 The ETF Authority for Monday, August 4th, 2003 Volume 2, Issue #31 Published weekly on Sunday evening, The ETF Authority is a short-term trading newsletter that can help you profit from some of the most heavily-traded securities on the market -- exchange-traded funds (ETFs). *Please
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newsletter each week for maximum benefit... (1.) MARKET SUMMARY WHAT HAPPENED? I THOUGHT
STRONG ECONOMIC DATA WAS A GOOD THING FOR STOCKS? All this good news was not able to even get stocks back to their mid-July peak, as investors appear to have taken a "buy on the rumor, sell on the news" attitude. This concerns me. What makes all this worse is that bullishness among newsletter writers and analysts remains at very high levels. And, this time, when stocks do turn lower (again, I'd like to emphasize the word "when" -- not "if"), very few sectors will be relatively cheap (see our "ETF Spotlight" section below). This is in sharp contrast to the March 2000 market peak, when value shares were relatively cheap and managed to outperform the overall market in the subsequent months/years. There is no doubt in my mind that the economy has picked up a bit recently. However, as evidenced by the disappointing payroll report on Friday, things are not exactly booming either. I suspect that as third-quarter economic data begins to roll in, the small pickup in momentum we've seen recently will disappear. When it does, the stock market will move sharply lower. THE GREAT BOND BEAR I am less sure that the spike in rates will truly harm the economy all that much, as interest rates are not high on a historic basis. However, the sharp flattening of the yield curve that we saw at the end of the week tells me that the expectation for recovery is not as strong as some people think it is. Our bulled-up friends in the financial media are going to have a case or two of egg on their face before this is all over. The Fed is not going to raise rates anytime soon, and I still see greater probability for the next Fed move being a rate cut than an increase. Of course, this is at least partially based on my big-picture forecast for a test (and more likely achievement) of new lows in the S&P 500 in the year ahead, with at least a 10-20% risk of a crash starting in the next 2-3 months. THE TOUTLOOK (TECHNICAL OUTLOOK) Some technical factors are taking it on the chin. However, all I can say is that we are in a trading range. A move below about 962 on the S&P would be damaging, but I really think prices need to dump beneath 950 or so to do major and irreparable damage to the overall market. I believe the market will regain its legs early this coming week for wave-d (Elliott Wave Theory) of a still-valid bullish triangle pattern. If the market fails to rally, however, then it will mean the triangle pattern has broken. At that point, a retest back to the 960s on the S&P will likely be upon us. Moving on to fixed-income markets, bonds are hugely oversold and may have bottomed. The recovery on Friday was pretty solid, and if prices manage to rally on Monday, then I'd feel pretty comfortable buying bonds on any dips, even if the stock market can rally some. Equities are still mired in a tight trading range, and the bond market is so oversold that I doubt range trading in equities will hurt the debt market anymore. THE BOTTOM LINE
http://www.StreetAuthority.com/subscribe-etf.htm Below you'll find a table of weekly performance data for all ETFs that I track for this newsletter...
(3.) ETF RELATIVE STRENGTH MONITOR (Note: If you're a first-time reader or you are otherwise unfamiliar with our proprietary ETF Relative Strength Monitor, then please click here for a brief description.) It was an ugly week in ETF land. Only the Oil Service HOLDR (OIH, $56.16, +0.4%) and Semiconductor HOLDR (SMH, $32.75, +1.3%) managed to finish in the plus column. These returns allowed SMH to hold onto the top spot in our relative strength rankings for the second consecutive week. Its +12.0% gain over the past four weeks is more than double that of any other fund we track. It has also gained +20.2% over the past 13 weeks; only the Biotech HOLDR (BBH, $132.56) has done better, with a +26.9% gain in that same time span. When a fund jumps nine places in the rankings despite falling -0.3% in value, as the S&P 400 Midcap SPDRs (MDY, $90.13) did last week, you know it wasn't a good week to be long. Even scarier was the five-place ranking jump in the Retail HOLDR (RTH, $82.90) despite a loss of -1.2% on the week. We are definitely losing momentum here. Eight of 19 equity-linked funds have now fallen over the past four weeks. I cannot remember the last time that statistic was so high. Biotech and smallcap stocks are still outperforming, in general, though tech (outside of semiconductors) is edging lower in the rankings. These are signs of an end game for this bull market, so I'd urge you to be cautious with your holdings. Here is this week's ETF Relative Strength Monitor...
