February's Employment Report

February's employment report was better than expected. Even though there was a loss of 36,000 jobs, weather factors had been fully expected to exacerbate the final number. More importantly, when weather-distorted values of employment such as February occur, the jobs number in the following month almost always shows a significant rise, as some of the weather-related loss is "made up." This is clearly the expectation going forward, that March will show a rise in employment (not just because of the addition of Census workers). The unemployment rate remained at 9.7 percent, also better than anticipated, leading some to conjecture that we have already. Gseen the peak unemployment rate (I am not convinced of this yet). Here is an article about the report, and two videos from CNBC about the employment report. The first is pre-report, the second occurred after the data were released. The bond market hated the employment news, selling off, as the 10-year bond rose 8 basis points (remember: when bond prices fall, interest rates rise).

Most of the time, when an employment number is released, the stock market tends to bounce around, as bulls and bears battle throughout the day. Generally, this leads to a small daily change for the market that day. This was not the case on Friday, as the market shot higher and sustained its momentum throughout the trading day. The result was a large candle, a large real body, and almost no shadow (tails). Here is the chart for Friday (click to enlarge). Note that resistance in terms of the RSI(9) remains above 60, but it is now slightly overbought. So, will we make it to the next resistance at 1150 without a short-term pullback? Check next week's economic releases and see if there are any major releases that can materially affect the stock market.

 I believe that the stock market sustained its earlier momentum as the day wore on because in addition to the jobs report, there was a report that consumer credit had risen, painting a potential picture of how a recovery will gain traction. Of course, time will tell if that perception turns out to be correct, but I believe the market is pricing this in.

There was a good video on CNBC that discusses sectors (a bit) and the interest rate to look at (2-year US Treasury) as a signal that the market will break out from its recent sideways action.

Finally, I didn't mention it in class Thursday, since I want to see who reads the blog postings, but our exam will be on Tuesday, March 16. So, dig in, do the assignment, and study for the upcoming exam.

Follow Up to January Employment Report

I hate to say I told you so (in the previous post), but the market sold off sharply yesterday (Tuesday, 2/10) when Treasury Secretary Geithner presented his plan (actually, more of a broad outline). Who was particularly hard hit? Banking and financial stocks. What the stock market did yesterday is what it would normally have done on Friday after the employment report. Note that this large market decline occurred along with a very large volume -- indicating "conviction" in this move.

Sadly, this was fairly predictable, not only based on a "buy on the rumor, sell on the news" basis, but since so many of the "talking heads" on television had been trying to convince people that this was an excellent time to get back into the market. I have even heard speculation that had (and when) sufficient details been provided for the financial package the market would rebound. Only if the package ends disease, brings peace to the world, extends global life expectancy to 100+ years! In other words, any package will be imperfect, and market participants will find reasons to be less than enthusiastic.

There are two things I want you to focus on from yesterday. First, we witnessed a textbook example of a flight to safety (review this in the Supply and Demand notes), where persons fled stocks, lowering stock prices, and moved their money to a more safe place, the fixed income (bond) market, raising bond prices and causing interest rates to fall. In fact, the US 10-year bond fell significantly, by about 16 bp yesterday. Second, the Dow-Jones average broke well below 8,000, closing at 7,888. This moves us back to levels we haven't witnessed since mid-November. Don't expect any significant positive market momentum until we get some meaningful clarity on the financial program. In other words, I believe the market will move lower before rising -- we will test further support.

How far might the market fall? Let's rephrase that: where is the next level of support for the Dow-Jones? First, check where price is relative to the 50-day moving average. We failed yet again to break the 50-day, which has to be viewed as short-term resistance at this point. Also, the RSI does not indicate an overbought condition (<30).

Look at the ten-year bond ($TNX) and see how it reacted yesterday. After peaking at 3.05% a few days ago, which had an overbought reading from the RSI, that rate has fallen sharply, yesterday and today (thus far). Also, there was a gap down yesterday. Try identifying relevant economic factors that determine the behavior of the ten-year, determine how those factors will likely be changing, then make a prediction of how the ten-year rate will be moving over the next few days.

January Employment Report

Friday's employment report was very close to my expectations -- very bad. As I stated in class on Thursday, my expectations were for payroll employment to fall by 550,000 and the unemployment rate to rise to 7.7%. The actual employment change was -598,000 and the jobless rate rose to (only) 7.6 percent. Read a story about this report. Also, view a video, the Short View by John Authers of Financial Times.

