The Stock Market

1. A broad list of investor sentiment measures, through Friday, suggest that the current mid August rally in the US stock market is in its latter stages and is probably within 1-2 weeks from a near term top.  These measures include various surveys of retail investors, brokerage firms, and hedge fund managers, several different measures of stock market options activity, and the asset flows of a variety of US stock market-related Rydex funds.
    

2. Bullish chart patterns have emerged over the past several weeks in several US stock indexes.  These indexes, the type of pattern, the date the pattern was confirmed and the upside target are all listed below.  Also included are key near term support levels that, if broken, would negate these patterns' bullish implications.

   • S&P 500 (SPX): An inverse head and shoulders pattern confirmed on September 18th targets a rise to 1,620 and will remain valid above 1,439.

   • Dow Jones Industrial Avg. (DJ): An inverse head and shoulders pattern confirmed on September 14th targets a rise to 14,525 and will remain valid above 13,021.

   • NASDAQ 100 (NDX): An inverse head and shoulders pattern confirmed on August 30th targets a rise to 2,120 and will remain valid above 1,899.

   • Russell 2000 (RUT): A double bottom pattern confirmed on September 18th targets a rise to 856 and will remain valid above 759.
      

3. Overbought/Oversold Conditions:  The major US stock indexes through Friday remain technically overbought on a near term monthly basis (as they were a week ago), but are still only about half to three-quarters of the way to reaching overbought extremes on a longer-term quarterly basis.  These data suggest that the mid August rally still has a a little more room to extend its recent gains, but is probably within a few weeks of a near term top.
    

4. An emerging "Dow Theory Non-Confirmation" warns that a corrective decline may be on the near term horizon in the US stock market.  This non-confirmation appears to be taking place as the Dow Jones Industrial Average is on the verge of rising above its July high, but the Dow Jones Transportation Index is still hovering around its August lows.
    

5. The relative strength line of the NASDAQ 100 (NDX) versus the S&P 500 remains at a multi-year overbought extreme (first chart, below) that had previously preceded every period of near term relative underperformance by the NDX since 2004, and had led every coincident broad market decline during this period.  Accordingly, this suggests that the US stock market's near term upside may be limited without at least a corrective decline first.
    

6. The Russell 2000 (RUT) has been underperforming versus the broad market S&P 500 since mid April, and in early August established a fresh new extreme in relative underperformance.  Along with Technology stocks, Small Cap stocks (as represented by RUT) have led the 2002 uptrend in the US stock market.  Without continued leadership from Small Cap and Technology stocks, the sustainability of this broad market uptrend will be in question.
    

7. The Nikkei 225 Index:  A bearish double top pattern on this chart, confirmed back in mid August, continues to target an eventual decline to at least 1,465.  This would equate to a 12.6% decline from Friday's closing price of 1,677, and is important to the direction of the US stock market because of the Nikkei's 92% positive correlation to the S&P 500 since October 1998 (when Asian stocks bottomed).  Assuming that this pattern eventually meets its downside target, this also suggests that a significant, coincident decline is also on the horizon for the US stock market.

Last Week, we said; "...a broad variety of technical, behavioral and quantitative indicators suggest that the mid August rally in the US stock market is likely to continue into early Q4.  However, this rally appears likely to lead into an important near term market peak and a subsequent decline which could dominate the rest of the quarter.  Investor sentiment, market momentum, current overbought /oversold conditions and percentage retracements of the July decline (which were broken to the upside last week) all support the likelihood that the August rally will continue for the next several weeks.  However, a weakening NYSE advance/decline line, an unmet downside target in the Nikkei 225 Japanese stock index, and recent relative weakness in both Technology and Small Cap stocks all suggest that a significant broad market decline is likely sometime in Q4."

This Week, the composite message of our analysis is that that the US stock market still has a little more room to extend its recent gains, but that it is probably just a couple weeks or so away from setting a near term top and kicking off a near term decline that, based on previous market reaction to similar conditions, appears likely to dominate much of Q4.  On the plus side, both investor sentiment  and overbought/oversold measures have not yet reached multi-year extremes that have previously been associated with near term market tops, and there are still near term upside targets in the major US indexes that have yet to be met.  However, what looks like an emerging bearish "non-confirmation" according to Dow Theory, recent relative weakness in Small Cap stocks, what looks like imminent peak in relative outperformance in  Technology stocks, and an unmet downside target in the Nikkei 225 Japanese stock index all suggest that a significant decline is looming in Q4.

