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The title of our update last weekend was Market Update: Indicators Flashing 'Risk Off' But The Real Test Is Next Week. Following the S&P 500's (NYSEARCA:SPY) decline through its 200 day moving average, we wanted to see if there would be follow-though action to confirm the downward move. The market was indecisive on Monday and Tuesday, before staging a big rally on Wednesday and ending the week flopping around on Thursday and Friday. At the same time, many of the "Risk Off" indicators that we analyze on a weekly basis seem to be in retreat, which is a good sign for the bulls. Last week's market activity seemed to us more bullish than bearish, but we are still cautious.

We begin this update with a review of the recent market activity. Then we will review our weekly "Risk On / Risk Off" indicators, which give us a better understanding of the macro environment. Finally, we will discuss the bull and bear cases for the market going forward and our investment plan.

S&P 500 Holding The Line

The S&P 500 has gone through several phases over the last two years, as depicted in the chart below. The summer 2010 rally peaked in early 2011 leading to sideways action until a major decline in August, following the downgrade of the US credit rating. The market then bottomed followed by a few months of sideways action before embarking on another rally in Q4 2011 and Q1 2012. Right before Q1 2012 earnings season the market peaked again and declined to its 200 day moving average last week. At the end of the week, the 200 day moving average was approximately 1,288 and the S&P 500 bounced off that level to close at 1,326.

(click to enlarge all images)

(Source for charts, unless otherwise noted: FreeStockCharts.com)

The 10% decline from the April highs does not seem as severe as the sharp fall in August 2011. Last week's action to hold the line at the 200 day moving average may mark a turning point. The bounce off the 200 day moving average was constructive, but we would like to see a more steady rise before becoming more bullish on the market.

The hourly chart of the S&P 500 over the last month shows a lot of sideways price movements in the 1,295 to 1,335 range, with a quick dip to test, and bounce off of, the 200 day moving average. The close on Friday at 1,326 was near the top of the range.

Additionally, on Friday the S&P 500 managed to close above its 20-day moving average, which is an indicator of short term momentum. The following chart of the S&P 500 year-to-date shows the price levels relative to the 20 day moving average.

After testing the 200 day moving average and closing above the 20 day moving average, we would view an upside move above 1,335 as bullish for the market. However, if the market fails to break out of the range, it may fall back to the 200 day moving average and may face further downside pressure.

The moves in the other major indices, including the Dow Jones (NYSEARCA:DIA), Nasdaq (NASDAQ:QQQ) and Russell 2000 (NYSEARCA:IWM), were similar to the moves in the S&P 500.

Review of Key "Risk On / Risk Off" Indicators

The EU, China and the Federal Reserve are the main sources of macro news that is influencing the market. Last week, each one came out with important statements and policies.

The situation in Spain has been deteriorating to the point where intervention from its EU partners is necessary. Spain's banks are continuing to face problems and require bailouts from the government. At the same time, Spain's borrowing costs are high, indicating investor caution about lending to Spain. There is widespread expectation that the EU will come up with an aid package for Spain and its banking system. In an important step, it has just been announced that Spain is turning to the EU for a bailout. This may be an important step toward a resolution to the crisis.

Also, comments from German and EU officials seemed to indicate that Europe may be moving closer to issuing joint bonds or creating some other shared mechanism for issuing debt. Such solutions may help Spain and other troubled countries to raise capital in the debt markets at more reasonable rates. These announcements were greeted by the market with optimism as European countries may work together to try and solve the current crisis, or at least come up with a bandage that would kick the can down the road.

While European officials were working on solving their problems, China cut its interest rates to try and boost its economy after recent fears that growth may be slower than previously expected. The market also reacted positively to this news. We believe that the market had already priced in slower than expected Chinese growth, so this move was a positive for the market.

Finally, there was a lot of speculation about the future policy actions by the Federal Reserve. The Fed's previous program to reduce long term interest rates, Operation Twist, is set to expire at the end of the month. With the recent employment numbers indicating a slower pace of job growth, the Fed is coming under more pressure to launch another program to support the economy. However, Ben Bernanke did not give away his plans, if any, in Congressional testimony this week. With interest rates already at historic lows it seems harder for the Fed to come up with a program that could have a meaningful impact. Nonetheless, the market wants some action from the Fed since previous Fed moves have been catalysts for rallies.

Interest rates are the key "Risk On / Risk Off" indicators of the moment. Although rates are at extreme levels (low in the US and Germany and high in Spain and Italy), they have come off their recent lows/highs, which is an encouraging sign.

The US 10 year bond yield closed the week at 1.64%, but bounced off of its lows earlier in the week. US Treasuries have been perceived as a safe haven during global market turbulence. Investors have been moving money into Treasuries, which pushes the price up and the yield down. The move last week may indicate that the Risk Off trade could be in retreat for the moment.

(Source: Bloomberg.com)

The ongoing decline in US Treasury yields, and rise in bond prices, can be captured in the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT), which has been rallying. However, as Treasury yields rebounded last week and bond prices declined, the TLT came off its highs. In fact it retreated to the previous high level reached last October.

Another indication of a retreat in "Risk Off" sentiment could be that the high yield market gained last week. The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG), a proxy for high yield bonds, bounced off of its recent lows. However, the high yield market has not yet returned to healthy levels, as reported in Bloomberg (Bernanke Anxieties Embodied As Bond Sales Tumble: Credit Markets).

European bond yields show a similar pattern. German bonds are near record low yields as Germany is perceived as a relative safe haven. On the flip side, Spanish and Italian yields are at much higher levels, though they received some relief on speculation that the EU would aid Spain.