Summary: (began trading on May 19, 2003) In a week that saw 21 of 23 ETFs lose ground, the Japan WEBS (EWJ, $7.51) -- which we've shorted in our Model ETF Portfolio -- was the biggest non-bond market loser, declining –3.5%. Only the Lehman Brothers 20+ year Treasury iShares (TLT, $82.51), which fell -3.6%, did worse. Adding to our strong outperformance was our long position in the Semiconductor HOLDR (SMH, $32.75), which gained +1.3%. This ranked SMH as the top-performing ETF last week, as it was one of only two funds to show a gain. I am happy with our current portfolio make-up, which has one short and a substantial cash holding, as I do not expect the market to break out either higher or lower just yet. If stocks rally next week, then I will likely take on 100 shares of the Software HOLDR (SWH, $31.96) and will cut loose my EWJ short position. If prices break down, however, then I will likely jettison my SMH longs. For now though, I see no reason to change the make-up of the portfolio. This week's instructions are:
MODEL ETF PORTFOLIO
BUY 100 SHARES SOFTWARE HOLDR (SWH, $31.96) ON A PULLBACK TO $31.75 Please note that this is not the exact same recommendation that I have provided in our Model ETF Portfolio above, where I recommended buying SWH if Microsoft breaks higher as well. This is because I typically hold Model ETF Portfolio positions for longer periods of time. Meanwhile, a failure at resistance for a "Trade of the Week" would usually have me exit more quickly. SWH did not fall far enough to get us into this trade last week, so I've decided to continue with this same recommendation this week. On the plus side, SWH outperformed the overall market last week, which is a good sign. I see risk for a drop to as low as $31.49, but losses could halt even at $31.74. At the moment, my only concern is that SWH was neither able to hold above its 20-day moving average, nor to stick with RSI north of 50.
Our reasons for buying SWH are as follows:
******************************************** BUY 100 SHARES SWH ON A DIP TO $31.75 TARGET: $33.98 Assuming a purchase at $31.75 and
sale at $33.98, you will make $223 from this trade, or +7.0%. (6.) CONTINUED GUIDANCE ON PREVIOUS TRADES SHORT 500 SHARES JAPAN iSHARES MSCI WEBS (EWJ, $7.51) AT $7.98 EWJ is moving mostly sideways at the moment. A weakening dollar could harm this position. However, for the moment, the trend is sideways to down, and the risk in the U.S. market is for lower prices as well. For that reason, I am going to maintain our short trade and will keep our stop-loss at $7.89. On the other hand, if the dollar continues to slide and if U.S. equities catch a bid on Monday, then I might decide to close this position early. If I do, then I'll be sure to let you know via a special News Flash.
RECOMMENDATION: Assuming we close the trade at our $7.16 target, we will make $420 on this short position, or +10.3%. If EWJ hits our stop, then we will still post a small profit of $45, or +1.1%. ---------------------------- LONG 100 SHARES SEMICONDUCTOR HOLDR (SMH, $32.75) AT $31.55 I am a bit concerned that SMH could be running out of steam. Although my stops remain at $30.40, any sign of a run back to that level will likely have me take profits ahead of time (again, I will send out a special News Flash if I make any changes to this trade.). The overall market is still stuck in a trading range, but if equities break lower on Monday, then SMH will likely fall as well. I still expect this fund to move past $34.00, but I'd rather buy it back at lower prices if equities slide again this week.
