SPX At Support, Time To Buy Or Sell?
The S&P 500, referred to by the trader types as the SPX, rebounded from a key support level Wednesday. The index represents the 500 largest publicly traded stocks on the U.S. exchanges. In other words, it's a good representation of the broader market. Let's take a closer look at the SPX.
Levels: Where's my risk?
The SPX's rebound from 1126 Wednesday was meaningful for that level has served as support on seven separate occasions in the last four weeks. Not exactly 1126, but in that general area. Let's call it 1127.50, plus or minus 2.50. You get the point.
The seven observations: 11/16 at 1129, 11/21 at 1129, 11/28 at 1128, 11/29 at 1125, 12/03 at 1125, 12/04 at 1128, and Wednesday at 1126. What's so special about the level? Maybe a simple retracement bracket can lend a hand.
Using the SPX's high in late-May around 1315 as my top anchor point, I've anchored the bottom of the retracement bracket at the SPX's September 21 low around 944. It looks like this:
Before elaborating on the 1127.50 area, let me give this bracket credence. Through the month of October, the SPX gyrated around the 38.2 percent retracement level around the 1085 area. It spent the month consolidating around 1085. At that point, the SPX had retraced 38.2 percent of its decline from late-May until September 21. The SPX then went on to break out of its range in early November, advanced past the 1127.50 area, and reached as high as 1173 on December 5. Does anybody else find it curious that the 1173 level is also the site of the SPX's 61.8 percent retracement level? Coincidence? I think it not. This bracket works.
Here we are back at the 1127.50 area -- the 50 percent retracement level of the bracket. As I previously pointed out, the 1127.50 level has provided support seven times during the most recent consolidation. Will the SPX rebound again and retest relative highs around 1173? If you're betting that way, at least you can measure and manage your risk relatively easy with the retracement bracket.
It works like this: You've identified support in the SPX at 1127.50, you've observed that the level has provided support on six occasions in the past. You buy your favorite STRONG stock on a bet that the SPX will again rebound from 1127.50 and trade higher over the short-term. If you're wrong, and the SPX cracks at 1127.50, then you can stop out of your bet quickly and minimize losses. Since the SPX has traded plus or minus 2.50 points around 1127.50, you would need to set a lower mental stop in order to weed out the whipsaws. Currently, I'd consider a decline below 1120 a break of the 1127.50 support area.
If you're right in buying at the 1127.50 level and the SPX trades higher in the short-term, you can use the retracement bracket to define your exit point. The obvious level to turn to is the 68.2 percent retracement level at 1173.
But, what if the SPX breaks down? A breakdown below 1127.50, again confirmed with a decline below 1120, could have the SPX trading lower over the short-term. Risk is more difficult to measure and manage when trading breakdowns (or breakouts for that matter). The reason is because the majority can see and will be in on the move. Where there's more participants there's more emotion, not to mention the fact that there isn't a meaningful resistance level immediately above the 1127.50 area to be used for a mental stop. In these type of cases, it's best to use a dollar amount- or percentage-based stop on bearish bets.
While the retracement bracket isn't a lot of help in measuring and managing risk in bearish bets, it clearly defines a downside target at 1085. Remember the 38.2 percent retracement level that the SPX gyrated around in October? That's your downside target on shorts/puts entered on a break below 1127.50.
What's In It?
The SPX is divided into ten industry groups: Energy, Materials, Industrials, Consumer Discretionary (Retail), Consumer Staples, Health Care, Financials, Information Technology, Telecom Services, and Utilities. Information Technology currently accounts for 18.83 percent, Financial accounts for 17.79 percent, and Health Care accounts for 14.36 percent of the SPX. The three are the biggest by far.
If the SPX is going to trade higher after its bounce from 1127.50 Wednesday, it will need participation from at least two of its big three industry groups.
Technology was the only group that participated in Wednesday's rebound. Within technology, Hardware, Software, Box Makers, Internets, Semiconductors, and Disk Drives were higher. Only Networkers finished lower within the group.
For the technology group, readers can use the Philadelphia Semiconductor Index (SOX). Curiously, the SOX rebounded from a key support level Wednesday in similar fashion to SPX. The SOX rebounded from 560, which is now a double-bottom in the index.
The SOX, however, has traced a pattern of sequentially lower highs since peaking on December 5 -- the same day the SPX hit its relative high. The SOX has fallen into a very short-term descending trend, which remained intact even after Wednesday's rebound. (Some technicians might refer to the SOX's recent price pattern as a flag or pennant.)
If the pattern of lower highs persists, the SOX may breakdown below its double-bottom at 560. Such a breakdown would be signaled with a decline below the 555 level. Any breakdown of the sort would add conviction to betting on a breakdown in the SPX below its support level.
After the bell, Applied Materials (NASDAQ:AMAT) reported that it was eliminating 1,700 jobs. The company is the world's biggest maker of semiconductor equipment and is one definitely worth monitoring as it relates to the SOX. Shares of AMAT shed about 40 cents in the after hours session on the news of the job cuts.
Within the financial industry group, only the insurers traded higher during Wednesday's rebound. Banks and brokers finished fractionally lower.