Reaction by markets was very likely the opposite of what you had come to expect. I will focus on only the stock and bond markets in this post.

The stock market actually rose by 217 points. There are a couple of reasons for this. There is a formal expectation for major numbers and what is called a "whisper number" -- what markets really expect and have braced for. The whisper number for employment was a decline of over 600,000, so the actual number was not much of a surprise (or scare). The whisper number for the unemployment rate was around 7.8%. So, in a sense Friday's stock market rally was a sigh of relief -- we apparently have dodged a bullet. But there is another level of causation involved.

The January numbers were so bad that markets have now discounted for the fact that some stimulus package will definitely pass -- and soon. Furthermore, Treasury Secretary Geithner is expected to announce a new round for TARP funding, and as of Friday, markets reacted to the "rumor" (their visions of what will likely occur) as they so often do. But there is a very old saying in the stock market: Buy on the rumor, sell on the news. So, when the actual details of the Treasury program are eventually released, apparently on Tuesday, expect there to be somewhat of a letdown, as reality seldom matches expectations, potentially resulting in some stock market giveback.

Technical analysis tools help in evaluating the likelihood of this. First, the RSI(9) for the Dow-Jones Industrial Average ($INDU in StockCharts.com) just moved over 50 on Friday, a bullish sign, and nowhere near an overbought reading (at 70). But, a look at recent highs in late January indicates that there is resistance point not far from where the market closed for the week. So, we have a toss up based on technicals.

What about the bond market? Review the online notes from Thursday. Interest rates rose on the "good" news, which means the bond market sold off (lower bond prices). Persons sold bonds, which lowered bond prices and raised interest rates, and moved into stocks, raising stock prices. This is a very typical "rotation, the reverse of a flight to safety. The ten-year US government bond rate rose to almost 3%, which is stunning since about a month ago it was threatening to break below 2%.

If we assume, as is quite possibly the case, that interest rates have bottomed, then bond prices will be falling from this point forward. If you were an investor, how could you "play" this expectation? There are inverse Exchange Traded Funds (ETF's). For bond prices, the symbol is TBT, the double inverse (i.e., ultra short) for 20+ year bonds. Check this out and graph it on StockCharts.com. Is there a trend? If so, which direction? Where is support? Resistance? What do the RSI and relative strength indicate? Please note: I AM NOT RECOMMENDING THE PURCHASE OF THIS ETF.

As I finish this post (11:30pm Sunday night), the Dow-Jones futures are signalling an opening that is down about 92 points from Friday's close. This might well change. But keep an eye on markets after the Treasury announcement on Tuesday.

GDP Report

On Friday, the preliminary GDP estimate for Q4 of 2008 was released. The number indicated a decline of 3.8% (versus Q3 -- an annualized change). This is well below my expectation of -4.5%, and the consensus figure of -5.5%. However, the preliminary (first-pass) number is based on estimates of inventories and net exports (exports and imports).

Interestingly, both inventories and net exports made positive contributions to the Q4 number. Personally, I believe these will be very different when the second pass number is released in a month, so I am sticking with my expectation of -4.5% to -5%.

What did the stock market do in reaction to the GDP number? After a brief and weak rally early, the stock market closed down. The Dow-Jones Industrial Average closed right at 8,000 (a fall of 148), which is a support from a few months ago (think of this as Support #1). Will that hold? Next Friday the employment number for January will be released, and it promises to be UGLY!! So, it is likely that we will test Support #2 of 7,962 from mid-November, especially since the RSI is not yet in oversold territory.

The bond market likes weakness (remember from class: bad news is good news in the bond market), so rates dropped slightly (this was not much of a surprise to bond traders). Commodities (in terms of the CRB Commodities Index) rose slightly, as did Oil and GOLD.

In my mind, the most significant trend from intermarket analysis is that in spite of Friday's result, the bond market might have already turned up (rising interest rate trend, falling bond prices). As Murphy discusses in his text, historically, BONDS LEAD STOCKS (and Commodities). So, if the bond rates have bottomed, we might see a stock market bottom by the fourth quarter of this year.

If you have not done so yet, purchase and read all of Stikki Stock Charts, download my handout for getting started with StockCharts.com, and try out the things in the handout. I will hand out material to you on Tuesday.