RECOMMENDATION: ---------------------------- BUY 100 SHARES SOFTWARE HOLDR (SWH, $31.96) AT $31.75 I have maintained this recommendation as my "Trade of the Week." Please see article #5 above for further details. (7.) ETF SPOTLIGHT -- S&P 400 MIDCAP SPDR (MDY, $90.13) Much like its bigger cousin -- the S&P 500 -- the S&P 400 is a capitalization-weighted index. However, unlike the S&P 500, which is designed to track a group of the largest companies in America, the S&P 400 is meant to track the fortunes of mid-sized companies. The average market capitalization of a stock in the index is just about $2 billion, and its largest component, Gilead Sciences (GILD, $64.55), boasts a market cap of about $13 billion. That is actually quite large. For example, Gilead's market cap is nearly double that of Lucent (LU, $1.84), which before the dot-com collapse was one of the highest capitalization stocks around. Lucent, however, is not in the midcap index. So, as you can see, the S&P 400 is not a perfect representation of mid-sized issues. Gilead is quite large (as is Lucent, for that matter), and the index also includes a number of fairly small firms with market caps below $200 million. The nice thing about the S&P 400 and the S&P 400 Mid-Cap SPDR (MDY) is that midcap stocks are not strongly correlated with other major indices. Obviously, if the overall market falls substantially, then MDY will tumble as well. However, it's worth noting that MDY has closed in the opposite direction of the S&P 500 in nearly 40% of all trading days since the start of 2002. In addition, the correlation between MDY and several other major indices (both largecap and smallcap) was not higher than 60% over that time period. What this means is that MDY can provide your portfolio with a good deal of diversification. It also means that you can analyze this index from technical and fundamental perspective while keeping only one eye on the broad market (as opposed to both eyes). In case the above discussion is a bit too esoteric for you, let's take a look at an example: MDY made a new high above its 2000 peak (albeit by less than a dollar) in April 2002. The fund has currently fallen just -10% from that all-time high. Meanwhile, the S&P 500 has not yet even approached its March 2000 all-time high, and is still down -35% from that level. So, as you can see, MDY does not necessarily move in tandem with the overall market. On the valuation front, note that the average PE ratio (including money-losing companies) for an MDY component stock is a fairly lofty 30.1 right now (in 2000, the fund's PE was in the mid-20s). That is not quite as high as what we saw at the 2002 peak, but it is approaching levels near which the index has peaked in the past. Because of this relatively high valuation, you cannot completely ignore the broader market when analyzing MDY right now. After all, with MDY extended on a fundamental basis, my thinking is that it will not be able to overcome a downdraft in the overall equity market. In the medium-term, I believe MDY will move in pretty much the same direction as the overall market. But, with technology comprising only about 15% of the fund, it is likely to be somewhat less volatile than the Nasdaq (or even the S&P 500, for that matter). So, if the market starts to move quickly, then you might actually be able to buy or sell MDY more easily without having to chase it higher or lower, which would likely be the case for SPY, which tracks the S&P 500, or QQQ, which tracks the Nasdaq 100. Having said that, of course, please note that with average daily turnover of only around 600,000 shares, MDY is not nearly as liquid as other major ETFs. Therefore, the bid/ask spread for this security is often fairly wide (it also means that some brokers may not have it available to short, so check first). If you are trading anything larger than a few hundred shares, then you are probably better off routing the trade to the American Stock Exchange and putting in a limit price order between the bid and the ask and making it "fill-or-kill" (FOK). "Fill or kill" means that the specialist must either agree to trade at your price immediately or cancel the trade. The reason for avoiding direct access routing in MDY, and other less liquid ETFs, is that if bids or offers are pulled, then the electronic trading systems will keep seeking prices further a field from where your original market order stood. This puts your order at risk for enormous slippage. (Slippage takes place when the amount you actually end up paying differs greatly from your estimated transaction costs.)
Much like the rest of the stock market, MDY has put in a stellar performance this year, rallying more than +30% from its mid-March low. This does not compare to the Technology and Biotech sectors, which have been trading on smoke and mirrors again recently. However, it is still rather impressive. Unfortunately, although MDY can and often does trade somewhat independently of the broader market, I fear that it will still fall substantially once it peaks in the next couple of months. In fact, there is a small chance that the mid-July high was "the" peak of this move. Even if we do make a new top, it is not likely to be anything major (MDY almost certainly won't take out its 2002 peak at $101.67). The fund is facing substantial ahead from both the blue resistance line and the old up trendline (green), which has now been broken.
