance rankings (and carry less risk). That includes consumer staples, healthcare, financials, utilities -- and even bonds.

Chart 1

CONSUMER STAPLES TAKE TOP SPOT... Last Tuesday I wrote an article explaining how sector rotations work at market tops. I explained that prior to market tops the two sector leaders are basic materials and energy. When they start to fall, money flows into defensive groups like consumer staples, healthcare, utilities, and financials (often in that exact order). That would make consumer staples the likeliest candidate for defensive (and risk averse) money coming out of fallen leaders. And that's exactly what's happening. Over the last month, the three weakest market sectors have become energy, basic materials, and technology. All were former leaders. Over that same time span, the four strongest market sectors were consumer staples, utilities, financials, and healthcare. While the first two have actually gained ground, all four have done better than the S&P 500. Since we're primarily interested in absolute as well as relative gains, that makes staples and utilities the two winners as the market has fallen. Chart 2 is a relative strength ratio of the Consumer Staples SPDR (XLP) divided by the S&P 500 over the last five months. Notice the sharp jump in the ratio since the beginning of May. That's where you want to have some money in a falling market. And utilities.

Chart 2

UTILITIES BOUNCE WITH BONDS ... Utilities have also held up relatively well since the start of May. The daily bars in Chart 3 show the Utilities Sector SPDR (XLU) trading well above their April lows and rallying today. The relative strength line beneath the price bars has been rising during May. That's what a defensive stock group is supposed to do. Since utilities are closely tied to bond prices, they're also benefiting from some rotation out of stocks and back into bonds over the past couple of weeks.

Chart 3

BROKERS FALL AS BANKS RISE ... Financial stocks have also held up relatively well over the last month. That's mainly because of banks. The next chart shows the Broker/Dealer Index falling sharply. It's nearing a test of the 200-day moving average. By contrast, the Bank Index has held up much better. The BKX is holding its 50-day moving average. Notice that it's relative strength ratio has climbed all month. I suspect that the relatively strong action in the banks is due to the recent steepening in the yield curve as long-term rates have been rising. Banks make money when long-term rates are higher than short-term rates. Banks have also historically done well when the Fed nears the end of its tightening cycle and thereafter.

Chart 4

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BEAR FUND UPDATE ... On Friday, May 12 I recommended buying an inverse fund based on the Nasdaq 100. It was the ProFunds Short OTC fund (SOPIX). I picked it for two reasons. One was that it's based on the Nasdaq 100 which was the market's weakest index. The other reason was that it was one of the first bear funds to exceed its 200-day moving average. Chart 6 shows the bear fund rising (through Friday) to the highest level in seven months. Its daily MACD lines are bullish. The only short-term caveats are an overbought RSI reading (over 70) and the proximity to its October high at 19.97. Chart 6 shows the ProFunds Ultra Short OTC Fund (USPIX) also exceeding its 200-day line. An "ultra" fund is designed to move twice as fast as the index on which it's based. The ratio beneath Chart 6 is the Ultra OTC fund divided by the OTC fund. The ratio has jumped over the past couple of weeks reflecting the stronger performance by the ultra fund. An ultra fund is more profitable if the NDX keeps falling. It's more risky if it doesn't. Chart 8 shows the ProFunds Bear fund (BRPIX) that I recommended last Wednesday. At the time it was moving up to challenge its 200-day average. It has since exceeded that long-term resistance line [as has the ProFunds Ultra Bear (URPIX)]. Both funds move inversely to the S&P 500.

Chart 6

Chart 7

Chart 8

RISING VIX SHOWS MORE FEAR ... On Friday, I wrote about the latest spike in the CBOE Volatility (VIX) Index spelling trouble for the stock market. That's because a rising VIX is usually associated with falling stock prices. Chart 9 shows the VIX jumping to the highest level in two years which is the first time in the last four years that the VIX has exceeded a significant previous peak. Since the four-year VIX downtrend coincided with the four-year uptrend in stocks, it's new strength is a bad omen for stocks. The VIX uptrend also explains the new aversion toward risk. The VIX is considered to be a measure of market fear. When the VIX (and fear) is low, investors take risks. When the VIX (and fear) rises, people become risk averse. This is the first time in four years that we're starting to see real fear creep into investors' decisions.

Chart 9

SOX BREAKS 200-DAY AVERAGE ... At the risk of seeming to be "piling on" the market while it's down, the final chart for today shows the Semiconductor (SOX) Index falling to a new six-month low after having broken its 200-day moving average. Its relative strength line peaked in February. That type of weak chart action spells bad news for the chip group, the Nasdaq market, and the market as a whole. One of the reasons I turned bearish earlier in the month was the breakdown in the technology sector and the Nasdaq market. Today's SOX breakdown is only making a bad situation worse. On Friday I had been hoping for an oversold market bounce this week especially with the S&P 500 testing its 200-day average. If a short-term bounce is going to occur, it's going to need more help from the technology sector.

Chart 10