The Market Newsletter Blog

We got stopped out on our attempt to short the market a couple of weeks ago. So now, we are flat and have no short or long positions. However, the recent rally has been on very light volume and the S&P 500 has not been able to close above 1100. Since we have been stopped out, we will wait to see more signs of professional selling before we can attempt to short again. We definitely don’t want to trade on the long side for now.

It seems that the correction has finally started. With the selling that we saw today, the bears will be back in force and will try to push the market further down. Recently, the sentiment on Wall Street has become very bullish, and that is the part that was missing for the correction to start..

The ability to read stock charts can help a lot in making sound investment decisions as it not only gives a snapshot of a stock past performance, but also helps predict the future direction. In this article, we summarize the most reliable chart patterns used by investment professionals.

The most reliable bullish chart patterns:

- Cup with Handle: The cup is in the shape of a ‘U’ and the handle has a slight downward drift. The right-hand side of the pattern should have a low trading volume. It can be as short as seven weeks and as long as one year. As the stock comes back up to test the old highs, Investors who bought at or near the old high will start selling the stock to break even. This selling pressure will make the stock price trade sideways with a tendency towards a downtrend for four days to four weeks, then it takes off and takes out the old highs.
- Double Bottom: This pattern describes the drop of a stock, a rebound, another drop to the same level as the original drop, and finally another rebound that goes higher than the previous highs.
- Pennant: It is formed when there is a large movement in a stock, followed by a consolidation period with converging trendlines, followed by a breakout movement in the same direction as the initial large movement.
- Inverse Head & Shoulders: This happens when the price falls to a trough and then rises again. The price falls below the former trough and then rises again. Finally, the price falls again, but not as far as the second trough. Once the final trough is made, the price heads upward toward the resistance found near the top of the previous troughs. The first and third trough are considered shoulders, and the second peak forms the head.

The most reliable bearish chart patterns:

- Head & Shoulders: This happens when the stock rises to a peak and subsequently declines, then the price rises above the former peak and again declines, and finally, rises again but not to the second peak and declines once more. The first and third peaks are shoulders, and the second peak forms the head.
- Double Top: This pattern describes the rise of a stock, a drop, another rise to the same level as the original rise, and finally another drop. The double top looks like the letter ‘M’. The twice touched high is considered a resistance level.
- Rounded Top: A rounded top, which looks like an inverse ‘U’, may form at the end of an extended upward trend and indicates a reversal in the long-term price movement. The initial upwards trend becomes exhausted as the demand for the stock dries up. The reversal to the downward slope of the rounding top indicates that demand has tapered off and a surplus supply is present, basically there are more sellers than buyers.
- Pennant: It is formed when there is a large movement in a stock, followed by a consolidation period with converging trendlines, followed by a breakout movement in the same direction as the initial large movement.

Since the market correction started in November 2007, Tech stocks have been hit really hard as investors sold everything they own, the good and the bad. The Nasdaq composite was down about 25% when it hit bottom a month ago, while the S&P 500 was down about 20%. If you look at the market leaders before the correction, GOOG and AAPL were both down more than 40% from their October highs.

The reason behind selling tech stocks was that the financial crisis will lead to slower IT spending by the Banks and Brokers, and a consumer led recession will result in slower tech sales. Six months later, those same big tech companies reported earnings for the first quarter and they easily beat wall street expectations. So why were analysts estimates so low for the tech sector?

In GOOG case, revenues for the first quarter were 42% higher than a year ago, and they beat analysts earnings expectations by 7%. It turned out that the data on paid clicks that all analysts base their numbers on was seriously flawed and they all blamed their bad estimates on the firm that provides these statistics. As for AAPL, revenues were also around 43% higher, and earnings beat expectations by 8.4%. It was the incredible number of Mac computers sold that boosted AAPL revenues. Analysts realized that even during a recession people are willing to spend some money to get AAPL’s cool products. Both companies also benefited from strong international sales.
Even if you look at other big cap tech names like IBM or AMZN, they reported very strong numbers that nobody on the street was expecting. Some of them even guided higher for the remainder of the year. But can these growth rates be maintained in the foreseeable future? Well, if with all the problems that hit the US economy in the first three month of the year they can report such numbers, it is highly unlikely that things will slow down in the second half when it is seasonally the best time for tech companies to sell their products. In addition, the US economy is now supposed to be getting better with all the Fed and Government bailout plans.

In addition to looking at the fundamentals, we also like to check the Technicals. Both GOOG and AAPL broke out from sound bases and are now back above their 50-day moving average.

GOOG broke out and gapped higher on strong volume the day after releasing its earnings report. Its relative strength is making new highs already. This is very bullish for the stock going forward. You can also look at the QQQQ chart which tracks the Nasdaq 100 index to get a more general picture. It bottomed at around $41 in March and is now trading at $47, around 15% higher. RSI is also making new highs.

Given both strong fundamentals and technicals, we believe that the Tech sector will outperform the overall markets for the remainder of the year and will be leading the markets higher going forward. If you would like to take advantage of these moves without being exposed to only one specific stock, you can invest in the QQQQ (Nasdaq 100) ETF, or if you can handle more risk you can buy QLD. With the recent run up of all the stocks mentioned here, you might want to wait for a pullback before investing your money.