After "The" Employment Report

As you know from class, the September employment change was essentially in line with expectations. Payroll employment for the prior two months (July and August) was also revised significantly higher. Most notably, the original employment change for August, a 4,000 decline, was erased. The revised August employment number is an increase of 89,000. Along with this, the unemployment rate rose slightly to 4.7%, and average hourly earnings rose by a greater-than-expected 0.4%.

Hopefully, you took the time to perform the practice exercise in advance of this report. The markets viewed this as a strong employment report. The perceived (key word!) likelihood of a recession dropped noticeably as the result of today's data.

- The stock market liked the report a great deal. It was not too high as to preclude further Fed rate cuts, but not so low that it might have indicated we were in the early stages of a recession. Read a story about this.
- The bond market didn't like this at all -- both significant employment gains and the "hotter" than expected wage gain raised the inflation flag. Here is a story about this. Examine the yield curve to see how the bond market ultimately reacted. Clearly, the yield curve got steeper, indicating the expectation of stronger upcoming growth and inflation.
- The oddity today was the foreign exchange market. Normally, we would assume that the greater perceived economic growth and higher interest rates would both strengthen the US Dollar. However, by day's end, the dollar had weakened further. Read about this. It might have been profit taking by currency traders and the overall perception that the direction for the US dollar is still down. Where is the bounce (support)?

Following what I did in yesterday's posting, I revisited the Market Carpet at StockCharts.com. This time, I looked at the most recent 10 days (not the entire time since the Fed rate cut). The "carpet" below is what pertains (click to enlarge):
Now look at the sectors that have performed the best over the period of this carpet, the last 10 days. All (no exceptions) are cyclically sensitive sectors (look at the bottom right). The leader is Financials. This sector had taken a beating after the financial worries in August. But, with recent data showing that the commercial paper market is improving and possibly stabilizing, there was some "make-up" momentum. Generally, however, it is desirable to see both the Financial and Consumer Discretionary sectors outperforming other sectors.
So, over the past 10 days, the equity market has signaled expectations for an improving level of economic activity. None of these sectors would have performed so well had there been substantial recession concerns. For extra credit (due at the beginning of class on Wednesday), replicate this market carpet (look at yesterday's post for how to do this) but for the 14 days since the last rate cut. Print out the carpet and bring it to class.

Finally, look at the sectors that underperformed: Utilities; Health Care; and Consumer Staples. All of these are defensive sectors, that outperform when recession worries accelerate, but underperform when recession fears abate, as has been the case recently.

Sector Performance Before "The" Employment Report

Tomorrow we get the September employment report. This will be a market mover, but not in the traditional way. The stock market wants the Fed to keep cutting. So, if the employment gain is very good, the Fed will be less likely to cut at its next meeting, causing a market sell off. The same is true for a very bad report. Yes, the Fed would likely cut again, but this would signal the possibility that we might already be in the early stages of a recession, so the souring of profit expectations would overpower the effects of lower expected interest rates. Remember:

Stock prices = f(expected profit, interest rates)

So, when both factors change, the effect of one may well offset the other. That is the nature of forecasting! The ultimate change in stock prices will ultimately be determined by the changes in each factor and how sensitive stock prices are to those factors when their changes are that large (or small). This is a non-linearity -- the impact of each factor depends on its own level and how the other changes.

The next thing to look at is which sectors have performed well since the Fed rate cut in September. To do this, go to StockCharts.com. On the left side, click on Market Carpet. Under the heading Available Carpets, select S&P Sectors Carpet. You should see the image below (click to enlarge):

Step #1: Stretch the number of days bar on the bottom right (indicated in red typing on image). Move this to 13 days. NOTE: you can change both start and end date by dragging on either or both ends of this.

Step #2: When step #1 is completed (the days are correct), click on the button on the top left (indicated by the red typing in image). This will give a more aggregate overview, listing the sectors that have done best and worst over the time period you chose.


The result should be the next image (click to enlarge): NOTE THE PERCENT CHANGES IN EACH SECTOR (Highlighted in a reddish tint on bottom right).

There is a mixed picture since the Fed cut rates. The leading sectors are Materials, Technology, and Financials -- this signifies that the rate cuts have up to now apparently stimulated sectors related to growth. But Health Care, a defensive sector has done fairly well, while Consumer Discretionary, which we would have expected to be among the best performers is one of the slower performers (it was the only declining sector).