Market Sectors

1. The Energy Sector SPDR ETF (XLE) is re-testing a multi-year over-invested extreme, according to our Rydex Energy Ratio (lower panel of next chart, below), which had previously coincided with every significant near term top in the XLE (and every coincident peak in relative sector outperformance, not shown) since 2005.  At the same time, retail investors are at a multi-year bullish extreme in both the crude oil and heating oil contracts which, as a contrary indicator, have either coincided with or immediately preceded every near term peak in the price of these commodities since 2000.  Considering the close positive correlation between the XLE, the crude oil contract and the AMEX Oil Index ((XOI), these data suggest that if energy prices are not peaking now, they are likely to do so soon.  (The Rydex Energy Ratio is the total assets invested in the Rydex Energy plus Energy Services Funds divided by the total assets invested in all 18 Rydex sector funds.)
    

2. The Materials Sector SPDR ETF (XLB) is also at or quickly closing in on a near term top according to our Rydex Materials Ratio, which shows that investors in this sector are at a multi-year over-invested extreme.  (The Rydex Materials Ratio is the total assets invested in the Rydex Basic Materials plus Precious Metals Funds divided by the combined total assets invested in all Rydex sector funds.)  In the meantime, other investor sentiment measures through Friday show retail investors at a multi-year bullish extreme in gold, while commercial hedgers (according to the latest Commitments of Traders data through September 25th) are at an opposite most bearish extreme because they are apparently betting that gold is overpriced.  Combined, these measures indicate that basic materials and metals prices (the XLB and the price of the gold contract have been 72% positively correlated since 1998) are either peaking now, or are quickly closing in on a near term top.

Last week, we said: "...our expectations for relative outperformance from both the Consumer Discretionary Sector (which tends to lead during periods f broad market strength) and the Financial Sector (the largest sector of the S&P 500 based on market cap, which represents Wall Street) corroborates our larger view that the August rally in the US stock market is amid favorable conditions to continue into early Q4. "

This Week, our expectation for a near term peak in both energy and basic materials / precious metals prices suggest that the US financial markets are likely to get at least a temporary reprieve from recent market-based inflationary pressures in Q4.  However, recent major bullish breakouts in both gold and platinum, and what appears to be an emerging breakout in copper, suggests that the decline we're expecting will be corrective in nature and should eventually result in the resumption of these larger bullish trends, perhaps in late Q4 or in early 2008.

1. A number of different retail and professional investor sentiment measures, through Friday  indicate that, although last week's rally could continue for another week or so (due to a low call-to-put ratio in the T-Bond contract indicating investor fear), mid to long dated Treasury prices are in the process of setting at least a 6-10 week peak (based on previous market reaction to similar investor sentiment-related conditions).
    

2. The Bonds/Bunds Spread (the price of the Bund contract subtracted from the price of the T-Bond contract, next chart below) is at a multi-year wide extreme that has previously coincided with most of the important peaks in both contracts since 1993.   It indicates that US bonds are over-valued, relative to the Euro Bund, and suggests that the prices of both assets are poised for a near term decline.
    

3. Overbought/Oversold Conditions:  US Treasury prices across the yield curve are in the process of working off technically overbought conditions on both a (near term) monthly and (longer term) quarterly  basis.  This establishes a favorable environment for the recent decline in Treasury prices to continue into Q4.
    

4. Bond Market Momentum: Near term daily market momentum is still negative (bearish) in mid to long dated US Treasury contracts across the yield curve, but the early September decline would have to resume from at or near current levels in order for bearish momentum to remain intact.  As long as momentum remains negative, we will expect the September decline to continue. 
    

5. Key Retracement Levels:  The June rally in the T-Bond contract failed near 113-16, which is the 61.8% retracement of the contract's larger June 2005 to June 2007 decline.  According to retracement theory, as long as 113-16 resistance is not appreciably broken, the June rally can be considered just a countertrend correction within the larger 2005 decline.  In addition, the contract is now hovering at the 61.8% retracement of its August 8th to September 10th rally at 110-22, which should hold as underlying support if the September 10th decline was just a countertrend correction within that August rally.  Any further weakness from here, however, would suggest that the September 10th decline is directional (bearish) and should continue.
    

6. Large bullish chart patterns in most US Treasury-related contracts and indexes suggest that  the recent trend of rising prices and declining yields will continue, overall, into the end of this year and potentially into 2008.  These patterns and their initial upside targets are listed below.

   • CBOT 10-Year Note contract (TY): A large bullish double bottom pattern confirmed on August 30th targets a rise to 114-16.

   • CBOE 10-Year Note Index (TNX, representing yield): A large double top pattern confirmed last week targets a decline (meaning declining yields) to 35.63.

   • CBOT 5-Year Note contract (FV): A huge bullish double bottom pattern confirmed on August 30th targets a rise to 110-06.

