VOLATILITY INCREASES

Last week was filled with volatility as investors tried to sort out the threat of a global meltdown tied to the possible collapse of Greece's financial system. In addition, China announced early Friday morning that it was tightening lending standards of its nation's banks and significantly cutting-back on its stimulus plans. The market, represented by the S&P 500, was a wild ride each day as shown in the graph below:

Dow Jones Industrials, one week. Chart courtesy of Yahoo Finance.com

In last Thursday evening's Action Alert, we said, "Since the sell-off began on January 19, the market has declined for 3 1/2 long weeks, resulting in a decline of 7.83%. Four consecutive weeks of downward market losses is very rare, so there is a better than average likelihood that the broad market will finish this week higher."

And so it did, finishing the week up by a wimpy 0.87%. We bought stocks for our Aggressive Portfolio on Friday morning, and gained 1.59% in 6 ½ hours for our efforts. (Hopefully there's more to come this week.)

IT'S ALL GREEK TO ME

Much of the recent turmoil in the markets has been the result of worries about the possible collapse caused by debts in the country of Greece. Why should the problems in the Greek financial system be important to us? Let's do a quick overview of how the current mess got started...

Back in October 2008, when the entirety of the world's financial system came within hours of collapse, governments across the world threw taxpayer money at the problem in an attempt to shore up the banks. According to a lot of people who are smarter than me, including billionaires Warren Buffett and Jeremy Grantham, a run on the banks across the world was forestalled by just a few hours.

Already, Money Market Funds briefly "broke the buck," and there were lines out into the streets filled with people trying to withdraw their money from some of the weaker banks. I hear a lot of my more conservative friends making off-the-cuff comments about how none of the banks should have been bailed out, but they don't realize that they too could have lost everything, with a system-wide collapse that could have scarred America for 50 years or more.

The problem came from the securitization of sub-prime mortgage loans. In the middle of the last decade, a new group of mortgage bankers approved home loans for anyone who walked in the door with a pulse. They then packaged a couple hundred of those loans and sold them to Wall Street. The credit-rating agencies then gave the packages AAA ratings and Wall Street investment banks sold shares in the billion-dollar packages to wealthy clients. Back in the Spring of 2007, before most people had heard of 'subprime loans,' I said in a Weekly Newsletter that it was "the modern-day equivalent of turning lead into gold" and a collapse was imminent. Unfortunately, I knew of no way for individual investors to short that market.

When the business cycle slow-down started (which occurs approximately every 4.5 years) and the house of cards began to collapse, governments across the world had to step in to save the financial system. Now the weakest of these nations are starting to collapse under the weight of the enormous debt they've taken on. Portugal, Italy, Iceland, Greece, and Spain (the 'PIIGS') are the primary problem areas in Europe. And these problems won't be resolved in the next couple of weeks - they will last for years to come, regularly rearing their ugly heads and causing market volatility.

WHERE'S THE MARKET HEADED FROM HERE?

The market has fallen about 7% since the intermediate high we called on January 19. Will the worries about the collapse of Greece and China's tightening cause the market to go lower? We feel that the markets may go lower, but its not because of China or Greece.

The market generally moves on its own accord, fluctuating between overbought conditions based on greed and oversold conditions based on fear. There is always both good news and bad news that's available at any given time. The media always assigns the current news as the ostensible cause of any market activity. If the market goes down, the current bad news is highlighted and the good news is ignored; and vice-versa when the market rallies.

Most of the time there is no correlation between good or bad news and the action of the market. However, occasionally a news story will nudge the market in a particular direction in which it was already predisposed. That's what happened with the China tightening story last Friday morning.

I felt that with the market right at a critical point in which it could go either direction, the Chinese government's announcement of tightening the screws on economic growth would send the market down.

So before the market open, I added an inverse Chinese ETF (FXP) for the Aggressive Portfolio and a 50% position in the leveraged-inverse ETF SDS of the S&P 500 in the Market Trends portfolio. Surprisingly, even though the market dropped dramatically at the open, it worked its way higher by the close, which was very positive price action for the market.

THE TECHNICAL OUTLOOK

The technical indicators that we watch are showing mixed signals between the large-cap S&P 500 index vs. the Nasdaq 100 (as well as the Russell 2000 small-cap index). The Nasdaq index is chock full of technology-related stocks and the Russell 2000 is based on the 2000 smallest-cap companies from the 3000 stocks tracked by Russell Investments.

John Murphy's editorial in StockCharts.com provided this commentary about the S&P 500 weekly chart on Friday:

"...It seems like the perfect storm is brewing for a stock market correction. First, the Shanghai Composite ($SSEC) broke down over the last few weeks. Second, the Euro broke down over debt concerns in Greece, Spain and Portugal. Third, the Dollar rose in a flight to safety as the risk aversion trade returned. Fourth, (the chart below) shows a long-term resistance-reversal zone in play for the S&P 500.

S&P 500 weekly chart shows a confluence of indicators that could be warning signs.
Chart courtesy of StockCharts.com.

From March to January, the S&P 500 advanced over 70% without a correction greater than 10%. This advance retraced 50% of the decline from October 2007 to March 2009 and 62% of the decline from May 2008 to March 2009. Taken together, we have a Fibonacci retracement cluster that marks a potential resistance zone.

There is also resistance from the October 2007 trendline in this area. With resistance hitting in January and the decline over the last few weeks, weekly MACD moved below its signal line for the first time since March 2009."