Note that on the left side of this Java Applet the sectors and their percent changes are noted over this period (which was summarized on the bottom left). If you double click on one of the gray headings you get a breakdown of that sector and the bottom right list shifts to the best and worst performers in that group.

Try double clicking on Consumer Discretionary. Let's see who has been holding this back, making its growth less than expected. Look at the bottom 5. What has been slowing this sector down to less than expected? How does this information alter you view (if at all) about growth prospects.

Tomorrow "the" report on employment is released at 8:30. I encourage you to see how the above results change. In general, when a major release occurs, read about it in the Carnes and Slifer text (Atlas of Economic Indicators), and check out the sector patterns to discern any rotations. What do these rotations indicate about growth expectations?

Finally, it is important to keep in mind that all of this note has pertained to the stock market only. To see how the bond market is viewing the world, look at the yield curve and how it has changed (go to Bloomberg.com for this or go to the Links for this blog under my picture). Has it steepened or flattened (or possible inverted)? Finally, check out the dollar's exchange rate with other countries and its index ($USD). What does the world think about how this report has altered growth prospects here? You can also check out www.dailyfx.com for exchange rate information.

This weekend I will post a follow-up note after the employment report has been released.

Employment Report Effects

The February employment report was released yesterday at 8:30 am. The stakes for the markets were high: too low a number and recession fears would re-emerge, which would hurt the stock market but help the bond market; too high, and the opposite would be a problem, with a reduced likelihood of the Fed easing in the near term.

The payroll employment number that emerged was +97,000, which was high enough to remove recession fears, but not so high that worries of overheating would emerge. This scenario has come to be called the Goldilocks Scenario. Read the following article about all of this. Also, read the chapter on the employment report in the Carnes and Slifer text (The Atlas of Economic Indicators).

The stock market began the day with a healthy rise but gave much of this back by the end of the trading day. This often happens when markets get what they were hoping for (this is a variant of the old saying: Buy on the rumor, sell on the news). So, SUPPORT AND RESISTANCE BOTH HELD.

The principle items that caused a reaction in the bond market were a higher-than-expected rise in average hourly wages and a decline in the unemployment rate to 4.5%. In addition to these, the prior months' employment numbers were adjusted upward (this has been occurring for a while now). So, it is very likely that today's somewhat tepid payroll employment increase will be revised higher with the release of next month's data. All of these factors heightened inflation fears, causing a bond market sell off. The 10-year bond rate rose to just under 4.6%, an increase of 8 basis points for the day. Clearly, the bond market wants the Fed to lower interest rates, and the employment report dashed those hopes (for now at least). I guess the bond market's view of the world should be referred to as "The Three Bears," given the stock market's view.

So the "wildcard" for now is the mortgage market. How far will weakness in the sub-prime market reach higher tiers? It has already impacted the "Alt A" market, and with the tightening of lending standards, it will very likely creep somewhat into the market for prime mortgages. The different perceptions of the future state of the economy held by the stock and bond market centers largely on the answer to this question. For now, at least, it appears safe to say that "all's quiet on the carry trade front." Stay tuned.

An interesting article for you to read is by Jeremy Siegel. He attributes part of the recent volatility in stock markets to "trend following" by technicians. These traders (myself included) often place automated "stop loss" orders below the trend so they can insulate themselves from potentially large losses. Here's how a stop loss order works. You choose a price level at or below which you want to get out of a stock (or index like an ETF). Hopefully your choice is based on where support is. You should place the "stop" a bit below support, so that if a false breakdown occurs you don't get "stopped out," after which the stock begins to rise again. You then place an order stating this with your brokerage account. To automate this, specify the time frame for your order as "Good Till Cancelled," or GTC. Normally, this will remain in effect for several months. If, instead, you specify market day, you are only covered for that trading day, after which the order no longer exists. Specifying GTC thus automates this process so you don't have to remain in front of your computer all the time.

So when trendlines are finally broken in sustained uptrends, many of these stop orders kick in, potentially causing large sell offs, and magnified price declines. Hence the volatility aspects. I doubt that stop loss orders played the major role in the large Tuesday sell off, but they were certainly part of it.

A recommendation when you buy stocks: USE STOP LOSSES, but leave room below support in case a false breakdown occurs. Remember, capital preservation should be a primary factor for you.

