Over the past eight sessions the market has rebounded from a sudden, sharp drop. One item worth noticing is the fact that the largest companies, the blue-chip stocks, are garnering the most attention. The stocks that most investors would consider to be safer investments are those which have more buyer demand. What can we infer from that fact? Investors want safety right now.
 
Consider the figure below which shows a relative comparison between the thirty stocks of the Dow Jones Industrial Average (all large companies) and the 2000 stocks of smaller companies in the Russell 2000 index. Here you can see that over the past eight weeks, the Dow has outperformed. 

If someone asked you which stock was riskier, and asked you to pick between IBM and Commvault Incorporated (a 15-year old company spun off of AT&T Bell Labs), which would you choose? If you are like most people you’d probably not think of IBM as the riskier one. That decision would not be based on knowledge of the companies, but perhaps just a general perception that one of them has been around longer and is likely to continue remaining around longer.
 
 
$DJI vs. $RUT – Daily Chart

So it is with investor attitude towards larger stocks with more easily recognizable names. People gravitate towards the stocks in the Dow when they get a bit nervous about where the market is going. In an effort to maximize safety over opportunity, they move money into stocks they consider to be less risky.

The key idea here is to recognize what a useful indicator this phenomenon can be. Safety-maximizing behavior by investors is an early warning signal for a potential change from an upward trend in the markets to a downward trend. This evidence it quite consistent with a recent surge in utility stocks and also an increase of volatility pricing in the options market.

All of this information together reinforces the idea that more investors in the market are beginning to get more nervous. When enough investors feel scared about the market’s current price level, then they will begin to take profits from the recent upward move. As early-acting investors accumulate, then more investors will follow. As more investors follow suit in taking profits and selling out of positions, then prices begin to fall more noticeably. Market prices will drop below previous supports and may even form a downward trend.

At this point investors have only just begun to show their preference for safety, so the downtrend is unlikely to begin immediately. Yet from this point moving forward, astute traders will keep an eye on whether the blue-chip stocks of the Dow will continue to outperform the smaller-company stocks of the Russell index.
 
By Gordon Scott, CMT, Learning Markets Analyst.

The market has gone down and back up with more speed lately. What can we expect from the market when we see that kind of action in prices? Watch out for falling stocks!
 
When markets trend upwards, prices will move with less and less volatility. That is to say that the difference between the highest price of the day and the lowest price of the day will gradually decrease, on average, as the upward trend progresses. This characteristic is a generality, however, because a market can certainly trend upwards and simultaneously increase its average volatility.
 
In fact during the 1990s the S&P 500 increased in price by double over a three year period even while become more volatile all along the way. Increasing volatility, as measured by the average daily change in prices, is not a bearish signal all by itself. It simply means that investors are getting nervous. It doesn’t mean they are ready to sell out immediately.
 
Bullish markets climb a wall of worry, so the saying goes, and increased volatility is certainly a sign of worry. How do we tell the difference between a worry-prone bullish trend, and a market that is ready to become a bearish and panic-stricken downtrend?
 
The answer is that we need to see more walk than talk. Before the trend of the market is likely to change we need to see signs of nervous investors changing strategy. Some people call it moving from greed to fear, but another way to think of it may simply be that investors change their preference from seeking opportunity to seeking safety.
 
While it is true that the markets have nervously risen over the past three years, the past twelve months have rarely had clearly definable moments of a preference of safety over risk. At such times when both rising volatility and safety-seeking investors mark the movement of money towards the safety sectors of the market, it is useful to observe the movement of utility stocks. As it turns out, utility stocks are rising higher over the past few days (see figure below).
 

Utility stocks show relative strength
 
When investors move money from stocks that are components of the broad market indexes into utility stocks, it is a signal that they are changing their strategy from seeking opportunity to seeking safety.  As of today, we have literally caught them in their tracks. This is only early evidence of nervousness. It will take a full eight weeks of this behavior to expect that it will continue for an additional twelve, but if it does continue, it is a reliable signal that the markets are ready to change trend from bullish to bearish.
 
Gordon Scott, CMT, Learning Markets Analyst.

Early in the trading session on Wednesday the stocks in the financial sector pulled back early, while at the same time utility sector stocks advanced. This particular dynamic may not mean anything in one-day isolation, but a continuing trend of this action is very meaningful indeed. Since this trend continued into a second day on Thursday (see figure below), it is worth examining this change more closely and taking a moment to review what utility stocks mean to investors and how financial stocks differ from that.