ANOTHER LOOK AT THE S&P 500

The chart below shows that since the January high (which we called before the SPX hit 1,150) the S&P 500 has been in a steep downward channel. The lower chart shows that the solid Relative Strength Indicator (RSI) dropped rapidly from overbought in mid-January to oversold at the start of February. The indicator still hasn't been able to break above 50, despite two brief rallies. The steep downward channel and the oversold RSI shows the strongest selling pressure since the rally began last March.

With such strong downward selling pressure, it will take a very powerful bullish catalyst with increased volume, wide breadth, and broad participation to make the index break through this trend channel to the upside.

These are a couple of the reasons we bought a 50% position in the leveraged-inverse ETF (SDS) for the Market Trends portfolio on Friday. The S&P 500 is truly poised to go in either direction, but the trend, until proven otherwise, remains downward.

WHAT ABOUT SMALL-CAP STOCKS?

If we look at the index of small-cap stocks, i.e., the Russell 2000 ($RUT), we see a different story. As you can see, the index has broken through the trend channel to the upside over the last few days. The Relative Strength Index (RSI) is also showing strong movement to the upside with room to run before it becomes oversold.

Why would small-cap stocks be doing better than the large-cap S&P 500 stocks? One reason is that the S&P 500 has a large contingent of stocks in the financial sector (which is a sector that is very challenged right now).

A second reason may be related to the strength of the U.S. dollar. With weakness in the Euro (a result of the debt weighing on weak European nations), the dollar (as well as U.S. Treasuries), continue to be a store of wealth for skittish investors across the planet. But the dollar strength weighs on companies which export or have divisions established overseas. A whopping 78% of S&P 500 companies have an international presence.

In contrast, a majority of small-cap companies do not export overseas. These companies won't have the perceived drag on earnings that S&P 500 companies may have because of the strong dollar. With the possibility that the European Union may be weighed down by their weak constituents for many years to come (maintaining the dollar's strength), small-cap stocks may have the upper hand for a while.

ADVISOR'S SENTIMENT

The Advisors Sentiment Survey is a widely watched report published every Wednesday since the 1950s by Investor's Intelligence. The report compares the number of bullish newsletter advisors to the number of bearish advisors and the result is a contrarian indicator at the margins. In other words, the higher the ratio of bulls to bears, the greater the chance that the market will head down in the near term. It's a classic measure that shows when the largest number of advisors (or investors) are expecting continuously higher prices, the market is most vulnerable to a selloff. And vice-versa, when advisors think that things can only get worse, the market is ripe for a rally.

Back on January 15, Investor's Intelligence analysis concluded that "the difference between the percentage of bullish advisors and bearish advisors climbed to its highest level since October 2007 and that was of course the bull market high. The reading, of +37.5%, screams caution and coupled to evidence of a defensive rotation, detailed further in the report, we are turning more defensive."

Recently, the number of bulls compared to bears has quickly plummeted from a ratio of 3.5-to-1 to a ratio near 1-to-1. When the ratio has dipped close to one, the chances of a market upturn are much higher. That's the case now, as show by the chart below:

Ratio of Bullish to Bearish advisors. Chart courtesy of Investor's Intelligence.

On the other hand, this analysis isn't really something that should be relied upon as a single tradable indicator. We can see that advisors were bearish from March 2008 to June 2009 and that turned out to be correct during that extreme period. Now that the market has resumed more normal price action, the indicator's turns can be used again as contrarian indicators.

COMPOSITE INDICATORS

Investor's Intelligence also maintains long-term and a short-term Composite Indicators which take into consideration a couple of dozen indicators of the market. These indicators are oscillators and when they reach extremes and begin to turn upwards, the market is likely to also head upwards. The chart below shows their Short-Term Composite Indicator:

As you can see, the lows of the indicator over the last year coincided with the March 2009 bottom, the July low, the November low, and the current mid-February 2010 correction. The current low is the deepest drawdown since the market low last March. One thing we need to keep in mind is that when this indicator begins to take off, it takes off in a big way. When we made our stock selections last Thursday evening, the timing decision was partly based on our desire to get in ahead of the sharp rebound that could occur this coming week.

OUR PORTFOLIOS

Last Thursday evening, I issued an alert with six long positions for our Aggressive Portfolio. These stocks all have charts that are going against the trend of the broad market. They have solid uptrends and are rising from oversold conditions on solid volume. All positions have 50-day moving averages that are higher than they were both 10 and 30 days ago, which indicates that the 50-day moving averages for our picks have been rising while the market has been floundering over the last month.

These were our first purchases since we called the market top at 1,150 on the S&P 500 in mid-January and backed up that call with our actions by leaving the portfolios in cash through the downturn. (We don't go short unless the primary, long-term trend has turned down.) But now there's change in the air and we've backed that up with our actions by filling our portfolios with solid selections. On Friday, the first day of our new positions in the Aggressive Portfolio, they gained a nice $1,161.

We do have one leveraged-inverse (short) ETF based on the Xinhau China 25 (FXP), which is a play on China's tightening announcement at 5AM last Friday morning. With the start of a new week and markets being very oversold, hopefully we'll rack up some significant profits in the days ahead. Should the market rally this week, we will be adding leveraged ETFs to take advantage of the rebound. Announcements of these purchases will be made in evening Action Alerts for purchase at the open the next moring.

We will also sell the 50% position of SDS in the Market Trends Portfolio as the direction of the S&P 500 is so tenuous now.

Sincerely,

Christopher Michaels
IntelligentValue.com

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