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INDEX INTELLIGENCE: SPX—Time to Test the Waters?
By Frederic Ruffy, Optionetics
4/14/2005 4:45 PM EST

http://optionetics.com/articles/article_full.asp?idNo=12248

Unless you stepped away from the markets, you probably heard the news: the Dow Jones Industrial Average ($INDU), the Nasdaq Composite Index ($COMPQ), and the S&P 500 Index ($SPX) all fell to 2005 lows today. The new lows follow a relentless two-day sell-off that has pushed the S&P 500 Index down 25.7 points or 2.2%. The index has tumbled more than 5% since early March. Now, some might wonder if this pullback has created a buying opportunity. That is, is it a good time to look at some of the beaten down stocks or sectors and begin testing the waters?

To some market watchers, the recent market decline might seem a bit overdone. After all, during that time, the news hasn’t been that bad. Yes, retail sales figures released Wednesday were a bit weaker than expected. Apple Computer (AAPL) did issue an earnings warning today. And oil prices remain above $50.00 a barrel.

However, there have been a few bright spots. For instance, several companies including McDonald’s (MCD), Pepsico (PEP), and Southwest Airlines (LUV) have posted solid earnings reports during the past two days. The economic news Thursday wasn’t all bad. For example, the Labor Department reported that weekly jobless claims declined by 10,000 in the week ended April 9. In addition, while oil remains above $50.00 a barrel, at $51 and change, crude is well below last week’s all-time highs of $58.28.

Yet, although the news is not altogether bad, investors are clearly focusing on the negatives. The retail sales numbers highlighted a growing concern that the economy is weaker than expected. Part of this is due to high oil prices. Investors might want to see a sustained period of lower oil prices before assuming that rising energy costs won’t slow the economy. Meanwhile, other worries such as the Fed’s recent rate hikes and the slowdown in corporate earnings continue to weigh on the market. As a result, stocks are falling and, as we can see from Figure 1, the S&P 500 Index is not only falling to the lows of the year, but it is in danger of violating its two-year uptrend.

Figure 1: Weekly Chart, S&P 500

This week’s market decline has not only pushed the S&P 500 index towards critical support levels, but it has also caused a noticeable uptick in investor anxiety. During the past two days, the CBOE Volatility Index ($VIX) has skyrocketed from 11.30 to 14.53. As we can see from figure 2, the VIX is also in danger of violating its two-year downtrend. It fell to new fifteen-year lows in mid-February (although the Relative Strength Index [RSI] did not confirm those lows), but on Thursday, the volatility index produced one of its highest closing readings of the year.

Figure 2: Weekly Chart, CBOE

One important reason why the S&P 500 Index has been getting hammered while the volatility index has spiked higher is due to the nature of the recent sell-off. It has been broad with, for example, the Dow Jones Transports ($TRAN) down 5.6%, the GSTI Computer Hardware Index ($GHA) off 5%, and the PHLX Semiconductor Index ($SOX) hit for a 4.2% loss. Investors fled the cyclicals, brokers, energy and any other sector that might be sensitive to the economic slowdown. Only the pharmaceutical stocks escaped the two-day decline unscathed.

The market decline since March, which seems to have accelerated during the past two days, has also taken a toll on the New York Stock Exchange Advance/Decline line. The indicator is plotted in figure 3 and is simply the running total of advancing issues minus declining issues on the New York Stock Exchange [NYSE]. It is a measure of market strength. Since January 2003, the NYSE Advance/Decline line has been in an uptrend and confirming the move higher in the S&P 500 Index. Now, however, it too is in danger of violating its trendline support.

Figure 3: Advance/Decline Line, NYSE

In conclusion, the market might be an important turning point here. The S&P 500 Index might be breaking through two-year trendline support, while the two-year downtrend in the VIX and two-year uptrend in the NYSE Advance/Decline both seem quite fragile. If they fail to hold, the stock market might continue to behave as it has during the past two days, which would mean lower stock prices, higher volatility, and a painful summer for the bulls. And, therefore, probably not a great time to go testing the water.



Frederic Ruffy
Senior Writer & Index Strategist