Gold prices have been rising sharply over the last few months while the equity markets went into a sharp correction. Over a one year period the popular GLD (Gold ETF) is up almost 40%. Compare that to the S&P 500 or SPY which is down 10% during the same period. The main reasons for the rise were basically Inflation and the weak dollar. The explosive growth in emerging markets over the last few years has led to a huge commodities bull run and fueled global inflation, which in turn put pressure and weakened the USD against most of the major currencies. And then to make things worse, a nasty credit crisis hit Wall Street last fall due to the collapse of the mortgage subprime market. The Federal Reserve, in order to avert a complete collapse of the financial system, had to start slashing rates and add liquidity to the system. Interest rates went down from 5.25% to 3% in a few weeks. That’s when Gold prices had their steepest rise, going up 300 points since November.

So why do we think you should sell Gold and specially the mining stocks if prices are so strong?

First, if you look at the mining stocks prices compared to the gold prices, while the GLD is up 40%, the mining stocks ETF, or GDX, is up only 20% over a one year period. The reason for the underperformance is that it is getting harder and harder to extract the metal from the ground and also more expensive. The margins for mining companies are not as good as they used to be.

Second, and more importantly, the 2 main reasons behind Gold rise may not be valid anymore, at least in the short term. At the last Fed meeting, interest rates were cut by 75 basis points to 2.25%. When that happened gold prices unexpectedly collapsed 100 dollars in 3 days. The reason was that investors in the metal were disappointed and the markets were actually looking for a 100 basis points cut. The fed’s next meeting comes in April and this time traders are expecting a 50 basis point cut. However, we think it is very likely that the Fed will only cut by 25 basis points and that might disappoint investors again. Even if the Fed cuts by 50 basis points, and rates go down to 1.75%, that might be the last time we even get a cut. Very few people are expecting rates to go lower than 1.75%. The ECB, on the other hand, is expected to just start cutting rates later this year when the EU economy shows more signs of weakness. All that could stabilize the dollar in the coming months.
As for inflation, the numbers are finally starting to moderate due to the weakness in the world economies led by the US housing crisis. The PCE inflation numbers just released show inflation for the last year at 2% which is still inside the Fed’s comfort zone. Actually the Fed has been predicting inflation to moderate for some time now but no one on Wall Street really believes them.

Finally if you look closely at the GLD chart, you can see that the short term uptrend has been broken. For the first time since Gold broke out last year, it has fell through its 10-week moving average and it has done so on high volume in the last week. This surely is another sign of weakness.

Gold might still be in a long term bull market, but for all the reasons mentioned above, it is now due for a correction in the short term.

Since the financial crisis started last Fall, the primary concern of the FED was to avoid a complete collapse of the banking system. By creating new ways of providing liquidity through Term Auction Facilities (TAF), together with reducing rates, they surely prevented that from happening so far. However they also pumped hundereds of billions of dollars into our economy (in addition to the government stimulus plan).

So who will benefit the most from this liquidity?

It is the financial services companies themselves who will be the biggest winners from this. The Fed has opened the door not only to commercial banks but also to investment banks who would like to borrow money and get these mortgage backed securities off their balance sheet. This is a tremendous amount of money that will be funneled to the Financial institutions before making its way to the other sectors of the economy.
What we have seen previously, when the Fed adds liquidity to the system, it usually takes about 6 to 12 months for its impact to surface in the corporate earning reports. So basically, we might just be seeing the bottom for a lot of the financial institutions at this moment.

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After the fed announcement today, Gold (GLD) is falling sharply by almost 3%. Is this the start signal for a major correction in the metal commodities? If that’s the case then the next ones to follow would be the Euro (FXE) and Oil. The coming days will tell for sure but this would be positive for equities.

The dollar has been weaker against all major currencies lately and the Euro has been making record highs every day. If you look at the FXE chart, it looks like the Euro might be reaching a climax top where the curve on the upside keeps getting steeper and steeper until the momentum finally stops and reverses back. At that point, the downside will be as steep as the upside. Of course, it is really hard to tell when it will break, but it is a good idea to stop betting against the dollar at this time.

Soaring oil and gold prices are now at all time highs even though the U.S and world economies are definitely slowing down, at least in the short term. Speculation about inflation and the losing dollar is obviously what is driving prices higher. In that environment, it is becoming almost impossible for stocks and equities to make any meaningful comeback. Even energy related stocks are not following the oil prices higher. So when will the Oil and Gold bubble pop? when the ECB starts slashing interest rates? A government intervention to save the USD? nobody really knows. However, when it does, we might finally see the relief in stock prices that we’re all looking for.

The primary concern of the FED at this point is to avoid a complete collapse of the banking system. With their new way of providing liquidity (TAF), together with reducing rates, they surely prevented that from happening so far. Also keep in mind that when the Fed adds liquidity to the system in terms of either rate cuts, or the TAF initiative, it usually takes about 6 to 12 months for its impact to start showing at the economy level. So basically, we might not see any improvement in the numbers until this fall.
The Fed actions won’t resolve all the problems, like the collapsing house prices, but they definitely help in some ways.