Off to the Races

With many traders (myself included) looking to see if Friday’s close above 1,100 on the S&P 500 was more than just a head fake, the index continued its July rally and closed the day at 1,115.01, up 1.12%.  Volume remained tepid as a mere 3.4 billion shares traded hands on the index.  As has been the case for the past couple of weeks, strong earnings reports and improving guidance from corporate managers continue to drive share prices higher.  Closely watched FedEx, in particular, got the day off to a positive start as it raised its earnings guidance for fiscal year 2011 to $4.60 to $5.20 per share, which was a marked improvement from the $4.40 to $5.00 range that was previously provided.  With a technical breakout now firmly in place, there’s not a lot out there to keep the S&P 500 from moving up to the 1,130 level in relatively short order.  But as I’ve said before, the fact that volumes remain depressed further reinforces the notion that this rally lacks conviction and is more prone to a change in sentiment than an otherwise fully-participated market.  With this in mind, good risk controls will be even more important to successfully navigate this market.

As a confirming signal for this equity rally, Treasury bonds saw the selling pressure that began last week carry through today’s session as well.  The 10 year bond now stands at 3.02% while the 30 year is sitting at 4.01%.  These yields are a long way from the levels seen just three trading sessions ago and are a testament to just how quickly investor sentiment can change.  The U.S. dollar also saw selling pressure on the day as the Dollar Index finished down 0.53% to 82.029, right on top of its 200-day exponential moving average.  Despite this weakness, though, gold finished the session relatively unchanged, making any already perplexing market all the more convoluted.  For a commodity that was as highly correlated to the U.S. dollar as gold was just six months ago, the inverse relationship seems to have been completely nullified of late.  Lastly, Asian equity markets finished their trading days in a positive fashion (South Korean KOSPI Index finished up 0.63%), which was a bit of a surprise as I would have expected the heightened tensions on the Korean peninsula to have cast a pall over regional markets.  That said, I still believe it’s worth remaining defensive in your exposure to the region at least until the U.S.-South Korean maneuvers are completed and the threat of inadvertent confrontation dies down.

With the equities markets leaning to the bull side of the fence for the time being, I decided to take a look at what areas of the market seem most likely to benefit from this sentiment profile.  This morning’s earnings from FedEx caught my eye and centered my focus on the Transportation segment of the equity market.  As a group, transportation companies are looked upon as leading indicators of market performance since their businesses are built around the commerce that economic growth generates.  And as UPS and FedEx earnings have shown, their businesses, for now, are growing in a solid manner.  Whether or not this growth continues is, of course, the big question that will have to be answered at some point in the future.  For now, though, it appears that investors are willing to place more weight on the outlooks provided by management than the economic data points that have been released.  So with this in mind, I decided to take a look at the charts related to the Dow Jones Transportation Index to see what, if any, signal it may be providing.

As can be seen in the chart below, there is a confluence of technical indicators here that suggest a move higher in the coming weeks.  Let’s walk through them one by one.

1.    Channel Breakout:  As was the case with the S&P 500, the Transports have broken the upper bound of the price channel that had been in place since April.  This upper trend line should now act as support to the index.

2.    MACD:  The Moving Average Convergence Divergence has been on a sell signal since April.  However, as you can see in the above panel, the oscillator is beginning to turn upward and cross the red indicator line (bullish signal).  Additionally, this turn in the MACD is coming above the 0 line (in the middle of the panel with bar sticking out of each side).  Breaking below this 0 line would, in itself, been a bearish indicator, so the fact that the turn is coming just above this level is an additionally bullish factor.

3.    Price Above 200-Week Average:  For years, traders have looked upon the 200-period averages as signals of coming price movement.  In this case, the Transports have moved above their 200-week exponential moving average (red line in price panel), which is a bullish signal.  The fact that the 50-week average (blue line in price panel) is also above the 200-average is further confirmation of this signal.

4.    RSI Divergence:  While this indicator did not work well in putting on my previous short, I still find it is right a lot more than it’s wrong.  In this case, we have the same type of signal, but with an upside projection rather than a downside projection.  As can be seen from the price levels denoted in the chart, the Transports made a pair of higher lows that corresponded with lower lows in the RSI.  Again, taking the difference between the RSI prices corresponding with the RSI lows and adding it to the price associated with the intervening RSI high, a price projection of 4,941.72 can be developed.  If correct, this suggests that the Transports will see a rally of just over 10% from today’s close.  And with the speed at which equity markets are moving of late, such a run could come quite quickly.  To be fair, this would mean that the Transports would take out their April highs, which, to me, seems unlikely, but given the thinness of this market, a quick move up isn’t outside the realm of possibility.

These positive technical factors coupled with both light trading volumes and overarching bullish sentiment, suggests to me that buying the Transports on a pullback may prove to be winning trade in here.  Using something like the iShares Dow Jones Transportation Average ETF (IYT) would be a great instrument to use.  I will be looking to add this position in just this manner tomorrow should the market stall.  (The Transports have been up five of the past six sessions, so a pause of some kind is certainly warranted.)  On the upside, I’ll be looking at resistance coming in around 4,750 and support around 4,100, which gives me about 8.50% downside risk versus 6.00% upside (about 10% if the projection is correct) from current levels.  To improve this profile, look to buy on weakness to improve the risk/reward ratio.  For those looking to take a little more risk, think about buying calls instead of an outright position in order to take advantage of the lower volatilities.  The $81 and $82 strike September calls, in particular, look quite interesting given that their implied volatilities are at or below 23%.

Despite my bearish stance on the equity markets over the next couple of years, there is no doubt that there will be sizable bullish and bearish moves along the way.  As I’ve spoken about before, technical analysis can do a lot to give us insight on where the market is likely to go and, thereby, make a little money along the way.  However, the fundamental challenges that the global economy faces during the back half of 2010 means that we must be sure to cover our downside risks first, rather than be concerned about missing a portion of the higher moves.  It is this perspective that has driven my decision to be a Transport buyer on weakness rather than a pure momentum buyer.  At the very least, it shrinks the amount of room between entry price and the stop-out point.  If I’m never able to get in the trade because things run away, fine.  There will be other opportunities.  But for now, it looks like things are headed higher and there’s enough room on the upside to warrant at least a little bit of long exposure.  Until tomorrow…..