The bank sector is perhaps one of the better gauges of the health of the economy and can be tracked through the KBW Bank Sector Index (BKX). The BKX ran higher about two weeks ago, but has since slid lower.
There are several issues at play in the sector that may be pressuring the BKX. Fears continue to linger over Argentina and the country's troubled financial situation. And the Enron fiasco isn't helping. Citigroup (NYSE:C) and J.P. Morgan Chase (NYSE:JPM) -- the two biggest components of the BKX -- have a significant amount of exposure to Enron. But a panel of Enron's creditors, including Citi and Morgan, convened Wednesday to sort out the company's debts. If all goes well, Citi and Morgan will get back part or all of the $1.5 billion the two banks recently injected into the troubled energy trader. Such a development could ease fears and lend strength to the BKX, thus propping up the SPX.
Away from the micro concerns, the macro environment is shaping up well for the bank sector. The yield curve is incredibly steep, which allows the banks to borrow at the short-end and lend at the long-end, thus capturing the spread and printing money in the process. The steep yield curve, which reflects a rebound in the economy, is a huge element of bullishness for the banks. Indeed, the trough of a business cycle is the right time for money-center banks such as Citigroup. The prospects of a recovering economy next year could translate into an elimination of bad debts and a boost to the balance sheets of many banks.
But the aforementioned fears are holding back the BKX in the short-term. The index has been struggling to advance past its 200-dma since peaking in late November at the 865 level. The BKX again rolled over at its 200-dma following the Fed's decision to lower rates Tuesday. An advance in the BKX could portend a run on relative highs and a subsequent breakout. Of course a breakout in the banks would boost the SPX. In the meantime, I think the banks make sense on weakness; or, a good sector to consider buying on weakness.
Healthcare, for all of its defensive attributes, has been one of the more volatile sectors of the SPX recently. I define the broader healthcare industry through the AMEX Pharmaceutical Index (DRG), the AMEX Biotechnology Index (BTK), and the S&P Healthcare Index (HCX). The HCX is the best representation of the broader sector. It includes medical device makers such as Guidant (NYSE:GDT) and HMOs such as Humana (NYSE:HUM). If you had to monitor only one index in the healthcare sector, it should be the HCX for its breadth; it includes pharmas and biotechs.
The three (DRG, BTK, and HCX) all finished lower Wednesday. The biggest drag on the DRG was shares of Merck (NYSE:MRK). The stock continued lower in Wednesday's session a day after the company warned on '02 financial performance. A slew of downgrades and earnings estimate reductions pressured MRK and others in the DRG Wednesday. Bristol-Meyers (NYSE:BMY) and Schering-Plough (NYSE:SGP) were knocked down patent expiration fears.
The BTK has had its share of weakness recently. The group went from one of the strongest in the market to a relatively weak sector recently. There's been several reasons why. First, a disappointment from Protein Design Labs (NASDAQ:PDLI) -- a component of the BTK -- sent the stock sliding lower. The company reported disappointing results for two of its developmental drugs. Second, several mergers have been frowned upon by the street, most notably the Millennium (NASDAQ:MLNM) and Corr Therapeutics (NASDAQ:CORR) marriage. The acquirer, Millennium, has seen its stock drop by more than 30 percent since announcing its merger plans, including another five percent drop Wednesday.
HOWEVER, like the SOX, the BTK is near a very meaningful support level. Using its relative low in late-September as the bottom and its recent high up around 625 as the top, I've laid a retracement bracket over the BTK's recent rally. The 38.2 percent retracement level sits at 540 -- a super serious support level. I think the stronger biotechs can be played on a bet that the BTK bounces from 540. If it doesn't, a tight mental stop can be placed at 530. For if 530 is broken, the BTK is likely to head much lower over the short-term and in doing so, pressure the SPX. But it's a relatively low risk (assuming you manage risk with the 530 level), potentially high rewarding situation.
Which are the stronger biotechs? Millennium is not. Neither is Protein Design Labs. Of the components of the BTK, Immunex (NASDAQ:IMNX) and IDEC Pharmaceuticals (NASDAQ:IDPH) are among the stronger. While not a component of the BTK, Myriad Genetics (NASDAQ:MYGN) is another that trades well.
Into The Unknown
The future is unknown. As traders, we operate in an environment of uncertainty, of risk. It's only after that risk is identified and managed should a trade be entered. Not all risks are foreseen. Not all risks can be managed. But the risks that are easily observed and managed should be observed and managed. If you take the step of identifying the easy risks, then you're better than 90 percent of the players in this game.
The risk in being bearish on this market is that the banks could blow-up to the upside. After all, they are primed for such a move at this point in the business cycle. The risk is being bullish on tech stocks is that the SOX could breakdown below its double-bottom, sparking a sell-off across the broader tech space. Will either of the aforementioned events occur? I don't know, but you're better-informed by knowing where the risks are. In the process of finding the risks, you begin to identify opportunities and piece together the puzzle that is the market. Why was the SPX higher Wednesday? That's an easy one: techs were higher. Will the SPX continue higher Thursday? You can find the answer through the process of risk management.