With these factors in mind, I would not initiate any major long positions in MDY just yet. With another leg higher still due in the broad market, there are better places to hold longs. The Technology sector and Biotechs still appear to be better places to buy on any market dips. If you must hold long positions anywhere in the equity market, then when the market tumbles, this would be the place (however, I'd rather hold outright shorts in weaker funds). On the other hand, spread trades in this security -- for example, you could go long MDY and short SPY -- should be profitable in the months ahead, as MDY's losses will probably be closer to -20% as compared with -30% in SPY and more in QQQ. GAPS -- PART II In last week's issue I introduced you to the subject of gaps. However, I only got about halfway through my analysis. So, as promised, here is Part #2. If you haven't done so already, I strongly recommend you review last week's Educational Bonus. GAPS ARE NOT ALWAYS FILLED "Company XYZ's stock gapped higher today. Our recommendation is to look for the stock to fill its gap (since gaps are always filled) and buy at that time." Come on, raise your hands! You must have seen this little bit of market lore before. (In case you don't know, when a stock "fills a gap," it merely means that prices trade back to where the gap began. For example, if IBM gaps lower from $85 to $82 and then moves back to $85 or higher, the gap is considered to be "filled.") If you recall, I wrote about two types of gaps last week -- "common" gaps and "measuring" gaps. Common gaps are typically filled, as they are not caused by exceptional changes in the market or its underlying supply/demand dynamic. (Although many other gaps will eventually get filled, it's worth noting that they might not get filled within the current trend cycle. For example, if a stock gaps from $10 to $12 and you are waiting for the gap to fill, and it only does so after reaching $35 first, then the fact that it got filled might technically be true, but it has no meaning with regard to the importance of that original gap.) The two types of gaps that are typically filled fairly quickly (within the same trend cycle) are "common" gaps and "exhaustion" gaps (I will cover the latter topic below). "Measuring" gaps and "breakaway" gaps (I'll analyze breakaway gaps later in this lesson) typically do not get filled until after the current trend reverses, and might not ever get filled (such as the multitude of downward gaps that occurred as our friends at Enron got carted off to jail). EXHAUSTION GAPS -- THE LAST
HURRAH What often happens in this type of scenario? Well, more often than not, you're not alone in your desire to purchase the shares. The market gaps open higher and rallies further, maybe just for that day, and maybe even for a few days or even weeks. Volume is probably very high, but maybe not quite as high as during prior moves higher. In addition, there's a pretty decent chance that the shares have some momentum (RSI, Stochastics, MACD) divergences going. This is a classic example of an "exhaustion" gap.
Exhaustion gaps come at the end of a trend. Somehow, the crowd seems to give in at the same time and a stock, bond, currency or commodity creates a final up or down gap before reversing course. It's kind of like watching Lance Armstrong surge past the field in the Tour de France and go on to victory. (The only difference being that Armstrong keeps going until the race is over, while exhaustion gaps are generally followed by a reversal or consolidation.) Sometimes the market reverses within a day or two. By definition, exhaustion gaps are typically filled very quickly. Note the chart above, where I've provided you with an example of an exhaustion gap in the Nasdaq-100 Trust (QQQ). See where prices gapped higher amidst a momentum divergence (I've circled the gap in early July on the chart)? Volume was strong, but not as high as during the late-May high. Furthermore, the chart shows a momentum divergence. This does not necessarily mean that QQQ has topped, but it does mean that the trend in force at the time has ended. QQQ has now entered into a period of consolidation. BREAKAWAY GAPS -- TELL ME
SOMETHING NEW
In the historical chart for Sapient (SAPE, $3.41) shown above, note the two distinct breakaway gaps (again, I've placed a circle around each gap). The first one was filled quickly, but the later one, on a trendline break, still has not been filled. Given that Sapient is now about 95% beneath its all-time high, it is fairly unlikely that SAPE will ever fill that gap again. ISLAND REVERSALS -- SHARK
INFESTED WATERS?
The correct answer is that NOT A SINGLE ONE of the above statements is strictly true! There can be several days between the exhaustion and breakaway gaps. This is one of the more hysterical bits of silliness I've seen on the Internet, as some sites say that one day is not enough, while others swear that an island reversal has not occurred if more than one day passes between the gaps. Amazingly, you can't believe everything you read!
Number four above is a more matter of figuring out which is a better signal. While the two gaps need not have prices in common, an island reversal is considered to be a better signal if the two have some gap area in common. Finally, while most island reversals do meet the requirement noted in choice 5 (exhaustion not filled first), not all do. In the chart of the iShares Lehman 20+ Year Treasury Bond Fund (TLT, $82.51) shown above, the pattern does qualify as an island reversal even though the exhaustion gap got filled before the breakaway gap took place. PUTTING IT ALL TOGETHER --
TRADING GAPS Common gaps:
Measuring gaps:
Exhaustion gap:
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