Big Drop in the Dow-Jones

This past week saw notable movements in the Dow-Jones Industrial Average ($INDU). We discussed much of this in class (thru Thursday anyway). Friday was not a good day. The DJIA closed down 120 additional points, ending at just over 12,100.

The DJIA has been in an uptrend for many months now (since August 2006), so some sort of correction was called for. Typically, these corrections range between 5 and 10 percent declines. The time frame is variable -- there is not a "typical" correction period. IF, however, a correction ultimately involves a 20% decline, the market is deemed to have changed to a "bear market."

After a week like the one we just went through, I recommend using weekly charts to view trends, etc. The chart shows $INDU weekly (click to enlarge it).

One thing to note: just as there is support for price in a main chart, you can use levels of the RSI to denote whether a trend remains in force. As you can see in the diagram, the uptrend remained in tact as long as the RSI (based on 9 periods) stayed at or above 50 (the demarcation point). Since July of 2006, until this past week, that condition was met.

Look at the large weekly bar, which closed near the low for the week. Not good!! Further note that this large drop occurred on large volume. Also not good!!

There is something that is visible on a weekly chart of $INDU that is not apparent from daily data: a bearish divergence. While $INDU was making higher highs since October of 2006, these were not confirmed by the RSI moving continually higher. Thus the bearish divergence.

Support appears to be around 12,000 (look at the chart). If we fall below this, things will get very interesting. How likely is it that we will move below 12,000? Fairly likely, since even after the horrible week, the RSI is not yet in oversold territory. Ugh! Stay tuned, let's see how this week plays out.

In situations like this, you should look to see if any major (i.e., potentially market moving) economic data will be released this week. The answer is yes -- the labor market numbers for January will be released this Friday. What kind of employment report would lead to further price declines? Increases? Also, don't forget about the bond market.

Post Election Info

The election is now over (thank God!!). A sharp market sell off that some had feared failed to materialize. Interest rates have come down about half way from their gain after the employment report last Friday.

There is an excellent article I want you to read by Michael Kahn dealing with political cycles and the stock market. The interesting question he explores is whether the market will be strong for 2007 and 2008, or just 2007. In other words, will a historical pattern hold?

Today, we received the most recent balance of trade data. The September trade deficit fell sharply. Why? Because this is a nominal value, and the price of oil dropped sharply over the period covered by this report. So, while short-term fluctuations in the balance of trade often result from changes in relative US income change (as I noted in class), at times when oil prices rise or fall sharply, large changes occur. Read this article on the balance of trade figure.

Perhaps the most important implication of the balance of trade figure is that it indicates the likelihood of an upward revision to Q3 GDP growth. That's because the initial number we received (+1.6%) uses an approximation (i.e., guess) of the balance of trade deficit, which likely included an overestimate of the value of imports. Remember, imports get subtracted from GDP, so lower imports (due to a drop in oil prices) will add to GDP growth figure.

Employment Report Implications

Today, the September employment report was released. There was a weaker-than-expected employment change of 51,000. If the market's focus were solely on this number, interest rates would have fallen (lower inflation expectations due to slower expected growth), and the stock market should have risen as this is consistent with the "soft landing" scenario.

As it turned out, the stock market dropped slightly. But, the biggest story was that the 10-year bond rose by 9 basis points, all the way up to 4.70%! How did that happen?

First, the bond market, which subscribes to the "hard landing" scenario, had not only priced in that the Fed is finished raising interest rates, they apparently also presumed that the Fed would begin easing early in 2007. Wow! While the 51,000 payroll change would normally have made them happy, there was a sizeable upward revision to August's payroll number (+60,000), the unemployment rate dropped to 4.6%, tied for its lowest value in a while, and the government released a statement indicating that payroll employment gains have been understated through March of this year, by about 800,000.

So, taken together, this information says the economy has more strength than the bond market had presumed, and the likelihood of the Fed lowering interest rates early next year is now remote. What is the outcome? You guessed it, a bond sell off, pushing interest rates higher. Go to StockCharts.com and plot the 10-year bond ($TNX) to see that action for yourself. The chart shows the 10-year (click to enlarge).

Note the large bar for today. Using the Raff Regression Tool (sixth icon from the top right), I made the blue price channel and have indicated three resistance levels (think of these as R1, R2, and R3 as technicans would). I have also located support.

