Turning Points

Includes: DIA, IUSV, IVV, QQQ, SPY
by: Financial Sense

By Thomas Smith

The market was strong last year. But, people do forget that there were some rough patches in 2013. From the beginning of last year through the third week of April, investors were reducing risk and the economic numbers were weaker than expected. Then, near the end of April and all through summer, risk-on was en vogue. During that time frame, there was a dramatic increase in the Leading Economic Indicators (LEIs).

For several consecutive months, economic releases were consistently ahead of expectations and the positive surprises led to strong moves higher in economically sensitive issues. That trend weakened from September and October prior to an aggressive move higher in the final two months of the year.

Will we see similar turning points this year? We have seen choppy trading so far. The market has been clearly more selective as fewer names are in technically sound condition. We have seen two sharp selloffs already in 2014. As I write, we are seeing another bounce in the market. The economic numbers and the technical condition of the market are sending conflicting signals.

Over the next few weeks these conflicts will likely be worked out. The economic numbers and the general direction of the market will be in sync. That can either be good or bad depending on the direction of the economic releases we see over the coming weeks and months.

Cold weather created an environment where the economic numbers were, for the most part, disappointing. The economic surprise index was trending lower as several numbers came in below expectations. As the weather has improved we have seen a pick-up in economic numbers. The surprise index has improved significantly over the past several weeks. The slowdown in emerging markets has led to a decrease in the prices paid component of economic releases for several months now. A prolonged period of lower prices paid in manufacturing numbers leads to positive surprises historically.

The Philadelphia Fed has beaten estimates for two consecutive months. The lower prices paid gave us an early warning that the Philly numbers could surprise to the upside. We focus on the Philly Fed because it has a long track record of pointing out economic troughs. Going back to the 1970s the Philly Fed has been early among the LEIs at spotting turning points. This measure is particularly sensitive to input costs so it has historically been first to detect macro changes in the U.S. economy. In April the number did not just come in above the consensus estimate, it came in above every estimate. With this turn and the lower prices paid component we could be setting up for a sustained series of positive economic surprises.

There was a fixation in the media a few weeks back with the sharp decrease in momentum oriented stocks. As Ralph Acampora says: "The first three letters of momentum are MOM, and MOM never lies." When momentum stocks are flying there are simply more buyers than sellers. When they tumble quickly the sellers simply outnumber buyers. There was an aggressive rotation out of the more speculative issues and capital flowed to more conservative areas of the market. This is not shocking when you consider how hard momentum stocks moved for several months. Consumer staples, industrials, old-line technology and utility stocks moved higher as investors reduced their risk exposure. Ralph Acampora also is famous for saying that rotation is the life blood of a strong market. There has been buying pressure in more value-oriented areas of the market over the past month or so.

In order for the next rotation to be toward more cyclically oriented areas of the market, we will need to see the other LEIs follow the lead of the Phlly Fed releases over the past few months.

The technical condition of the market improved dramatically last week. The sell-off in speculative areas of the market continued as the small cap averages tested their 200 day moving averages. When the Russell 2000 and Nasdaq held their respective long-term moving averages it was a sign that a short-term bottom had been put in. There was a tremendous amount of technical damage done to secondary issues as roughly half of them are in weak technical conditions. Weakness is concentrated in the more speculative growth-oriented areas of the small-cap universe. Large-cap stocks are in better shape technically, led by energy, industrial and healthcare stocks.

For the averages I follow, resistance levels for the S&P 500/Dow/ NASDAQ/Russell 2000 are 1900/16,635/4373/1214. Important support levels are 1798/15,940/3945/1094.