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Saturday, August 4, 2007

Markets are in a correction now

Markets have been down three weeks in a row now. For those of you who use the TradeRadar software, I'm sure you're seeing SELL signals all over the place.

I often check ETFs to gauge the health of various sectors as well as the overall market. After this run of bad news it seems like a good time to take a more comprehensive look at the markets.

SELL signals everywhere

Today I looked at ETF performance over two time periods: from the June-July 2006 low point to the present and from the early-March 2007 low point to the present.

The ETFs corresponding to the major indexes (DIA, SPY, QQQQ, IWM) are all showing TradeRadar SELL signals with about 80% strength over the longer time period and about 70% strength over the shorter time period.

I consider 80% signal strength to be pretty significant and 60% to 70% modest.

I keep reading that tech is holding up pretty well so I checked a group of tech ETFs. Networking: IGN and PXQ -- modest SELL. Semiconductors: IGW, SMH and PSI -- not quite a SELL signal yet. Software: IGV and PSJ -- modest SELL. Broadbased tech ETFs: MTK, XLK, IYW and VGT -- outright SELL with XLK the worst of the bunch. Even the global tech ETF IXN is flashing the SELL signal.

I don't need to go into detail to describe how financials (XLF, KBE) and real estate (IYR, ICF, XHB) are absolutely buried in the SELL zone. They have been down for months.

How about energy ETFs? Both US (XLE) and global (IXC) ETFs are flashing a modest SELL signal. Equipment and services ETFs (IEZ, XOP, OIH) are showing a weak SELL. This is in spite of the fact that USO and DBE have been trending up. Even the "green" and alternative energy ETFs (GRN, PBW, PZD) have been suffering.

Healthcare? IYH and XLV are also showing modest to strong SELL signals.

Retail? Consumer Discretionary (XLY) and Consumer Staples (XLP) are also flashing the SELL.

I could go on but you get the picture. There seems to be no place to hide in this market with all the indexes and most sectors rolling over. TradeRadar is not the only indicator flashing SELL. Pretty much all the ETFs listed above have fallen below their 20-day moving averages and most have fallen below their 50-day MAs as well.

More Concerns

Another area of real concern is the fact that two major market averages have now fallen below their 200-day moving averages and, to make matters worse, for both indexes the 20-day moving average is now crossing below the 50-day moving average.

First the Russell 2000 broke down. This week, Friday saw the S&P 500 actually close below its 200-DMA.

These negative technical events will trigger some traders to begin taking defensive actions which could easily include selling stocks, which would push the averages down even further. The only saving grace is that with the S&P only about 1% below its 200-DMA, there is a good chance the majority of investors will take a wait and see attitude. This is the fifth time the S&P 500 has dipped below its 200-DMA during the last four years. Previous times it recovered and moved on to new highs. What will happen this time?

Three Potential Scenarios

There are a three scenarios that could play out now.

1. Bear Market

Scenario -- the fact that two major averages are engaged in bear moves and many sectors look nearly as bad may indicate the market is heading significantly lower.

Likelyhood -- LOW: There are signs the economy is slowing but on the whole, it doesn't look too bad. Core inflation is still under control, joblessness hasn't ticked up significantly, the consumer is still shopping. The stock market doesn't look like it is exhausted from a big buying binge. We seldom get bear markets after the markets have climbed a wall of worry as they have been lately. Though markets have fallen recently, most of the averages are still positive for the year.

2. Correction

Scenario -- We are now well on the way to a 10% pullback, the common definition of a correction. Issues in the credit and bond markets will eventually clear themselves up without crippling the economy and the market will resume its rise after a few months with some of the buy-out related excess shaken out.

Likelyhood -- HIGH: The Russell 2000 has already fallen 10% from its highs and the S&P 500 and the NASDAQ have fallen more than 7% already. The Dow has only fallen 5.8% from its high. We could see the markets drift lower over the next month or two as the other averages give up some more ground. The reasons that make me believe we won't see a bear market (signs the economy is slowing but not too much, core inflation under control, jobs OK, consumer still shopping) are the same reasons why I think that a correction will occur followed by the market moving to new highs. In addition, the international economy remains robust and US companies that are exporting or otherwise doing business overseas will continue to benefit.

3. Snap-back Rally

Scenario -- the bad news from hedge funds and the credit market eases, the Fed says some kind words about economic growth and the market engages in a snap-back rally from what are clearly oversold conditions.

Likelyhood -- DOUBTFUL: there is too much fear in the market about what the next round of bad news from hedge funds, banks or ratings agencies will be. Credit is tightening. The market is weighed down by the under-performance of the financial and real estate sectors. It is unlikely the Fed will deviate from their inflation fighting stance with food and energy prices at worrisome levels.

Conclusion

Look for sectors that have the best potential to bounce back when the correction runs its course. Tech still looks good to me. Is there an opportunity in the beaten down financial sector? Keep an eye out for a reversal there. With continued strength in energy prices, we could also see those ETFs rise from current levels.

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