SEMI HOLDRS SURGE TO 200-DAY INTEL, TEXAS INSTRUMENT AND APPLIED MATERIALS CHALLENGE 200-DAY TOO UTILITIES CONTINUE TO SHOW RELATIVE WEAKNESS CAREFUL WITH OSCILLATORS IN A STRONG TREND TREND FOLLOWING WITH MOVING AVERAGE ENVELOPES

SEMIS SURGE TOWARDS 200-DAY ... Chart 1 shows the Semiconductor HOLDRS (SMH) challenging its 200-day moving average with a move above 20 today. On the price chart, SMH broke above resistance from the December-February highs and then started working its way higher. The magenta trendlines show a channel of sorts taking shape since late March. The bulls are in good shape as long as this channel holds. A move below 19 would break channel support and start a correction. Chart 2 shows Intel (INTC) challenging its 200-day moving average again today. The stock is also trying to hold its break above the December-February highs. Charts 3 and 4 show Texas Instruments (TXN) and Applied Materials (AMAT) with similar characteristics. Challenging the 200-day moving averages is a show of strength, but this key moving average can also act as resistance. In addition, upside volume over the last two days was not inspiring in these three stocks.

Chart 1

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UTILITIES CONTINUE SHOWING RELATIVE WEAKNESS ... The Utilities SPDR (XLU) remains the weakest of the sector SPDRs since early March. In fact, XLU is the only sector that does not sport double digit gains since March 2nd. PerfChart 5 shows all nine sector SPDRs and SPY over the last 42 trading days. Eight of the nine are up double digits with XLU up less than 7%.

Chart 5

Chart 6 shows XLU with a consolidation extending back to late March. The ETF recovered around half of its Feb-Mar decline with a move back to 26 in late March. XLU then traded flat until the end of April and did not partake in the broad market rally. The bottom indicator window shows the price relative (XLU:SPY ratio). Notice that the price relative (ratio) moved steadily lower over the last two months. Turning back to the price chart, I am watching the current consolidation for a signal out of XLU. A break below consolidation support would be bearish. Given relative weakness, the odds favor a break to the downside. Nevertheless, should XLU hold support, look for an upside breakout to revive the bulls.

Chart 6

OSCILLATORS AND TRENDING MARKETS... Even though the major stock indices are overbought and ripe for a correction, the surge over the last seven weeks shows no signs of reversing. The advance may be slowing, but we have yet to see an actual breakdown. Declines have been limited in duration (1-2 days) and distance (3-5%). With this in mind, I decided to dissect a prior strong advance to show what works and what doesn't work. Let's look at what doesn't work first. Negative divergences in oscillators do not work in a strong uptrend. A negative divergence forms when the index moves to new highs, but the oscillator fails to confirm with a higher high. Chart 7 shows the S&P 500 from July 2003 to March 2004 with a 20% over a 6-7 month period (early Aug to early Mar). There were some short pullbacks, but the index recovered quickly each time and moved to new highs a few days later. MACD and Chaikin Money Flow formed negative divergences in September and November, but these did not foreshadow a significant peak, just minor pullbacks. RSI also formed a negative divergence in September. The advance continued until RSI became overbought and MACD formed a rather large negative divergence (late January to early March). RSI also formed a large negative divergence from January to early March. The trend actually reversed when the index broke support at 1120, MACD moved below zero, RSI moved below 50 and Chaikin Money Flow turned negative (blue line). Lesson here: be wary of the first negative divergences in a strong uptrend.

Chart 7

MOVING AVERAGES AND TRENDING MARKETS... Moving averages are better suited for trending markets. With that in mind, Chart 8 shows a one year advance with a moving average envelope. The blue line is a 20-day simple moving average, while the red envelope lines are 3% above and 3% below this moving average. This envelope acts as a noise buffer by ignoring small moves. It takes a pretty significant move to break above or below the envelope. Notice how the uptrend started in March 2003 with a big move above the 3% envelope and continued until the index broke below the 3% envelope in March 2004, one year later. That was one strong trend. There were some pretty sharp pullbacks, but the lower envelope ultimately held. Although this indicator is far from perfect, it will work in a strong uptrend. Charts 9 and 10 show two more examples from 1998-1999 and 2006-2007.

Chart 8

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CURRENT SPX CHART... Chart 11 shows the S&P 500 currently with the moving average envelope, RSI and MACD. The index moved to a new high for the month yesterday, but MACD and RSI remain below last week's highs. Small negative divergences are brewing. However, a look at the moving average envelope shows a surge above the top envelope in early March. This increases the possibility of a strong uptrend and decreases the relevance of negative divergences. Should a strong uptrend trend unfold (continue), these negative divergences will foreshadow nothing more than short pullbacks. Until we see a sharp decline that breaks the bottom envelope, I would expect this advance to continue working higher. Despite this uptrend, SPX is currently near the top envelope and overbought. This makes it prudent to wait for a pullback. Using this moving average envelope system, a trend reversal would not occur unless the index breaks below the bottom envelope, which is currently at 825 and rising.

Chart 11