There is no regular MarketOwl report this week. I’m out of town on vacation to welcome my second grandchild. Our next regular report will be July 5.

Today might be the first official day of summer, but it has felt like summer for investors for a few weeks. The market fluctuations since early May produce a sensation in my stomach that is not unlike that popular summer pastime of riding a roller coaster. Just so you know, I rarely ride roller coasters because I really don’t enjoy that feeling at all.

That chart below provides a pretty good picture of the type of ride we are experiencing. Since early May, the Nasdaq has advanced, but the gains have been meager and there have been several big down days. This increased summer volatility is actually not unusual. Lower trading volume can result in accentuated market movement. In fact, summer is usually the weakest season of the year for stocks. So the fact that the market is still trending up could be considered an anomaly. 

The gold line on the chart below is a simple 50-day moving average (MA) of the Nasdaq. Notice that the index has held above that line on all of its recent pullbacks and it is still trending well above that mark. In most cases, I consider 50 days a fairly short-term MA. So when a investment breaks below that mark, it is kind of like an early warning that all might not be well. When considering positions to purchase, I generally look for investments that are trending above a 200-day MA.

The middle portion of the chart below is a relative strength index (RSI). So far the Nasdaq is holding above the 50 level on this indicator as well. When an investment is trending above 50 on its RSI, that is usually an indication that it has enough positive momentum to advance. For now that positive momentum is also confirmed by the moving average convergence divergence (MACD) on the bottom portion of this chart.

Right now none of these indicators are at levels that would lead us to expect a powerful upward surge in stock values. But hey, minimal gains are still better than losses, right?

Rising oil could derail economy

Right now the biggest threat to market stability could well be the rising cost of oil and gas. With the price of crude oil approaching $70 a barrel, continued economic growth is in jeopardy. A few weeks ago the government reported that first quarter GDP growth had slowed to 0.6%. At about the same time, Federal Reserve Chairman Ben Bernanke said he thought economic growth would pick up a little for the rest of 2007.

The reality of the situation is that a GDP growth rate of 0.6% is virtually no growth. Higher oil costs could easily be enough to stall the economy and result in a negative GDP number. Most economists define recession as two consecutive quarters of negative GDP. We are just a week away from finishing the second quarter of 2007. We are about a month away from the preliminary GDP reports for that quarter. It will be interesting to see whether the economy has stayed on the brink of negative growth or whether it moved back to a higher number. Regardless, higher oil prices could doom the economy to recession in the second half of 2007.

Because the cost of oil is integrated into every aspect of our society, higher oil costs impact the economy in much the same way as a tax increase. Of course, rising oil costs also present an opportunity for those who invest in energy funds. The chart below shows the one-year performance of Merrill Lynch Oil Service HOLDRS Dep Receipt (OIH). Since March this sector is on a steady climb that shows no indication of stopping.

Unfortunately, when the energy sector does really well, the rest of the market tends to struggle. So it will pay to keep a close watch on oil prices for the rest of the summer.

F.S.

Long time readers know that when it comes to trying to forecast what stocks are likely to do, I use charts and technical analysis to help. But in spite of the fact that I rely on technical analysis, I am also aware that it has many shortcomings. Today I am going to tell you some of the weaknesses of technical analysis that I have observed through years of study and practice.

Let’s start with a definition of technical analysis from Wikipedia: “Technical analysis is the study of past financial market data, primarily through the use of charts, to forecast price trends and make investment decisions.[1] In its purest form, technical analysis considers only the actual price behavior of the market or instrument, based on the premise that price reflects all relevant factors before an investor becomes aware of them through other channels.”

In other words, technical analysts attempt to forecast future market activity by studying what has occurred in the past. Technical analysts use a wide range of tools and philosophies. These include everything from moving averages to candlestick charting. Some proponents rely on a single tool or methodology while others combine a number of tools to make investment decisions. That brings us to one of the major weaknesses, which is actually not a weakness of technical analysis but of technical analysts.

Many believe too strongly in the infallibility of their tools or systems. There is no tool or system that can accurately forecast every market top or bottom and there never has been. Over the past 20 years I’ll guess that I have met or talked to at least a couple of dozen technical analysts who are convinced that they have found the Holy Grail tool or system that is essentially perfect at predicting market turning points. The common factor is that they all eventually fail. In most cases these analysts have mistaken luck for perfection. It’s kind of like the guy who flips a coin that comes up heads 20 times in a row. After 10 times he is convinced that he can control the flip of the coin and after the next 10, he is believes he is the most skilled coin flipper of all time and is willing to wager ever increasing amounts on each flip. So what are the odds that the coin will come up heads on his 21st flip? Fifty percent. Just like the odds on every one of the previous attempts. While his run of luck is unusual, it has nothing to do with his ability nor does it matter what he believes.

One reason that these analysts all eventually fail is that no system can account for all of the variables that impact the financial markets. For example, no technical tool foresaw the 9-11 attacks and their impact on the financial markets. On that day every foolproof system got fooled. Such unpredictable events are called “black swans.” This refers to the fact that when a when swan is hatched, we expect that it will be white and in almost every instance it is. But on rare occasions a black swan is born, taking everyone by surprise.

Events the magnitude of 9-11 are rare, but smaller unpredictable events happen with regularity. They can range from unexpected comments from a Federal Reserve chairman to a currency meltdown in Indonesia.

The opposite weakness is technical analysts who develop a good trading system or rules and then don’t stick with them or constantly second guess their own systems. I can specifically recall an investment manager several years ago who had developed a reliable technically based trading system. Yet in spite of an impressive back-tested track record and of real trades in his own account, once he started to manage other people’s money he kept second-guessing and overriding the signals. Invariably his decisions proved wrong. At one point he even started seeing a psychiatrist to try and help him figure out why he couldn’t adhere to his own methodology. He never could resolve the problem and he eventually failed as a money manager.

