Saturday, September 01, 2007

Technical Strength and Weakness: A Look at the Stock Market's Foundation

A number of commentators have been noting a head-and-shoulders bottom in the S&P 500 Index (SPY). Indeed, when we look at my basket of 40 S&P 500 stocks evenly drawn from eight market sectors, the new high/new low and advance/decline data are supportive of that notion. New 10-day highs continue to exceed new lows (top chart) among the basket stocks (though, interestingly, Friday did not see an expansion of new highs; something I'll be watching), and we are seeing nice strength in the basket AD Line (bottom chart).

The momentum data are supportive as well. Yesterday, I introduced a measure of Technical Strength and noted that, within the basket, we had 13 stocks qualify as technically strong, 18 as neutral, and 9 as weak. The Technical Strength Index (TSI) closed at +160. On Friday, that changed to 22 stocks strong, 13 neutral, and 5 weak, for a TSI of +920.

The one thing I don't like is that two of the nine weak stocks in my basket are C and JPM. One would think that, if we were out of the credit/liquidity crunch woods, the investment banks would be one of the great beneficiaries. Conversely, if the worst of mortgage defaults are yet to come, someone, somewhere is holding a lot of questionable paper. Among other stocks not making 10-day new highs with the broad market: GS, LEH, BSC, MER, DB, and CS.

And that's the other thing: the Fed chief seems determined to not cut rates unless it's absolutely necessary. Apparently the recent downdraft in the market has not been enough to trigger such a decision. Yet the markets are clearly expecting cuts in the not-distant future. Either the markets are wrong in their anticipation, or they're expecting that bad news is about to get worse.

So, no question, we're seeing recent signs of strength. But the market pays me to look at what's not obvious. When we're seeing record put/call ratios, huge excesses of new lows over new highs, and panic selling on expanded volume, I question whether we're really going to hell in a handbasket and start identifying yield plays that look attractive. Conversely, when we're seeing broad near-term strength and hear about head-and-shoulders bottoms, I look at weak bank stocks and expectations for Fed cuts and wonder if we're putting in a head-and-shoulders *top* in that AD Line.

I'm happy for now to stand on a pretty strong foundation. Short-term, I'll participate in expanding strength or weakness. But I'm always looking for cracks in that foundation. Those often provide the greatest payoffs.


A Listing of Stocks in My Basket, Along With Their Sectors

Breakdown of Technical Strength by Sector