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Technical Cross Roads

May 20, 2009 10:55 AM ET
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Nobody wants to argue with the market - at least, not if they can help it. But how do you avoid doing that when you don't have any idea what the market is TRYING to say in the first place? The market speaks with a mouth full of marbles, in obscure languages and after having had too many drinks. Then there's a second problem: assuming you correctly translate the market's incoherent ramblings, how do you figure out WHY it's saying what it's saying?
As to the first problem, I believe that most of the time, technical analysis is a very useful tool to figure out what traders are actually doing, and since these are the guys who set prices, they're basically the market's vocal cords. Technical analysis is descriptive, rather than predictive, so once you decipher the technical signs, that brings you to the next phase of the analysis, which is figuring out what fundamental conditions the market may be reacting to. Do that, and then you can make a somewhat more informed guess about whether these fundamental conditions are likely to persist, and, if so, whether the market's reaction to them is likelier to continue or fade. At least until the unexpectable arrives un-announced, as it inevitably must and will.
What technical signs have shaped up that are worth paying attention to at this moment? I suggest the following several. First, I have been watching the Proshares UltraShort Financ... ETF (SKF) with glee. I watch this because fundamentally, the bear market of 2007, 2008 and 2009 is caused by an imbalance in the debt markets (ie., the issuance of too much low quality debt that was inaccurately priced) that lead to a collapse of the global financial system. The system came close to collapsing in 2008, but didn't. Here’s the takeaway: that which does not kill you will make you stronger. Accordingly, because the financial system did not collapse, it will only become stronger. Banks will prosper. And as to that "debt bubble" you hear so much about? Look, the problem wasn't too much debt. The overall quantity of debt is irrelevant. The problem with any bubble is all about incorrect pricing. Credit risk was underpriced in 2007. When stuff is incorrectly priced, all hell breaks loose. And the guys that own the debt get hosed. We saw that with the collapse of the global banking giants like Citigroup.
Back to SKF. It is tanking. The 50 day EMA dropped below the 200 day EMA in a stellar way back in April, and this means that SKF is in a massive bear market. Bear markets tend to last a while, so technically speaking, SKF is likely to go lower still. This bodes rather well for banks and financial institutions. Indeed, we see now that Financials Select Sector SPDR (XLF) bounced off $6 a share and is now 100% higher at $12.32 a share today. It's about to pop above the 200 day EMA as well, and if so, it will enter into a technical bull market. Goldman Sachs (GS) - fifty day EMA just crossed above the 200 day EMA - technically, this company is in bull market zone already. Goldman is a leader, and where it goes, other financial firms often follow.
So, if the financials are technically poised in fresh new bull markets, what does that say about the financial crisis? It says it's over, and the players are getting stronger. And the underlying debt bubble? Well, it is hard to say credit risk is underpriced in the debt markets when you've got credit default swap spreads way up in the stratosphere. I really have no idea, but when it comes to bank stocks, it seems like the market is saying the price of credit risk is appropriate now, so the owners of these credit-linked assets are likelier to make, rather than lose, money. And if the debt bubble and ensuing financial crisis drove the market down, then the removal of these causes should drive the market up - unless something new happens which, eventually, is certain to happen.
I watch the Chicago Volatility Index (VIX). After hitting an historic high last year, the sucker has dropped. Quite a bit, in fact. So much so that the 50 day EMA is lower than the 200 day EMA now. Long options on the VIX, and VIX-linked exchange traded funds, are now firmly in bear market territory, and, trends being things that last a while most of the time, the VIX seems poised to drop further still. When the VIX is low, equities are usually going up because bull markets are less volatile than bear markets. If the VIX is now likelier than not to drop from a technical perspective, the way to interpret this message is that the market is expecting less volatility and, accordingly, may be expecting gains, a protracted flat period, or a slow, orderly grinding down period. At a minimum, the market is not expecting the wild crashes we saw last year.
I also like to follow ETFs with the highest Beta - stuff like emerging markets. Why? Small caps and emerging markets tend to be leading indicators for the broader markets. Ishares FTSE China 25 (FXI) - high above the 200 day EMA, 50 day EMA closing in on the 200 day. This security appears poised (almost, almost, almost) to enter a new technical bull market. Comparable technical postures now exist with IShares MSCI Emerging Markets (EEM), IShares Latin America 40 Index (ILF), Russell 200 Ishares (IWM), IShares MSCI Pacific Ex-Japan (EPP). We are not there yet. To really confirm a technical upward trend, you want to see that 50 day EMA go above the 200 day EMA with some conviction, some heavy volume. This has not yet come to pass, but we are close.
Close enough to conclude that we are now at a major inflection point. If these securities cannot confirm an upward trend, ick. You'll see a stunning collapse. Why? Because when the bulls take their best shot at the bears and miss? They look like sissies who cannot fight, and the playground bullies will just knock them flat. And if, on the other hand, FXI, EEM, EPP, ILF, IWM do break into technical upward trends, then it is likelier that they will go higher still, possibly bringing the broader markets along for the ride.
So what does this all add up to in terms of what the market is actually "saying"? It is saying "watch out". Inflection points are risky places to be. Risky places are also those places that offer the highest returns, so, for some of us, it is exactly the time to place bets. For the rest of us who would rather leave the first and last 20% on the table and take that easy 60% in the middle, this is time to get out and watch what happens next.
Disclosures: the author owns (XLF), (EEM), (IWM), (GS).

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