STOCKS DECLINE AFTER JOBS REPORT- CLUES FROM THE 1998 SURGE - WATCHING THE MAY LOWS - MONTHLY TREND REMAINS DOWN - VOLATILITY CONTINUES TO FALL - CUMULATIVE NET NEW HIGHS CONTINUES TO RISE

EMPLOYMENT REPORT ROCKS STOCKS... Non-farm payrolls declined 467,000 for June, which was worse than expected. Stocks took the news hard with a broad based decline in early trading. The major indices were down over 2% around noon. All sector ETFs were lower with the Consumer Discretionary SPDR (XLY) leading the way lower. Chart 1 shows XLY plunging over 3% by noon Thursday. The ETF is on the verge of breaking support from its mid-May lows. With a double top taking shape, a break below this support level would target further weakness towards 19. The height of the pattern is subtracted from the support break for a target. As the most economically sensitive sector, relative weakness in consumer discretionary is not a good sign for the overall market. In fact, XLY could become the third sector to break support from the mid-May lows. The Industrials SPDR (XLI) and the Energy SPDR (XLE) already broke this support level.

Chart 1

A BIG SECOND QUARTER... The second quarter surge in the S&P 500 was the one of the biggest in over 10 years. This prompted me to take a look at another big quarterly surge for potential clues on what to expect after the surge. Chart 2 shows the S&P 500 from February 1998 to January 2000. After the big surge in the fourth quarter of 1998, (yellow area), the index consolidated for around two months and then worked its way higher for another 4-5 months before there was an actual pullback. Basically, this advance continued another 6-7 months after the big quarterly surge.

Chart 2

The bottom indicator shows the Percentage Price Oscillator (PPO). Instead of a 9-week EMA and 26-week EMA, I am using a 5-week EMA and 35-week EMA to make the indicator more sensitive. The 5-week EMA moves faster than the 9-week EMA, while the 35-week EMA moves slower than the 26-week EMA. The combination of a faster 5-week EMA and slower 35-week EMA produces a more sensitive indicator. Notice how momentum peaked in January 1999 and the PPO moved lower until October. There were also negative divergences in April and July. The first negative divergence did not produce a good signal, but the second foreshadowed the July-October pullback. Lesson learned here: be wary of the first negative divergence.

Fast forward to 2009 on chart 3. Even though the S&P 500 looks ripe for pullback, we must always be prepared for the unexpected. Keep an open mind. As the 1998 example shows, further gains are possible before embarking on a pullback. Such a scenario might involve a choppy advance towards 1000 over the next few months. The green line marks the May lows, which is the first important support level. Lets call it the line-in-the-sand. Technically, the trend (since March) is up as long as these lows hold. This applies to a number of major index, sector and industry group ETFs. A break below these lows would argue for an extended pullback or correction. A typical correction could retrace 38-62% of the prior advance (666 to 955). This area is marked in gray. Also keep in mind that September and October are just around the corner. October is an especially dangerous month for the stock market. The other dangerous months are January, February, March, April, May, June, July, August, September, November and December. That little tidbit is courtesy of Samuel Langhorne Clemens, a.k.a. Mark Twain.

Chart 3

MONTHLY TREND STILL DOWN... The trend on the monthly chart remains down, but there is room for further upside before hitting resistance. This is one heck of a counter-trend rally. As noted above, further upside is possible as long as the May lows (key supports) hold. All bets are off if the May lows are broken. Chart 4 shows the S&P 500 ETF (SPY) over the last 15 years with two indicators: the 18-month moving average and 20-period Commodity Channel Index (CCI). Believe it or not, these indicators confirm one and other. The trend turns down when SPY breaks its 18-month moving average and CCI breaks below zero. Conversely, the trend turns up when SPY breaks its 18-month average and CCI breaks above zero. This combination works when there is a strong trend, but not in a choppy range-bound market. There was a strong uptrend from 1995 to 2000, a strong downtrend from 2001 to 2002, a strong uptrend from 2003 to 2008 and now a strong downtrend. SPY bounced off the 2002 lows in March and is now undergoing a reversion to the mean. Within a downtrend, we should expect resistance near the 18-month moving average or when CCI approaches the zero line. This means SPY could move above 100 (SPX above 1000).