This figure shows the dramatic drop that financial stocks (the gold-colored line) have made in comparison to utility stocks over the past two days. The two sectors have not diverged so recognizably for nearly a year.
 
Financial sector stocks and utility stocks share an interesting relationship. They both tend to be indicators of directional change near the end of business cycle trends. The difference is that one of them is going up while the other is going down at precisely the moment the trend is about to change.
 

 
XLU compared to XLF over the past month.
 
What Utility Stocks Mean to Investors
 
The simple explanation for the difference between the two is that utility stocks represent a greater degree of predictability for investors. They tend to fluctuate less and they also tend to pay larger dividends. A stock that doesn’t move up quickly is unattractive to an investor seeking opportunity, but a stock that pays dividends is very attractive if that same investor thinks the market is not going anywhere—or worse, going down in price.
 
Utility stocks attract money from investors who are looking for relative safety in times of uncertainty. It isn’t that these stocks never go lower—they certainly do—but that they tend to not fall by as great a percentage as other stocks when markets sink. Perhaps the old stock market adage that “a rising tide lifts all ships” could have a corollary for weakening markets. If so it would go something like this: “the ebb tide lowers all decks—and utility stocks can be found hanging around on the uppermost of those decks.”
 
How Financial Stocks Differ

Financial stocks, on the other hand, represent the front edge of the business cycle. After the market and the economy have languished for a while, businesses and consumers at some point begin to take out loans. This happens when they see that their prospects might improve if they can only take advantage of some nearby opportunity. During such times the financial sector tends to attract those investors who are eager for growth and looking for opportunity.

Thus the financial sector tends to rise earliest in a bull market, while, not surprisingly, the utility sector turns out to be a laggard under those circumstances. These signal times when investors are seeking more growth than predictability. Those times are the opposite of what the market has shown in the last two trading sessions.

If the trend of these last two days continues over the next two months, it would signal a major change in the business cycle and investors can expect a prolonged downward trend in the markets. But it is much too early to predict that outcome just now. The tide has not turned yet.

By Gordon Scott, CMT, Learning Markets Analyst

The Dow Jones Industrial Average (more commonly known as the Dow) hasn’t spent many days marking a price above 14,000. Before this year the index registered that price or higher on only 15 days in 2007. This month so far the index has reached above that level six times and the price has managed to close higher than 14000 only twice. It isn’t any wonder that the market may be stalling at this level.

Can this index go higher? In 1966 the index broke above 1000 for the first time, but it took 15 years before the market could trade above that level and never return. Sometimes a psychological barrier to stock prices can be a strong thing.

In this circumstance, however, the Dow is not likely to find lasting resistance at 14000. Though it may pull back for a few days this week or next, before long it will likely find itself moving above 14000 and breaking historic highs throughout this year. That may seem like a bold prediction but it really isn’t.


 $DJI – Weekly Chart

Consider that the Russell 2000, the index of small cap stocks, broke its all-time high of 868.57 in January and has subsequently moved over seven percent higher since then. Though the NASDAQ 100 index is still barely above half of its all-time high, it broke the 2500 level (a previous 10-year high) without hesitation over a year ago and has rarely traded below that since then.

In fact, if you were to adjust for dividends, the value of the Dow is actually following a pattern similar to these more risk-laded indexes which are composed of stocks that typically don’t pay dividends. Investors have long ago determined that the value of stocks in 2013 is greater than it was in most years previous.

Whether it be the combination of Quantitative Easing actions by the Fed and other central banks around the world (with some help from stimulus spending by the U.S. Government), or an aging population of investors seeking greater returns before entering a looming retirement, the market has declared that higher prices are acceptable. Thus they are likely here to stay even if it will take a while before the skeptics stop taking profit at this level.

Investors entering the market just now however should take caution and realize that greater fluctuation may occur as psychological barriers are overcome. Any investors making new entries would be prudent to allow for pullbacks in price along the way.

By Gordon Scott, CMT, Learning Markets Analyst

Increased volatility and indecision in the market this week are classic signs of worry among investors. But is the market in danger of falling rapidly any time soon? The answer is probably not.
 
The past two years started out similarly with the markets rising from January through March. During those time frames the market would make occasional dips along the way. Why does the market dip? If you follow the news, you can find a variety of ready explanations. Two years ago the news would proclaim that it was because of the Arab Spring and the Japanese tsunami. Last year around April the news explained that renewed Eurozone fears could signal the possibility of a Greek default. 
 
But in reality the underlying cause is that investors simply begin to feel worried. They want to take profits and protect their recent gains, so they watch carefully for any reason to do so. The markets, in such a state, are more sensitive to bad news than they might be at other times.
 
