DOW AND S&P 500 TEST THEIR JANUARY LOWS -- ANALYZING DOUBLE BOTTOMS -- LOWER RATES NOT HELPING -- FLIGHT TO SAFETY CONTINUES -- SMH SHOWS SOME RELATIVE STRENGTH

IN THE EYES OF THE BEHOLDER... Today's Market Message was written by Arthur Hill. John Murphy will return tomorrow. - Editor

Technical analysis is a little art and a little science, which makes it subjective and open to interpretation. It is kind of like, gasp, economics. With a test of the January lows underway, some pundits are talking double bottom. The interpretation of this double bottom depends on the charting style. Chart 1 show the Dow with OHLC bars and Chart 2 shows the Dow with closing prices only. The bar chart sports a potential double bottom with two lows around 11750. In addition, the March low is actually above the February low. However, the close-only chart shows a clear downtrend with a lower low in March. The close-only chart looks more bearish than the bar chart. Before getting too excited about double bottom chatter, take a close look at different versions of the same chart.

Chart 1

Chart 2

ANATOMY OF A DOUBLE BOTTOM... For the sake of argument, let's look at a double bottom and apply the analysis to today's situation. By analyzing a prior double bottom, we can identify the requirements for a confirmed double bottom. This will give us an idea of what to look for in the coming days.

Chart 3

Chart 3 shows a double bottom in the S&P 500 in June-July 2006. After a sharp decline in May-June, the S&P 500 found support around 1220 to start the double bottom process. I have identified five critical points. First, the index established a reaction low in mid June. Second, there was a support test in mid July. Third, the index surged off support with a big move. Fourth, there was follow-through after this surge. Fifth, the index broke resistance around 1280 to fully confirm the double bottom. You can also see that the index broke above the 50-day and 200-day moving averages. Perhaps more importantly, the 200-day moving average never turned down and continued to rise in June and July. This last point could be critical.

A DOUBLE BOTTOM NOW?... Now let's look at the current S&P 500 chart for comparison (Chart 4). First, the index bounced in January to forge the initial low. Second, there was a support test in early March. Third, there was a surge off support. That leaves steps four and five left in the process. One big surge, while impressive, is not enough to reverse a 4-5 month downtrend. Follow through (step four) is required to validate this initial euphoria. With key resistance set at 1400, the sixth step requires a break above this level. Such a move would also break the 50-day moving average.

Chart 4

It is also noteworthy that the 200-day moving average is currently falling. In contrast, the 200-day moving average was still rising in July 2006. This means the index is in worse shape now than it was in July 2006. With that in mind, the odds of a successful double bottom here are reduced.

LOWER RATES NOT HELPING STOCKS... The Fed has been busying cutting rates since August, but these rate cuts have yet to filter into the stock market. Chart 5 shows the 10-Year Note Yield ($TNX) in red and the S&P 500 in black. Both have been moving lower since October. TNX peaked around 4.6% (46) in October and is currently trading around 3.6% (36). The S&P 500 peaked around 1550 and is currently trading around 1308. Lower interest rates translate into lower capital costs and economic stimulation, both of which are generally bullish for stocks. However, lower interest rates also imply weakness in the economy, which is bearish for stocks. The Fed lowers interest rates when the economy is weak, not when the economy is strong. Lower rates will one day help stocks, but that day has yet to arrive. The decline in rates is also helping bonds. Chart 6 shows the iShares 20+ Year Bond ETF (TLT) as it bounces off support.

Chart 5

Chart 6

FLIGHT TO SAFETY CONTINUES... We can also see a strong flight to safety with money moving into short-term T-Bills. When looking at interest rate charts, keep in mind that bonds move up as rates move down. A sharp decline in rates corresponds to a sharp advance in T-Bonds or T-Bills. After being above 4.75% (47.5) in October, the 3-Month T-Bill Yield ($IRX) declined below 1.5% (15) in March. That is a massive fall in short-term rates and it corresponds with a massive buying in short-term T-Bills. These 3-month T-Bills represent the ultimate flight to safety. They are backed by the U.S. government and their duration is a mere 3 months. That may be an eternity for a primary election, but it is a very short time frame for a debt instrument. T-Bills are a place to hide until the dust settles. As long as the 3-Month T-Bill Yield falls and remains low, the flight to safety continues and we could see continued pressure on stocks. Money moving into T-Bills is not available for stocks. Look for a surge in the 3-Month T-Bill Yield to signal a movement out of T-Bills that could benefit stocks.

Chart 7

SEMIS SHOW SOME RELATIVE STRENGTH... With the market getting a bounce and techs leading the way, I went through the charts to see which industry group ETFs held up well in February and early March. The Nasdaq 100 ETF (QQQQ) broke below its January low, while the S&P 500 ETF (SPY) tested its January low. By extension, stocks and ETFs that held above their January-February lows would show less weakness, which can also be interpreted as relative strength.

Chart 8

The Semiconductor HOLDRS (SMH) declined with the rest of the market from October to January. After a surge in the second half of January, SMH moved into a trading range in February and early March. While QQQQ moved to a new low in March, SMH held above its January-February lows and this shows some relative strength. The two indicators show the price relative comparing SMH to SPY and SMH to QQQQ. Both bottomed in the first half of January and edged higher the last two months. This shows that SMH has been outperforming SPY and QQQQ since early January. Back on the price chart, the ETF has lots of resistance at 30 from the February highs and October trend line. Look for a break above this level to spur the semiconductor bulls. As noted with the S&P 500, follow-through and a breakout are needed to fully reverse the 4-5 month downtrend. Until then, the bears remain in control of the trend and a break below the March low would signal a continuation lower. You can click on this chart to see the setting and save it to your Favorites.