THE LONG-TERM PICTURE FOR DIA, SPY AND QQQQ -- BREADTH REMAINS WEAK AND WITHOUT A DIVERGENCE -- XLF APPROACHES ITS 2002-2003 LOWS -- ITB STILL UNDERPERFORMING -- BIOTECHS SHOW RELATIVE STRENGTH

TAKING A BIG STEP BACK... Today's Market Message was written by Arthur Hill. John Murphy will return next week. - Editor

The stock market is oversold, but just getting even more oversold. Chart 1 shows the Dow Industrials ETF (DIA) moving to a new low for 2008. The Commodity Channel Index (CCI) is back in oversold territory and bounces are limited to 1-3 days. There will eventually be a bigger bounce, but the big trend is dominating price action right now. With this in mind, I am stepping back to look at the long-term picture with some monthly charts. Technical analysis is fractal, which means the techniques used on daily charts can be applied to intraday charts or monthly charts. The principles for trend lines, retracements, flags, support and resistance are the same, regardless of the time frame. As you may have guessed, I will also be providing some downside targets for the major index ETFs. Take these targets with a grain of salt.

Chart 1

LONG-TERM RETRACEMENTS FOR DIA, SPY AND QQQQ... Chart 2 shows the Dow Industrials ETF (DIA) with monthly candlesticks. The ETF advanced from October 2002 to October 2007. This was a five year run that saw DIA (and the Dow) double. One hundred percent in five year is roughly 20% per year - an outstanding return for five years. In fact, it is way above the long-term average for the stock market, which is around 10%. Yes, I know, this number is debatable. A period of above average returns is often followed by a period of below average returns that causes a reversion to the mean. Ten percent is the average annual return for stocks over the long run. This means there will be periods of above average return (>10%) and periods of below average return (<10%). Returning to the DIA chart, a process of two steps forward and one step backward makes for good returns. The advance from 2002 to 2007 looks like two steps and a 50% retracement of that advance could act as one step backward. Retracing 50% of a move is not unusual. Such a pullback would target a decline to around 100-105 (yellow area) or 10,000-10,500 in the Dow. There is also support around 102.4 from broken resistance. On a daily or weekly chart, a decline of this magnitude looks incredibly drastic. On the monthly chart, it looks entirely feasible. Charts 3 and 4 show long-term retracement targets for the S&P 500 ETF (SPY) and Nasdaq 100 ETF (QQQQ).

Chart 2

Chart 3

Chart 4

BREADTH REMAINS WEAK... Nobody rings a bell at the bottom, but there are certain indicators we can watch for signs of improvement. Breadth often improves or deteriorates ahead of a market bottom or top. The next four charts show the AD Line for the NYSE (red) and the NY Composite (gray). To display this indicator in SharpCharts, enter the symbol ($NYAD) and then choose "Cumulative" under Chart Attributes/Type. The AD Line is a cumulative measure of AD Net (advancing stocks less declining stocks). Charts 5 and 6 show positive divergences in March 2003 and August 2004. A positive divergence forms when the index moves to a new low or equal low, but the indicator forms a higher low. The higher low in the indicator shows underlying strength that can foreshadow a bottom in the index. Chart 7 shows a negative divergence in October 2007. The NY Composite moved above its July high in October, but the AD Line formed a lower high for a negative divergence. This showed underlying weakness in the rally and foreshadowed the October peak. Chart 8 shows the current situation. Both the AD Line and the NY Composite moved to new lows over the last few weeks. There is no positive divergence and no sign of underlying strength.

Chart 5

Chart 6

Chart 7

Chart 8

CURING THE CULPRITS... At the risk of sounding like a broken record, the Consumer Discretionary SPDR (XLY) and the Financials SPDR (XLF) are the two sectors most responsible for current conditions (i.e., a bear market). Charts 9 and 10 show monthly candlesticks for these two ETFs and both are trading below their 2004 lows. XLF is closing in on its 2002-2003 lows. The bottom windows show the price relative, which compares the performance of the ETF to the S&P 500. On Sharpcharts, you can create this indicator by selecting "Price" and then entering "XLY:$SPX" under Parameters. The price relative rises when the ETF outperforms the S&P 500 and falls when the ETF underperforms. Notice that both XLY and XLF were outperforming the S&P 500 in 2002 (green dotted lines). This relative strength helped facilitate a significant bottom from October 2002 to March 2003, and ushered in a five-year bull market. XLF and XLY are currently underperforming and a major bottom in the market is unlikely as long as both are relatively weak. We can start anticipating a bottom when/if these two start showing some relative strength by outperforming the index. Taking this a step further, Chart 11 shows the Home Construction iShares (ITB). Unfortunately, data does not go back seven years. ITB peaked in June 2005, which was over two years ahead of the S&P 500. This key group hit a new 52-week low in July and remains an underperformer. When housing turns around and ITB starts outperforming the S&P 500, we can also start thinking about a bottom in the market.

Chart 9

Chart 10

Chart 11

WHERE'S THE STRENGTH?... Or the beef for that matter? After perusing through a number of monthly charts, one group stuck out over the last 6-9 months. Biotech stocks have held up quite well since the S&P 500 peaked in October 2007. Charts 10 and 11 show the Biotech HOLDRS (BBH) and the Biotech iShares (IBB). BBH surged in 2003, consolidated in 2004, surged in 2005 and then consolidated the last 2 and a half years. This consolidation looks like a massive flag and a breakout at 180 would be bullish. The price relative turned up over the last six months and BBH is starting to show relative strength. IBB surged in 2003 and then traded in choppy fashion the last 4 and a half years. The ETF actually underperformed the S&P 500 during this period as the price relative moved lower. With some firmness over the last six months, the price relative turned up and IBB is starting to outperform. In addition, the ETF remains in a slight uptrend over the last four years.

Chart 12

Chart 13