(Source: Bloomberg.com)

The Euro has been on a steady decline since it peaked in May 2011. Investors have been selling the Euro, and European assets, as the crisis in Greece and Spain has played out, which has driven down the Euro relative to the US Dollar. The Euro bounced off of its recent lows, indicating a retreat in the Risk Off trade, but many investors and commentators expect further declines as the EU will need to aid its weakest members.

The crisis in Europe has been weighing on the US financial sector, which was dealt more bad news. The Federal Reserve proposed to increase the capital reserve requirements for banks. However, the Financial Select Sector SPDR ETF (NYSEARCA:XLF) bounced off of its lows and closed above its 200 day moving average.

If the rebound in the overall market and the financial sector continues, we may be interested in going long some of the banks. Interestingly, Citigroup (NYSE:C) and JPMorgan (NYSE:JPM) are near their 2011 lows. The banks are an important indicator for general market moves and were among the leaders of the Q4/Q1 rally. The market will likely need the banks to turn around before it can launch another multi-month rally.

Commodities also moved up last week, but they remain at very low levels. A slowdown in China would likely lead to lower levels for commodities since China has been a significant consumer of commodities over the last few years. However, if the Chinese government can boost growth then commodities could rebound. The Thomson Reuters/Jefferies In-The-Ground CRB Global Commodity Equity Index (NYSEARCA:CRBQ) is a proxy for commodity prices.

WTI Cushing oil closed the week at $84.10 per barrel. Although it moved up last week, it has experienced a sharp decline since early May. Brent oil has also been declining and closed the week at $99.64 per barrel, below the psychologically important $100 level.

An encouraging sign for the "Risk Off" retreat was the decline in the CBOE Volatility Index (VIX), which is often referred to as the fear index. The VIX closed the week at 21.23. Although this level is still slightly elevated it is far below the panic levels of the mid-40s that it reached during the major decline last summer.

Last week we mentioned that Apple (NASDAQ:AAPL) seemed to be diverging from the lows of the overall market. Apple was a key leader in the Q4/Q1 rally and is the largest component in the S&P 500, so its price action has significance for the overall market. Apple moved up again this week to close at $580.32 per share. It is now approximately half way between its high at $644 per share and its recent low at $522 per share. It will be interesting to see if Apple makes another move toward its highs and eventually breaks out to the upside, or continues to trade in this range.

Wal-Mart (NYSE:WMT) has been making impressive multi-year highs recently. The monthly chart of Wal-Mart shows its range going back to 1999. On Friday, Wal-Mart closed at $68.22 per share, near its all time high of $70.25. If Wal-Mart makes reaches new highs, investors may bid up other large cap stocks that have been stuck in multi-year multiple contractions and now have relatively low PE multiples and high dividend yields.

Finally, key dates to consider going forward are the Greek elections on June 17, the Fed Meeting on June 19-20, the EU Summit on June 28-29.

The Bull Case

Last week we said that the bears seemed to have the short term momentum, but the recent market action seems to now favor the bulls. The market held the line at the 200 day moving average and closed above the 20 day moving average.

Now that Spain has asked the EU for a bailout, maybe Europe will move toward a resolution of the crisis. Last week, speculation about a bailout encouraged the bulls and pushed the Risk Off indicators into retreat. Additionally, the interest rate cut by China may indicate that the Chinese government will act aggressively to boost growth, which could have positive repercussions around the globe. It is still unclear how the Fed will react at its upcoming meeting. However, the market may react positively if it launches another quantitative easing program like make are hoping for.

Finally, with all of the negative sentiment over the past couple of months, the market may be set up for positive surprises in the Q2 earnings season, which starts in early July. The last earnings season marked an end of the Q4/Q1 rally and since then we have only had bad news. But many corporations are still in good shape and if they can beat expectations, which may be reduced by then, the market could have another reason to rally. Last week, there was a lot of talk about the S&P 500 falling to record low PE levels. We think that many corporations are trading at low valuations, which could be another catalyst for moves to the upside.

The Bear Case

It is unclear how the market will react next week to the news about the Spain's request for a bailout. We want to see if the recent rally on expectations for such a move can be sustained, or if this is another case of "buy on the rumor, sell on the news."

Although the market held above the 200 day moving average last week, it will need to take out more key levels on the upside. If the S&P 500 cannot clear the 1,335 level, it may fall back for a test of the 200 day moving average.

While the EU and China seem to be acting to support their economies, it is unclear how the Fed will act at its next meeting. If the Fed does nothing, as it seemed to indicate recently, investors may be disappointed and the market may fall.

Furthermore, the US faces a turbulent second half with the US election and the Fiscal Cliff. It is unclear how the market will react to the campaign season and the eventual winner. Furthermore, the Fiscal Cliff has the potential to move markets down if it is not addressed.

Investment Plan

We entered the week having increased our short positions and cash balance. At the beginning of last week we initiated some additional small short positions, but covered most of these positions as the market rallied on Wednesday. On Friday, we reversed course and initiated a couple of long positions. All of our action last week, both on the short side and the long side, has been in rather small position sizes as we remain cautious.

We slightly favor the bull case going into next week. If the market continues to move up and confirm its bounce off the 200 day moving average we will likely increase our long positions. We will continue with small position sizing until we get more confidence in the market's direction.

Disclosure: I am long WMT.

Additional disclosure: We have a position in WMT and the ProShares Short Dow 30 ETF (NYSEARCA:DOG). We may trade these positions or the stocks/ETFs mentioned in the article in the next 72 hours.

Source: Market Update: 'Risk Off' Indicators Retreating; S&P 500 Holding The Line