The other story is the recent strength in the dollar. I discussed in class today that when we see the combination of rising stock prices, rising bond prices (declining r) and a rising dollar, this indicates that foreign investors are bringing money into US asset markets. This happened earlier in the week. What about today?

With the threat of a nuclear weapons test by North Korea, the dollar strengthened. Once upon a time (translation: when I was a student), gold was the "safe haven" when indicents like this occurred. Today, gold only rose $1.50. The US dollar has now become the safe haven. And when the US dollar strengthens, US asset markets also become relatively more attractive to foreign investors. This bodes well for stock indices not falling too far too fast. When the US dollar strengthens, this also puts downward pressure on commodity prices. Check out the CRB Index ($CRB) to see this.

Finally, to see the international fallout (sorry!) from the possible nuclear weapons test, check out the Japanese Yen index ($XJY). Not a pretty sight!

Dow Jones Record

The Dow-Jones Industrial Average ($INDU) set a new record today, closing at its highest level ever. You can read about today's performance or explore its history. The real question is whether this upward move has "legs." Will resistance hold, and today be part of a failed breakout, or will we move toward even higher levels?

Applying technical analysis, there is reason to think that today's record will be met with a pullback in the near term, even though the RSI doesn't indicate that $INDU is oversold (based on the weekly data used). The chart below (click to enlarge) illustrates that the record -- as resistance from early 2000 -- was broken today. Why do I think some pullback is coming? Using the RSI, there is a bearish divergence: the $INDU has moved higher (it has higher highs) but this has not been confirmed by the RSI (it has lower highs).

Where will the Dow-Jones go from here? To answer that question, economics is needed (see the prior post for an example of this).

stock prices = f(expected profit, interest rates)

Put these together and you get the present discounted value of expected future profits. Here are the types of questions that must be answered to arrive at an answer (which, bye the way, is a forecast):

(1) Has the Fed finished raising interest rates?
Will they actually lower rates next year (as the bond market presumes), or will inflation remain in the problematic range?
(2) Today, oil prices fell below $59/barrel. Will this continue? If so, this will moderate inflationary expectations and the inflation premium in nominal interest rates). What about declining gasoline prices? This will help consumers, but with a lag (it takes time to replenish the spending power lost over all these months with $3+ gasoline prices.
(3) How much damage to economic growth will be done by housing sector weakness? Have declining interest rates placed a bottom on the decline in housing, or is there quite a ways (down) to go yet? Look at a few home builder stocks. These appear to have bottomed. Is that a leading indicator of what is to come for the housing sector? Business construction (in the GDP accounts) have begun to rise. Will this be able to offset home construction weakness?
(4) Consumer debt has piled up -- largely through the use of home equity. What will power spending in the next several quarters if home equity can't? Job growth and income gains are critical here.
(5) Will business spending (Equipment and Software) be able to pick up the slack from weaker growth (or actual declines) in consumer spending? Judging from the most recent quarter's GDP report, no. But was the decline in this category an anomaly?
(6) Will growth in Europe continue to pick up and that of Asia remain strong? If so, this bodes well for export growth and profits to firms that have international sales.

This is not necessarily the entire list. But for a forecast of stock prices, like any forecast, you must identify what the relevant factors will be in the next 6 months or year, predict what each of these will do, then put all of this together to arrive at a conclusion.

Technical Analysis Applied to a Stock Pick

Today, Barron's Online had an article (subscribers only) with a strong recommendation to purchase Texas Instrucments (TXN), the maker of computer chips for computers and cell phones. While I have no doubt that just this recommendation led many to run out and purchase TXN, persons who know the tools we are using in class would have held off. Clearly, the "fundamentals" of TXN are very good, so the stock passes and important test. But should one buy it when a recommendation occurs? For persons who don't believe in technical anaylsis, the answer is a resounding "yes." They would likely point out that as a long-term investor, if the stock should fall in the near-term, it will surely rise later based on its strong fundamentals. Let's look at an annotated chart of TXN (click on it to get an enlarged version).

The first thing to determine is how close TXN is to resistance. It is apparent that resistance is at 34 (from April). It failed a breakout above 34 in late April and early May. That resistance recently held as well. Note from the Relative Strength graph (bottom) that TXN has failed to outperform the overall stock market since mid-August. So purchasing this stock now is a wonderful illlustration of my handouts in class -- how persons often tend to buy when a stock is close to resistance (i.e., price is high).

