NYSE BULLISH PERCENT INDEX SHOWS NEGATIVE DIVERGENCE -- BREADTH DETERIORATION IS SEEN IN FINANCIALS, HOUSING, REITS, AND SMALL CAPS -- BONDS JUMP AS STOCKS FALL -- GOLD JUMPS ON WEAK DOLLAR -- RISING YEN MAY WEAKEN CARRY TRADE

NYSE BULLISH PERCENT INDEX ... I wrote yesterday about some short-term negative divergences appearing on some of our market breadth indicators. Here's another one. But first an explanation of what it is. The NYSE Bullish Percent Index ($BPNYA) is the percent of stocks in an index that are in point & figure uptrends. Chart 1 plots the BPYNA over the last five years. The three lines mark the most important numbers to watch for. Major oversold readings (and market bottoms) usually occur from below 30. The last time the line was below 30 was in October 2002 as the last bear market hit bottom. Readings over 50 signal a bull market. The line crossed over 50 in the spring of 2003 (green circle) and has been there since then. Bull market corrections should find support above the 50 level. That happened three times between 2004 and 2005. The spring 2006 correction dipped slightly below 50, but quickly rose back above it. Overbought readings occur over 70 (red line). I look for two things to happen to warn of a possible market correction. One is a "negative divergence" between a rising market and a falling BPNYA line. The other is a dip back below 70. We're presently in danger of that happening.

Chart 1

BPNYA DROPS BELOW 70 ... The red line in Chart 2 is the BPNYA since the start of the year. The green line is the NYSE Composite Index. Since the start of June, the red line has been falling while the green line has been rising. That creates a short-term "negative divergence" between the two lines, and is similar to what we saw yesterday in the NYSE Advance-Decline line and the New Highs-New Lows line. Another danger sign is that the BPNYA is slipping below the 70 line. That's the first time that's happened since late February which was the last time the market corrected. Chart 3 is a point & figure version of the NYSE Bullish Percent Index. Each box is worth 2 points. A drop to 68 would cause a three-box reversal to the downside for the first time since March. That would be another caution sign. To get a major sell signal, however, the BPNYA would have to drop to 62 to undercut its March low at 64. These short-term negative divergences are no doubt playing a role in Friday's market selloff. So is weakness in small cap stocks.

Chart 2

Chart 3

SMALL CAPS FAIL TO SET NEW HIGHS ... I suggested yesterday that part of the recent weakness in market breadth figures was most likely due to the fact that most of the recent buying has been in large cap stocks, and that small cap indexes had yet to hit new highs. That discrepancy is shown in Chart 4. The Russell 2000 Small Cap Index has been unable to clear its early June peak. [The same is true of the S&P 600 Small Cap and the S&P 400 MidCap Indexes]. The relative weakness in small caps is even evident in today's market selling. Small caps fell much harder than large caps. Chart 4 shows the RUT in danger of breaking its 50-day average. The RUT/S&P ratio at the bottom of Chart 4 shows small caps lagging behind large caps throughout the latest market upleg. That's where a lot of the breadth deterioration is coming from. A lot of the breadth weakness is also coming from a continuing breakdown in financial shares. That's because the financial sector has the heaviest weighting in the S&P 500. Financials stocks have been lagging behind the rising market for months and are today's weakest sector. So is anything tied to housing.

Chart 4

FINANCIALS AND HOUSING CONTINUE TO DROP ... Chart 5 demonstrates where most of the market weakness has been coming from (outside of small caps). The black line on top is the S&P 500, which has gained more than 8% since the start of the year. By contrast, the Financials SPDR (blue line) has fallen 3%, REITs (red line) have lost 8%, and the Housing Index (green line) has dropped -12%. Those three groups are also the weakest in today's falling market. REITs and homebuilders are the biggest losers with Friday losses of more than 2%.