In a strongly bullish market, however, longer-horizon investors and bullish-minded traders tend to buy up dips in price. So when the market reacts to an initial downward spike in prices, it is important to take note how quickly prices rise thereafter. 

So far this week the market has erased or significantly blunted all of the downward pulses, including Thursday morning’s forceful challenge of previous daily lows. This would seem to indicate that markets aren’t likely to fall strongly yet for another week. Among individual stocks it is a mixed bag. Worry is clearly evident for investors in Amazon (AMZN) and Apple (AAPL), while Google (GOOG) and Netflix (NFLX) seem to be filled with less jittery participants—at least for now.
 
Emerging Markets, often a canary in the coal mine, so to speak, are showing that they are struggling for breath—another sign of worry. But in contrast, transportation stocks, often a leading indicator, are hitting new highs. So the market signals continue to be mixed up in a way that leads us to believe that some investors remain optimistic and are actively looking for bullish opportunity right now.
 
Traders should be cautious in entering new positions however because this could change rapidly. By as early as next week the market dynamics could change into something far less favorable.
 
by Gordon Scott, Learning Markets Analyst

The advance GDP report for the 4th quarter of 2012 was released yesterday and it showed negative annualized growth. Most analysts had been expecting postive growth of a little over 1%, so the reading of -0.1% was an unwelcome surprise and is one of two steps towards an official recession. Technically, most economists define a recession as 2 consecutive quarters of negative GDP, so we are basically halfway there.

There is an argument being made that if you remove the reduction in inventories and a surprisingly large decline in defense spending from the data then GDP was actually a robust 2.6%, but if you remove enough negative data from any report it can become positive. In this case, there does seem to be room for that argument to be made as opposed to what happened the last two times quarterly GDP went negative. 

In the next chart you can see the last two times negative GDP signaled a recession plotted on a chart of the S&P 500. What is most important was the reaction in the market prior to those two releases. If we assume that market prices are a reflection of the underlying fundamentals and growth expectations, then it seems reasonable to suggest that "this time really is different." In 2008 and 2001 the market had already been in decline for some time because trends for investment and spending were already very negative by the time the economy officially went into recession.


S&P 500 ($SPX) Monthly Bars

One of the biggest differences between 2012 and those two prior instances was that the economy doesn't have very far to fall right now. Growth has been low enough to prevent any obvious asset bubbles (besides bonds of course) so a dramatic decline in stock prices seems unlikely. However, we can't fully rule out a correction - even a short term one in February and/or March. The GDP results were bad regardless of how we massage the data and if that trend continues traders will have to be very careful.

What to watch in the short term

Fortunately we are in the middle of a data-rich period of time. Earnings season is still in full-swing and the reports have been reasonably positive on average. If that trend continues I would expect to see the potential for very small declines in the market relative to the potential upside over the coming months. Labor is also due from the BLS tomorrow (Friday February 1st, 2013), which is a key bellwether that could also help support the rally and minimize draw-downs if the news is good. Conversely a negative shift in an already weak hiring trend would be a big problem for the market and GDP.

Finally, it is important to realize that GDP is released in three different versions. The first is called "Advance" and is revised a month later when the "Preliminary" report is released. Preliminary GDP is also revised a month later by the "Final" GDP report. Each of these revisions are an opportunity for GDP to be restated a little higher or a little lower. Just like a corporate earning's report, each of these revisions are a chance to surprise analysts and investors. Preliminary GDP is due to be released on February 28, 2013 and it could revise the advance report positive again.

I would assume that if the market hasn't turned significantly lower by the end of February then we shouldn't expect a second quarter of negative GDP growth and the U.S. will have not officially gone into a recession. That matters to me because it can make a difference to consumer and investor sentiment. It is more likely that consumers will spend, business will hire, and banks will invest if we aren't in a recession even if it is just a small one.

So, does this really count as a recession? No, but its close enough that we all should be paying close attention to how this number changes for the better or worse over the next 60 days.

by John Jagerson, Learning Markets analysts  

When investors are seeking opportunity more than they are seeking safety, bad news is easy for the market to shrug off. As the market moved through the thickest part of earnings season this week the price action was more bullish than bearish; it was as if no significant bad news had been given.

At least that’s how it was until Apple Computer (AAPL) released its earnings report after hours on Wednesday. On the surface the report wasn’t really so bad. The company met its profit target, even though it fell short on total sales. That doesn’t sound like bad news all by itself, but in the context of Apple’s previous performance, it is a big disappointment to investors. Simply put, the company fell out of the ranks of the high-growth headline makers. It was a tough fall—and it may not be over yet.