Why not wait until (or if) TXN clears resistance, then purchase it, or better yet, purchase at support? That is what I would recommend. Consider the "fundamental" investor. Should TXN drop to $30 from $34, assuming they purchased it at $34, they would need to recoup a 13.3% loss just to break even (=$4/$30). What they won't do, and that I recommended that you would do, is to consider purchasing at support -- this is the equivalent of "buying low."

The motto of the story: I often see buy recommendations for stocks given at a time when the technicals of those stocks are not "right." Use technical analysis with stop loss orders to manage gains and losses, and don't just "resign yourself to fate" in terms of whatever the stock price does, as the fundamental investors do.

Enter economic analysis: Is it likely that TXN will test resistance or fall to support? (As practice for you: Where do you see support here? Where would you think of buying this stock?) Since stock price is largely determined by expected profits (and interest rates), what is likely to be true of future profits for chip makers? Will electronics and computer purchases slow down as the year ends or will this get stronger? THIS WILL BE DETERMINED BY THE MACROECONOMIC OUTLOOK. What a coincidence, that's what ECN 327 is all about!!! The products TXN's chips go into are part of discretionary spending, which is highly cyclical. So, if the bond market is correct, that a sharp slowdown is coming, prospects for TXN's stock price are not very bright, in spite of its present fundamental strength. If the stock market is correct, that we are headed for a "soft landing," then the prospects for TXN are brighter, and this might be a stock to keep track of. So, look at the graphs of cyclical stocks ($CYC) and discretionary goods (XLY). What is the real-time information from these graphs telling us? Is the Fed done raising interest rates? Will housing's fall not be sharp (due to falling 10-year bond rates, etc.)? These are the questions to consider.

Bearish Divergence As A Leading Indicator of Price Change

Cyclical stocks ($CYC) move in the same direction as actual or expected economic growth. As a market, this is itself a leading indicator. And, its changes contain real-time information on market expectations concerning growth.

As you know, yesterday (9/21), two indicators were released that caused markets to change sentiment -- reflecting the belief that the economy would weaken farther and possibly faster than was previously expected. On yesterday's blog post, I detailed how this affected the 10-year bond rate. That rate fell again today (to 4.6%). With the expectation of slower growth, cyclicals should also weaken. And they did.

In the handouts on technical analysis, I detailed what is called a bearish divergence: price action moving higher but the RSI not experiencing higher highs. This is a leading indicator of a downward move in price in the near term. Note this is not 100% accurate, but it has a fairly good track record.

I have included a graph of cyclical stocks where such a bearish divergence is evident (and marked). Click on the chart to enlarge it.


Based on this bearish divergence, one should have expected some decline in cyclicals, and thus the perception of a weakening economy gaining traction. THIS DOESN'T MEAN THE ACTUAL ECONOMY WILL NECESSARILY WEAKEN -- JUST THAT THE EXPECTATION OF THE MARKET IS THAT IT WILL WEAKEN.

To earn extra credit, get the chart of cyclicals and using weekly data for the past two years, annotate the chart, drawing lines and adding comments. Determine if a bearish divergence occurred. Also, draw the support line for weekly data and a possible support line for the Relative Strength indicator. This will be accepted no later than the beginning of class on Monday. No pencil or pen lines will count.

The next test is to see if the support line (indicated in the graph) is broken next week. Note that cyclicals have been underperforming the overall market (based on a declining Relative Strength (below the graph) since early May. It is also possible to draw a support line for the Relative Strength indicator.

Is the Market Headed Higher?

We discussed technical analysis a bit in class today along with sector rotations. When the economy is slowing, you will observe a rotation from sectors that do well with a strong economy (like cyclicals ($CYC) and discretionary spending (XLY)) toward more defensive sectors like consumer staples (XLP), telecommunications (IYZ), and public utilities (XLU).

A good article dealing with this by Michael Kahn of Barron's discusses this. It provides more practice as you learn the material from the handouts today. He points to relative strength as an indicator (recall this is a symbol or index divided by the overal S&P 500). When the relative strength graph is upward sloping, that market is outpeforming the overall stock market. For XLP, that has been the case since mid April.

Finally, note how you can apply lines to other measures such as advancing issues versus declines, or as Kahn's article shows, advance volume vs. decliner volume.