Chart 4

Chart 5 shows the Nasdaq 100 over the last 15 years. I am using $NDX because QQQQ data does not go back this far. NDX broke wedge support with a sharp decline in 2008. After becoming oversold, the index found support just above 1000 and surged over the last three months. Broken support turns into resistance around 1650. In addition, the falling 24-month moving average confirms resistance in this area. NDX could conceivable make it back above 1600 before embarking on a correction. Note: the moving average and CCI periods are longer to provide a better fit for NDX.

Chart 5

VOLATILITY CONTINUES TO FALL... Falling volatility means more money is becoming available for stocks. Chart 6 shows the S&P 500 Volatility Index ($VIX) over the last three years. There were three periods: bull market volatility, bear market volatility and crisis volatility. After reaching 80 in October 2008, the VIX steadily declined over the last nine months and moved below 30 for the first time since September 2009.

Chart 6

Many fund managers were priced out of the stock market when volatility surged. Why? Because volatility equals risk. Many fund managers could not buy stocks because their funds charter prohibited investments with high volatility. With the VIX declining back to more reasonable levels, risk (volatility) also fell and this allowed fund managers back into the stock market. A falling VIX is bullish for the stock market. Chart 7 shows the S&P 500 Volatility Index ($VIX) as a 3-day SMA to smooth the time series. Rising volatility (VIX) has been associated with a falling stock market (SPX), while falling volatility has been associated with a rising stock market. The green and red dotted lines show VIX reversals that coincided with stock market reversals. The VIX indicator hit resistance around 32.5 in June and then fell sharply the last seven days. I am marking resistance at 32.5. VIX remains bullish for stocks as long as this level holds. Chart 8 shows the Nasdaq 100 Volatility Index ($VXN) with similar characteristics. It is also interesting to note that the VIX (S&P 500) and VXN (Nasdaq 100) are relatively equal. Who would have thunk it?

Chart 7

Chart 8

NET NEW HIGHS STILL RISING ... In a testament to the ongoing uptrend in stocks, cumulative Net New Highs continue to rise. Net New Highs equals new 52-week highs less new 52-week lows. This cumulative line rises when there are more new highs and falls when there are more new lows. Compared to the AD Line and AD Volume Line, the cumulative Net New Highs line lags because new 52-week highs/lows do not happen overnight. It takes a substantial move to produce yearly highs or lows. In addition, cumulative Net New Highs is smoother than the AD Line and AD Volume Line. In other words, it less sensitive to short-term price movements. In contrast, the AD Line and AD Volume Line rise/fall with the ups/downs of the stock market. Chart 9 shows the AD Line for the NYSE moving step-for-step with the NY Composite.

Chart 9

Despite the lag, the cumulative Net New Highs line can help confirm the underlying trend. In general, the trend for stocks is up when the line rises and down when the line falls. Armed with some background, lets look at the charts. Chart 10 shows the cumulative Net New Highs for the Nasdaq. The indicator plunged with the Nasdaq in February and early March. It leveled out at the end of March and turned up in early April, about a month after the Nasdaq bottomed. This is the lag. Chart 11 shows the same indicator from late March. Despite a couple of flat periods in mid May and mid June (orange boxes), the indicator has been moving higher the last three months. The uptrend in stocks could continue until we seen a noticeable decline in this indicator. The scale on the right hand side (Net New Highs cumulative) depends on the starting date for the chart.

Chart 10

Chart 11

Chart 12 shows cumulative Net New Highs for the NYSE since mid January. The indicator plunged along with the NY Composite in February. While the NY Composite surged in the second half of March, the indicator flat-lined as Net New Highs held near zero (new 52-week highs = new 52-week lows). Chart 13 shows the indicator turning up in mid April, dipping in mid May and moving higher throughout June. The indicator is clearly trending up and this is generally bullish for stocks.

Chart 12

Chart 13