One other company experienced slightly similar dynamics about eight years ago; namely, EBAY. The stock price of EBAY had a great run in 2003 and 2004, nearly tripling in value during that period. Then in early 2005 the company’s earnings report brought the explicitly stated notion that EBAY would change from trying to be a high growth company to a steadily performing company. Investors reacted in a panic that sent the stock almost 50 percent lower over the next four months (see figure below).


EBAY – the share price has yet to fully recover from the drop in 2005

Investors take on ownership of a stock because they expect it to return gains greater than inflation and available low-risk instruments like CDs, Bonds, or its peers. So if investors come to believe that a given stock has clearly lost its opportunity to return stellar growth, they have a strong incentive to find an alternative.  

In the case of EBAY, the share price was so decimated by the flight of investors looking for growth, that even eight years later the stock is only now beginning to approach the previous high before that precipitous fall. Could AAPL follow the same pattern? A decline like that is certainly possible, but there are some factors to consider that make it a less likely scenario for AAPL.

The first is the fact that AAPL’s bad news didn’t catch investors by surprise like EBAY's did. AAPL's share price actually began its descent a few months ago from $700 per share. A near 50% drop would still mean another $100 in decline—which is significant but not the same as it was for EBAY. Though more losses could come, AAPL shares may bottom out sooner rather than later like EBAY.

The second reason is that the market is showing a remarkably resilient trend even in the face of AAPL’s slide in share price. Considering how far AAPL shares have fallen in price since September, it is interesting to compare how the NASDAQ 100 has performed compared to AAPL (see figure below).


QQQ – The relative strength of QQQ when compared to AAPL

This chart compares the NASDAQ 100 to AAPL. The steadily upward trending line implies that QQQ, the index-based ETF tracking the NASDAQ 100, would currently be hitting new highs without the drag created by AAPL. With investors this bullish, it is likely the case that die-hard fans of the stock will hold on, making AAPL, like EBAY before it, a great buy at some point near its post-slower-growth lows.

-by Gordon Scott, CMT, Learning Markets Analyst

Within the next 24 hours a string of earnings reports will come from companies in almost every sector of the economy. Additionally the University of Michigan preliminary Consumer Sentiment report will be published just after the market opens on Friday. Will the market respond with a bold and decisive reaction to all of these news events? It is highly unlikely.
 
If the trend is a signal, then the markets have shown quite a bit of noise in their patterns of late. So far earnings season has yielded very little in the way of strong price moves, but the heavier part of earning seasons has yet to occur. Today marks a shifting of gears, so to speak, as more household names make headlines. Before the market opened on Thursday Bank of America (BAC) and Citigroup ( C ) released reports with less than stellar results and neither opened positive.
 
However that news didn’t hinder the market averages from moving higher. All four major indexes opened nearly flat but moved mildly higher in the opening minutes of the day. Even AAPL computer (AAPL), the price of which has recently dipped below $500 , moved one –half percent higher to solidify its rebound above that figure.
 
After the markets close on Thursday, highly-watched Intel Corporation (INTC) will report, and Friday morning before the markets open, General Electric (GE) and Schlumberger (SLB) will also have reported. Normally, any one of these three high-profile companies could bring news that would trigger a market-moving headline, but even the most earth-shattering reports from these stocks will have a tough time making much impact on the market this week.
 
Two technical influences and one market structure event will likely conspire to keep the markets tightly range bound on Friday. The technical influences can be seen on the chart below.


S&P 500 –Daily Chart with Average True Range study below.    
                  
The S&P 500 average is nearing its September high and appeared to be testing the resistance of that level through the Thursday trading-session. Traders may be looking to take profits at this price level on Friday and any hint of bad news will give them the excuse to do so thus pushing prices slightly lower. However the market’s price pattern shows that daily trading ranges are getting smaller. The Average True Range (ATR) study below the chart shows a downward sloping line which indicates smaller daily price ranges. This is actually a bullish indicator which implies that investors would rather not do a lot of selling right now if they don’t have to. They prefer to hold and let markets go higher as other investors (fingers crossed) buy in after them.