Chart 5

BOND YIELDS FALL AS BOND PRICES RISE ... As usually happens when stocks sell off, bond prices rise. That can be seen in two ways. Chart 6 shows the 10-Year Treasury Note Yield (TNX) falling below 5.00% today and undercutting its 50-day line for the first time in more than three months. When bond yields fall, bond prices rise. And that's what Chart 7 shows. The 20 Year Treasury Bond Fund ETF (TLT) has climbed back over its 50-day line for the first time in two months. That tells us two things. Investors are becoming a bit more concerned about the fallout from a weak housing sector and growing subprime mortgage problems. They're also hedging their bets a bit more by switching some money out of stocks and into bonds. Falling bond yields are also weakening the U.S. Dollar. As usual, the main beneficiary of that is the gold market.

Chart 6

Chart 7

GOLD FOLLOWS GOLD STOCKS HIGHER ... With gold stocks achieving bullish breakouts, it was only a matter of time before bullion followed suit. Today's combination of falling bond yields, a falling dollar, and falling stocks was enough to push some money into the yellow metal. Chart 8 shows the streetTracks Gold Trust ETF (GLD) climbing the equivalent of $6.00 dollars today and trading at a new three month high. Most other metal markets (industrial and precious) were also higher today. Gold stocks spent the day consolidating their recent gains.

Chart 8

RISING YEN IS WARNING SIGN ... Chart 9 shows the Japanese yen trading above its 50-day average for the first time since mid-April. The main reason I point that out is because the yen has been moving inversely to the world's stock markets based on the so-called yen carry trade. Global traders have been selling the yen short and buying higher-yielding assets elsewhere. It seems that each time the yen rallies, stock markets correct. That's because they're forced to cover their yen shorts and take profits somewhere else. The last time that happened was during February when the yen last exceeded its 50-day line. Chart 10 compares the yen (orange line) to the S&P 500 (green line) over the last eighteen months. The last two upward spikes in the yen in May 2006 and February 2007 (up arrows) coincided with market corrections (down arrows). The two earlier spikes in the yen were signalled by broken down trendlines. Chart 10 shows the yen breaking its four-month down trendline (orange circle).

Chart 9

Chart 10

THE VIX MAY BE BOTTOMING ... With all the recent gyrations in the CBOE Volatility (VIX) Index, it's easy to miss the bigger picture. Several recent runups in the VIX (some of which I've pointed out) have been followed by sharp pullbacks in volatilty. Neither seems to have had much effect on the market. With that acknowledgement, there are some subtle changes taking place in the trend of the VIX that are worth noting. Chart 11 compares the VIX (purple line) to the S&P 500 (green line) since the stock market bottomed in October 2002. The main message is that the market bottomed in late 2002/early 2003 as the VIX was peaking (see arrows). That's because a falling VIX is bullish for stocks. Each spike in the VIX (see circles in 2005, 2006, and early 2007) was accompanied by a market pullback (down arrows). After the 2005 and 2006 VIX spikes, however, it dropped down to a new low. That kept its downtrend intact along with the bull market in stocks. The last downturn in the VIX after the February 2007 spike, however, didn't hit a new low. In fact, it formed a higher low (purple arrow). The VIX is now rising again. To me, the action since 2005 looks like a potential bottom forming. It would take an upside breakout, however, to turn its major trend upward. Chart 12 gives a closer look at the 2007 VIX action. The short-term wiggles don't change the fact that the VIX has been forming a series of "higher lows" since late February and is 70% above its February low. That's usually how new uptrends start. It would, however, take a VIX close over its February high to confirm a new VIX uptrend. That would be bad for stocks if and when it happens.

Chart 11

Chart 12

S&P TREND WEAKENS ... The daily bars in Chart 13 show a number of short-term negatives. Prices in the S&P 500 SPDRS (SPY) have closed below their June high at 154. And they've done so on rising volume. [The two biggest volume days this week were on down days]. The 14-day RSI line failed to confirm the recent price move to new highs, and is threatening to drop back below the 50 line. Those negative features, combined with all of the short-term negative divergences I've described over the last two days, raises the odds for at least 5% pullback to its late June low. Those downside odds are greatly increased by the falling financials. Chart 14 shows the Financials SPDR (XLF) tumbling another 1.9% today to a new four-month low. And it did so on massive volume. This is also the first weekly close below its 200-day moving average in two years. Compare the falling financiala to the rising S&P 500 (green line). That's another pretty big negative divergence. And one that the rest of the market may not be able to shrug off much longer.

Chart 13

Chart 14