HOMEBUILDERS, RETAILERS, AND TRANSPORTS CONTINUE TO SHOW NEW MARKET LEADERSHIP -- BANK BOUNCE ALSO HINTS THAT FINANCIAL SELLOFF IS OVERDONE -- A LOT OF SHORT-TERM POSITIVE DIVERGENCES ARE SHOWING UP, SUGGESTING A POSSIBLE MARKET BOTTOM

FORMER LAGGARDS CONTINUE TO LEAD ... Last Thurday I showed that several 2007 market groups that helped pull the market lower last year were showing much better relative strength in 2008. The groups I showed included transports, retailers, homebuilders, small and midcap stocks. I suggested that their improved relative performance was hinting at subtle improvement taking place in the market beneath the surface. If anything, those signs of improvement are becoming more pronounced. The first three charts show three of those groups continuing to act better, both on an absolute and relative basis. The upturns in the relative strength ratios of the transports (Chart 1) and the retailers (Chart 2) are especially pronounced. What makes the improvement in homebuilders (Chart 3) so encouraging is that's where all the trouble started two years ago. Outside of homebuilders, financial stocks have been the biggest drag on the market. Even that situation may be improving.

Chart 1

Chart 2

Chart 3

BANKS ARE BOUNCING OFF CHART SUPPORT... Financial stocks have been the biggest burden on the market since the start of the year. As a result, the Financial Select SPDR has been one of the few sector ETFs to actually hit a new low for the year. That, however, is due primarily to the recent plunge in brokerage stocks. If we look outside of brokerage stocks, however, we see some signs of financial improvement. I'm talking primarily about bank stocks. Chart 4 shows the KBW Bank ETF (KBE) climbing more than 5% today after bouncing off its January low. It's relative strength ratio (bottom of chart) is bouncing as well. The daily chart of the Bank Regional Holders (Chart 5) is even stronger. The RKH is further off its January intra-day low as is its relative strength ratio. If banks are bottoming, that would suggest that recent selling in the financial sector has been overdone. Needless to say, any bounce in the financial sector would take a tremendous weight off the rest of the market, which also appears to be trying to form a bottom.

Chart 4

Chart 5

SHORT-TERM DIVERGENCES SUGGEST A MARKET BOTTOM... A number of short-term positive divergences, combined with major market indexes testing chart support around their January lows, strongly suggests that the market is putting in some type of a bottom. Maybe not a final bottom. But possibly a rally of intermediate proportions. First the divergences. Virtually every short-term indicator that I look at failed to confirm this week dip to a new 2008 low. Chart 6 shows the 14-day RSI line bouncing from oversold condition and showing a short-term pattern of rising bottoms. The MACD histogram bars (below chart) show the same rising pattern. The March histogram low is much higher than the January low. That contrasts with yesterday's intra-day violation of the January low by the S&P itself. When a market fails to stay at a new low, it's usually ready to rally. I'm looking for at least a test of February highs near 1400. Chart 7 puts that in perpective. An intermediate rally in a downtrend usually retraces at least 38% of the previous decline. That would also support a test of the February high. Chart 8 shows the 10-Year T-Note yield also trying to bounce off its January low. Its 14-day RSI (solid) line is also showing positive divergence. A bounce in bond yields (and a pullback in bond prices) would be consistent with a stock rally. A rise in bond yields could provide short-term support for the dollar and cause some profit-taking in commodities.

Chart 6

Chart 7

Chart 8

WHAT TO DO ... Assuming that I'm correct about the market putting in an intermediate bottom, there are a few steps that investors with a shorter-term horizon might want to consider. The first is to lighten up on existing short market positions. A second is to consider putting some funds into some of the market leaders I've mentioned above. A third is to take some profits in bonds and commodities. Although I remain bullish on the long-term trend of commodities, a firmer stock market (and higher bond yields) could produce a bounce in an oversold dollar which, in turn, could cause some profit-taking in overbought commodities.