Friday marks January option expiration weekend. Option expiration Friday has a smaller range than average about 80% of the time. With all three of these factors in place, investors and traders have very little reason to make sudden, panicked moves. The bottom line is that the market looks likely to be pretty quiet on Friday, however, this may simply create more pent up energy for next week when earnings season shifts into a higher gear with the likes of Apple (AAPL) and Google (GOOG) reporting. Investors should beware of larger moves in the coming week if Friday shows a tight range-bound day. 

by Gordon Scott, CMT, Learning Markets Analyst

A well-known stock market phenomenon referred to as the January Effect seems to be underway in textbook fashion. What is this effect precisely and why does it persistently show up 3 out of every 4 years? The January effect refers to the tendency for stocks to rise in the first part of the year. Some people specifically refer to the outperformance of small cap stocks as the January Effect, but either can be easily verified by observing the historical data of the S&P 500 cash index.
 
If you simply compare whether January closes higher than it opens in each year since the index was tracked, you can see the evidence for yourself. This event is not a myth. Since 1928 the month of January has closed higher than it opened 71% of the time. Small caps have outperformed large caps in January about 76% of the time during that same period. So the evidence seems to indicate that if you buy stocks at the beginning of the year, you have better than even odds that your account will be more valuable at the end of a month.
 
But trading this phenomenon isn’t as easy as it sounds. There are some years where a volatile January creates extreme drops before pulling out a winner. January is typically a more volatile month than those on either side of it anyway. The daily moves (whether up or down) tend to be larger than those in December or February for two simple reasons. The first is that January marks the start of a new tax-year calendar (a time when more investors choose to participate in the stock market). The second is that the first earnings season of the year takes place early in January. It is likely that 2013 will be no exception.

In fact, the coming year may actually feature a greater number of significant daily moves than in years past. When you consider the debt-crisis headlines likely to come out of Washington D.C. over the next 60 days, you realize that investors could be in for some serious movement.

Because January makes for strong bullish moves 3 out of 4 times, the prudent trader or investor would do well to watch for days where the market indexes seem to have met support in January. Chances are that days where the market has sold off for several sessions and landed near a previous low might provide excellent buying opportunities. For an example consider the following figure.


SPY – Current Channel

As you can see from this picture of the S&P 500, the market is moving upward in a sort of channel. It is possible that if the price falls to the lower part of this channel that the upward trend may resume—providing an opportunity for late participants to join in. The market’s action from the previous months of November and December are providing excellent clues for where to anticipate a good buying opportunity.

By Gordon Scott, CMT, Learning Markets Analysis

The market made a significant jump upward this week, but for those who know how to read the market's signals, this wasn't a great surprise. The market had been telegraphing its lack of fear for a matter of weeks. The big question is what comes next. Will the markets begin to fret over the debt ceiling issues and will this worry drive investors to flee the stock market for safer havens? The answer is that since the markets have stopped seeing red, probably not.

Investors put indexes back in the black to start the year. In doing so they are not exhibiting the behavior of true panic. They are also unlikely to increase their disposition to panic over the next few weeks. Here’s how you can tell. In the final weeks of December as markets begin to express their fear of Congress' self-imposed deadlines, commonly referred to as the “fiscal cliff,” broad market indexes fell; however, large company stocks fell further than small company stocks. This is backwards when compared with typical market panic behavior.

Investors tend to flee risk when markets truly panic and under such circumstances small-cap stocks lead the fall. When investors seek opportunity by acquiring more small-cap stocks, then it’s a good guess that the markets are not in panic mode and not likely to get there in the near term. But this is not the only evidence.

The CBOE Volatility Index ($VIX), a.k.a. the VIX, is showing signals that investors are much less fearful now. This index measures option premium pricing on the S&P 500 index options, which are often used as a hedge against long stock positions. Since a put option represents a form of insurance against market drops, measuring the relative premium inflation of those options is a good measure of how nervous investors might feel at the moment. Consider the following chart which shows the last two times the US Congress faced issues regarding the debt ceiling.


$VIX – The Volatility Index, weekly chart of closing prices

In August of 2011 prices fell dramatically as investors panicked over the news regarding the debt ceiling and a subsequent downgrade in the rating of US debt quality. By comparison the current market action over the fiscal cliff hullaballoo is extremely mild. Not only did this mini-panic fail to register a new high on the VIX, but its resolution dropped the index back into the territory of its lowest levels of the past 18 months.

This reading is quite bullish because it means that investors don’t want to spend money buying insurance against a market fall. And when investors don’t believe a market is likely to fall in the near term, it usually doesn’t. At a minimum it takes several weeks to change their mind. Almost all major bear market cycles have been preceded by a noticeable rise in VIX levels in the weeks leading up to the downturn. So far we are not seeing that evidence.

By Gordon Scott, CMT, Learning Markets Analyst