Another manager had few very simple, but solid rules. These included things like: never buy a stock that isn’t in an uptrend. Or, don’t buy a fund unless it is trending above its 50-day moving average. As simple as these rules were, he could not make himself stick to them. Anytime an investment moved sharply upward for a few days, he worried about missing the move and would jump in even if it were in a long-term downtrend. He also often sold funds in long-term uptrends if they had a few days of correction.

The area of technical analysis that I find most amusing is the attempt to forecast the movements of investment vehicles based on chart patterns. There are many books devoted to the study of chart patterns. Most investors have heard phrases like “double bottom” or “head and shoulders.” I believe that studying chart patterns is about as reliable as looking for images in the clouds. Seeing the same fluffy bunny formation three days in a row is not necessarily predictive.

When it comes to charts, I do believe there is some value in identifying areas of support and resistance. Because so many investors and traders watch these levels, I think they often become self-fulfilling.

The main value of charts and the main value of technical analysis, in my opinion, is to identify trends. Remember that law of physics that says “an object in motion tends to stay in motion”? While an investment is not generally considered an object, I think this rule holds true. The best indicator available for forecasting market movement is long-term trends. I don’t worry much about short-term trends. I like trends that have been in place for at least six months to a year. Longer is better.

Most of the technical tools I rely on–moving averages, MACDs, RSIs, momentum, stochastics, etc.–are all helping me to try to answer a single question: Is the trend intact? As long as a long-term trend has not been violated, I can hold through some corrective action without much worry. When a long-term trend breaks down, it is usually a signal that the underlying instrument is going to be in serious trouble for some time.

In addition to technical tools, I also consider cyclical tools and fundamental analysis when making investment decisions. Once again, these elements primarily help me determine whether or not a trend is likely to remain in place.

In spite of many years experience and reliance on some pretty good and sophisticated tools, I’ll be the first to admit that I have no ability to predict what the markets will do. I’ve made my share of investing blunders through the years. On one of my very first forays into investing I bought the Japanese market when the Nikkei peaked at 42,000. Unwilling to admit my blunder, I held on to the position until it dropped to about 17,000.

I’ve learned a lot since then. I still make mistakes–just like every other manager or investor I know. But I’ve learned to be more conservative and to accept my losses when I am wrong.

Right now most of the technical tools are giving a mixed picture of the market’s health and direction. But the economic fundamentals remain strong and the long-term trend still seems to be up, so holding on appears to be the smart decision. Let’s hope we don’t run into any black swans in the next few days.
F.S.

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It is always a little frightening when the market starts a correction. In the back of an investor’s mind he is always wondering if this is the start of the next big bear market. Truthfully, no one knows. But in the case of this current three-day downturn, this seems like just normal corrective activity. After today’s downturn, the major indices were each off slightly less than 3% and have given up about three weeks of recent gains.

The prior downturn in February was steeper and even more worrisome. Take a look at the chart below to help keep things in perspective. What you are seeing is a one-year comparison of the Nasdaq (black line), the Dow (gold line) and the S&P 500 (blue line). The curved brown line is a 50-day moving average (MA) of the Nasdaq.

In the February drop, all three indices dropped below their 50-day MAs almost immediately. The entire correction lasted just over a week and three weeks later the indices were back above their 50-day MAs and and climbing steadily toward new highs. So far this decline is not as sharp, but it could persist longer, just because of the summer season. Trading volumes tend to be lower and traders and investors often liquidate or hedge long positions before going on vacation.

The two bottom sections of this chart show a moving average convergence divergence (MACD) and a relative strength index for the Nasdaq. Both are currently resting on levels that indicate that stocks could go either way from this spot. The market’s direction over the next couple of days should give us a better idea of what lies ahead. A bounce from this level could quickly send major indices back to new highs in a couple of weeks. But more downward action could end with stocks testing support another 3% or 4% below the current mark.

Today’s continued slide was primarily attributed to the fact that 10-year bond yields climbed above 5%. But that number is really only psychologically significant. Most investors are not going to turn from stocks to bonds just because the yield exceeded 5%. What will eventually drive investors to choose bonds over stocks is a weak economy. And in spite of much weaker GDP growth in the first quarter of this year, there are still plenty of indications that the economy is far from falling into a recession.

In fact, those signs of economic strength are actually hurting stocks right now because Wall Street realizes that Federal Reserve officials can point to plenty of reasons for avoiding a decrease in interest rates. The indicators of a solid economy remain the same as for the past several months: unemployment remains very low, inflation seems to be under control, consumer spending is still strong, corporate earnings are very good, and interest rates are still low by historical standards.

Even the financial markets remain healthy in spite of the latest downturn. The long-term trend is still up for stocks and there are many sectors that are doing very well.

To get an idea of how well the market sectors are faring, let’s take a look at the 136 iShares exchange-traded funds (ETFs) that cover almost every sector or index one can think of. For the 30 days prior to June 5, 101 of those funds had positive returns. Over the prior three months, only 12 funds had negative returns and they all represented bond indexes. For the prior six months only 14 have had negative returns and they were all funds representing real estate or bond indexes.

International funds continue to outperform the U.S. markets in general. Here are the returns of the top 25 iShares funds over the past 30 days. The list is dominated by international and energy or natural resource funds.

For now the wisest action for investors would appear to be to hold the course. As long as the long-term trend remains intact, corrections like this one should prove to be nothing more serious than a normal bump in the road.
F.S.