FINANCIALS SURGE AHEAD OF SENATE VOTE -- BIG BANKS TAKE THE LEAD -- USING MOVING AVERAGES TO LOWER THE NOISE -- DOWN SWING RESISTANCE FOR SPY -- RETRACEMENT TARGETS FOR SPY

FINANCIAL SECTOR SHOWS RELATIVE STRENGTH... Today's Market Message was written by Arthur Hill. John Murphy will return tomorrow. - Editor

The market was mixed on Wednesday as investors waited for the Senate's vote on the bailout package. Despite overall indecisiveness, the Financials SPDR (XLF) showed strength by gaining almost 4%. Perhaps the big financial institutions are anticipating passage. Chart 1 shows XLF with gray bars, the 5-day EMA and the relative performance line (XLF:SPY ratio). Focusing on the 5-day EMA, there was a surge in July and then a consolidation over the last two months. This consolidation looks like a falling flag or wedge. A 5-day EMA break above the upper trend line would confirm the pattern and signal a continuation of the July advance. Failure to break out and a move below the September lows would send a bearish signal to Wall Street, and to Congress. John Murphy noted how key financials are to the overall market and the moment of truth is near. The relative performance line has also been trading flat the last two months. XLF is holding up better than SPY in September as the relative performance line remains well above its July low. In fact, the relative performance line is trying to break resistance and this would affirm leadership from this key group.

Chart 1

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BIG BANKS LEAD XLF... JP Morgan (JPM), Bank of America (BAC) and Citigroup (C) led the market higher on Wednesday and propelled the Financials SPDR higher. These three stocks account for over 25% of the ETF. Chart 3 shows JP Morgan surging to its May high on Wednesday. Also notice that the relative performance line broke resistance in mid September. Chart 4 shows Bank of America surging over 8% and the 5-day EMA moving above its Aug-Sep highs. Chart 5 shows Citigroup breaking its July high and the 5-day EMA breaking to new highs. The relative performance line also broke above its resistance line as Citigroup showed relative strength.

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FILTERING OUT THE NOISE... September has been one of the most volatile months in recent memory. Bar charts and candlestick charts are great, but the wild high-low swings can interfere with basic trend analysis. Moving averages provide a good means to smooth volatility by cutting through the noise. John Murphy likes to use the 13 and 34 period EMAs to smooth the data series. Shorter moving averages are more sensitive, while longer moving averages are smoother. The number of periods and moving average type depend on your analysis style, time frame and objectives. Moving averages are a double-edged sword. While the moving average reduces the noise by smoothing the data series, it also creates a lag for slower signals. The smoother the moving average is, the more the lag.

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THE BEST OF BOTH WORLDS... For those who want it all, may I suggest a combination of high-low-close bars and a short moving average. This combination shows the high-low range, but also focuses on average prices to discern a trend. Chart 7 shows the S&P 500 ETF (SPY) with bars in gray and a 5-day EMA in blue. Even though September has been exceptionally volatile, the 5-day EMA shows a steady downtrend. In fact, the 5-day EMA does not look any more variable than the prior months. Despite Tuesday's big rebound, this EMA hit a new low to affirm the downtrend that began August. Chart 8 shows the 5-day EMA without bars or candlesticks. It is a pretty empty chart, but it sure cuts through the clutter. There are four trend lines that denote the swings over the last six months. The current swing is down and the 5-day EMA needs to move above 120 to reverse this down swing (break the trend line).

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RETRACEMENT TARGETS FOR SPY... If the 5-day EMA for SPY breaks above 120, it will be time to start thinking about some upside targets. However, keep in mind that the ETF has yet to actually reverse the current downswing. Tuesday's recovery was impressive, but strong follow through is what separates knee-jerk reactions from sustainable rallies. Even with a break above 120, I would still consider the long-term trend for SPY down. Chart 9 shows the 5-day EMA for SPY over the last 16 months. This chart captures the bear market thus far (October to September). The blue Fibonacci Retracements Tool extends the length of the first decline. Notice that the counter-trend advance retraced 50% of this decline and met resistance near broken support (yellow area). The red Fibonacci Retracements Tool extends the length of the second decline (thus far). A 50% retracement of this decline AND a move back to broken support would extend to around 128-129 (orange area). If the second counter-trend advance is anything like the first, then the target around 128-129 seems logical. Unfortunately, the market can be anything but logical! Think about this one for a moment. We have 34 days until the presidential election. If the last 34 days are anything like the next 34, we are in for one heck of a ride.

Chart 9