   • CBOE 5-Year Note Index (FVX, representing yield): A large double top pattern confirmed on August 16th targets a decline (meaning declining yields) to 34.70.

   • CBOT 2-Year Note contract (TU): A huge bullish double bottom pattern confirmed at the end of last week targets a rise to 104-16.
      

7. European Government Bonds, specifically the Euro Bund and UK Long Gilt contracts, are still in the midst of secular downtrends that began in 2005.  Moreover, a huge bearish double top pattern in the gilt contract, confirmed in late May, continues to target an eventual decline to 96.00 ( which would equate to a huge 10% decline from Friday's closing price of 106.94).  Considering the US T-Bond contract's 91% positive correlation to the UK gilt contract, and its 97% positive correlation to the Euro bund contract (both since 1990), these conflicting trends between US and European government bonds suggest one of things is true: 1) either US or European bonds will reverse their current trend to get back into sync with the other country, or 2) these nearly-lockstep long term correlations between these countries' bonds are no longer valid.  We strongly believe it is the former which, if we are correct, means that the government bonds of at least one of these countries is currently mis-priced.

Last week, we said: "...the near term directional bias for Treasury prices strongly favors the likelihood that the early September decline will continue into early Q4, this according to the latest investor sentiment data, the recent negative (bearish) shift in near term market momentum, and technically overbought conditions that are still in the process of being worked off by falling prices.  Our bigger picture outlook is still unclear, however, due to the opposing directional implications of normally positively-correlated US and European government bonds.  Specifically, bullish technical patterns in US Treasuries suggest that the June rally will eventually resume, after the near term decline we are expecting now.  However, still-valid bearish major trends and bearish technical patterns that are clearly apparent in European government bond prices suggest that significantly lower prices and rising yields are in store going into 2008.  These conflicting technical signals mean one of two things: 1) either these tight, long term positive correlations between US and European government bonds are no longer valid (which is highly unlikely), or 2) one of these two markets is currently mis-priced.  We think it's the latter and, considering all of the borderline hysteria surrounding the housing/sub prime credit debacle over the past several months, we believe it is more likely that this mis-pricing has taken place in the US.  However, we stress that, at this point, this is our unconfirmed opinion based on several related factors including our future expectations for inflationary pressures (see our September 21st Commentary entitled, FOMC Update: Tuesday's 50 bps Rate Cut Could Intensify Already-Emerging Signs Of Inflation)."

This week, multi-year extremes in both retail and professional investor sentiment, September overbought conditions (that are still in the process of being worked off), and a multi-year wide extreme in the US T-Bond / Euro Bund spread all suggest that mid to long dated US Treasury prices are in the process of setting a near term top.  Moreover, based on previous market reaction to similar conditions, this expected decline (which appears to have began at the early September highs) appears likely to continue through at least the first half of Q4.  Our bigger picture outlook isn't quite as clear, however, as there is still an unresolved conflict between the current trends in typically-correlated 1) US and European government bond prices, and 2) benchmark US interest rates and the Nikkei 225 Japanese stock index.  These conflicting trends suggest one of two things:  either these tight, long term positive correlations between markets are no longer valid, or one or more of these markets is currently mis-priced.  We think it's the latter, and suspect that this mis-pricing may have taken place in the US.  However, at this point this is just our un-confirmed opinion based on a number of different factors including expected future inflationary pressures in the US.  It would take a sustained decline in US Treasury prices, one that negates the chart patterns discussed in Key #6, to confirm our suspicions.

Last week, we said: "...extremes in investor sentiment for both a variety of foreign currency contracts and for gold, current technically oversold conditions, and major long term support levels just below the market all agree that the US Dollar is probably within just a week or so of a near term bottom, particularly versus Europe.  Moreover, based on previous market reaction to similar conditions, the corrective rally we are expecting appears likely to dominate much of Q4.  Bigger picture, however, our expectations for the eventual resumption of the current bullish trend in precious metals, and the implications of a failed breakdown from a year-long bearish triangle pattern in the Swiss franc contract (discussed at length in previous Keys To This Week), suggest that the larger trend of a weakening US currency is likely to eventually resume in 2008."

This week, investor sentiment measures for both foreign exchange and for gold prices (which are tightly correlated to one another) suggest that the the US Dollar is either at, or just a week or two away from, a near term bottom versus both Europe and Japan.  At the same time, the US Dollar Index (which is heavily weighted toward Europe) is testing a 16-year benchmark low while technically oversold.  Combined, these conditions suggest that the mid-August decline in the US Dollar is probably in its final stages, and unlikely to move appreciably lower without at least a multi-week corrective rally first.  However, a contraction in open interest in the US Dollar Index contract would be necessary to confirm that the corrective rally we're expecting is underway.