Market Internals

Introduction

Did you expect the typical small-range day after a big-range day such as Friday's? If so, the markets produced the action you expected on some indices typically watched. Most indices produced small gains or losses either side of the flat line. However, a late-day short-covering run up changed the shape of the candle on another much-watched index. What does it mean?

Last week, geopolitical developments delivered two shocks to the markets. Those shocks came in the forms of an unanticipated Supreme Court decision and a possible shift in tenor in the eurozone negotiations. This morning, markets received another shock in the form of U.S.'s ISM Manufacturing PMI. That PMI dipped into contraction territory. The U.S. produced its first ISM Manufacturing level below 50 since the summer of 2009.

ISM Manufacturing PMI:

Long before the ISM released its U.S. Manufacturing PMI, other PMI numbers appeared across the globe last night. The reports had started out with a slight hopeful note, a glass half-full aspect. Australia and Japan led the lineup of manufacturing indices for the week. Australia's index measured 47.2, still in contraction territory but well above the prior 42.4. This was Australia's fourth month in a row with numbers in the contraction zone, however.

The number 50 might mark the benchmark measuring contraction versus expansion in Australia as well as many other countries, but the number 0 serves as the benchmark for Japan's important Tankan Manufacturing Index. Like Australia's report, the Tankan was also in contraction territory, at -1 in this case, but that small negative number was well above the forecast -4 and the prior -4, too. The Non-Manufacturing Index measured 8, above the predicted 6 and the prior 5.

As those seemingly better-than-expected numbers appeared, the Nikkei 225 futures turned lower. The focus appeared to be on the continued contraction rather than the better-than-expected aspect. The Nikkei 225 was to close lower by 0.04 percent, at 9003.48. That close was well off the opening high of 9103.79.

The night's slate of manufacturing numbers continued when China's HSBC Final Manufacturing PMI came in at 48.2, slightly above the preliminary 48.1 but below May's 48.4. That was the eighth report in a row for China showing sub-50 levels. Weakness in new orders and employment dragged the index lower. The Shanghai Composite dropped into negative territory a couple of hours after its open. In what turned into a volatile trading session, it then climbed well into positive territory before settling back to close at the flat line, up only 0.03 percent. The Straits Times closed higher by 1.12 percent; the Hang Seng, by 2.19 percent.

European trading started mixed but European bourses soon climbed, buoying our futures. The UK and Final eurozone PMI's were both above expectations, although both remained in contraction territory, at 48.6 and 45.1, respectively. Yields on Spanish 10-year notes were testing and perhaps even edging just beneath a rising trendline upon which they had been climbing since March 1. That was the climate into which the U.S.'s two manufacturing reports appeared and U.S. cash markets opened.

Monday's Developments

Among today's big economic events in the U.S. were Markit's Final Manufacturing PMI (Purchase Managers Index) at 9:00 am ET. As is usual, Thompson Reuters subscribers obtained that information two to five minutes ahead of the rest of us.

Futures did not at first react when the final 52.5 number slipped below the most recent forecasts of 53.0. Perhaps that's because just last Friday, forecasts led market watchers to expected a lower 46.7. Perhaps they were just more interested in a more familiar release that would be coming an hour later and glad that the Markit version showed values above 50. They might have remained concerned enough about some aspects of the report to prevent reacting with relief.

For example, the prior June number had been 52.9. A further drop was apparent in the final number. When compared to May's 54.0, the change became more visible. Bullet points for this release included a slowing of growth in employment, new orders and output and a "first fall in input prices since June 2009." New export orders, backlogs of work, output prices, input prices, stocks of purchases, stocks of finished goods and suppliers' delivery times all figured among the categories that fell into contraction territory, below the benchmark 50.

Terms such as "slowest rate of growth since last October" were sprinkled throughout the report. Despite those terms, the lower-than-expected numbers, and the initial lack of reaction in futures, U.S. equity futures found something reassuring and bounced back into positive territory.

Often given more attention than the Markit number, the Institute of Supply Management released its Manufacturing PMI and Manufacturing Prices at 10:00 am ET. They delivered a jolt that stalled early equity gains. The RUT had topped 800 in early trading, for example, but it quickly dropped back to 797.68 before steadying for most of the day. The end of the day was to change that pattern.

Expectations had been for a drop to 52.1 from the prior 53.5, with 50 as the contraction/expansion benchmark. Instead, the PMI dropped to 49.7, into contraction territory, as the earlier chart showed. Manufacturing prices dropped like a malfunctioning elevator to 37.0, well below both the expected 45.8 and prior 47.5.

The Institute for Supply Management's report included some bright notes, with bullet points noting that new orders and inventories both contracted, but that production and employment were growing and supplier deliveries occurring faster. Production measured 51 percent and the employment component, 56.6 percent.

Still, those bright points could not conceal the fact that the PMI decreased 3.8 percentage points and new orders dropped 12.3 percentage points, to 47.8. This is the first time new orders contracted since April 2009, the ISM commented. Raw material prices contracted sharply. Some purchasing managers replied to the survey with continued optimism, the ISM report noted, while others expressed concern that economic uncertainties in China and Europe could continue to soften demand. The comments section appeared to be more optimistic than the numbers.

Seven out of 18 industries reported growth but nine of the 18 reported contraction. Inventories were deemed "too low" by the ISM, which could indicate that if the demand doesn't soften as much as manufacturers worry that it could, production would need to quickly gear up another notch. Reading inventory levels and their impact into the future can be a changeable task.

ISM might have overshadowed construction spending. Experts had predicted a 0.3-percent rise to follow the prior 0.3-percent climb, but the Commerce Department reported much more optimistic numbers. The prior report was revised to an 0.6-percent gain, and the May report tagged at a 0.9-percent rise. This was termed the largest increase for this year. Private construction strength was not matched by the government sector, however, with government construction spending dropping 1 percent, the fifth straight month of declines in government spending.

At 1:15 PM ET, Federal Reserve Bank of San Francisco President John Williams participated in a panel discussion in San Francisco, with the title "Federal Reserve Monetary Policy Since the Financial Crisis." Since Williams serves as a 2012 voting member of the FOMC, some attention focused on his comments. He termed worries about hyperinflation due to the $1.5 trillion in reserves to be an outdated worry. He anticipates that the Fed will raise rates on those reserves as it's raising the target federal funds rate and believes that coordinated action will keep the multiplier on the reserves "close to zero."

Some among you will agree with Williams; some will be doubtful. Market watchers across the globe certainly expressed doubt this weekend about the latest "plan to make a plan" to improve stability in the eurozone. This morning, a Reuters article reported that the Netherlands and Finland would act to keep the eurozone's permanent bailout fund from acquiring bonds in secondary markets ("Finland to block ESM secondary bond buying"). According to the information provided in the article, employing the ESM to buy bonds from secondary markets would require unanimity.

Despite that wrinkle in the eurozone plan, European markets closed solidly higher. The FTSE 100 gained 1.25 percent; the DAX, 1.24 percent; and the CAC 40, 1.36 percent.

Story stocks included many in the pharma space, including Amylin Pharma (AMLN) and Bristol-Myers Squibb (BMY). BMY will acquire AMLN for $31.00 per share in cash. Both boards have unanimously approved the acquisition. The deal appears a complicated one with contractual payment obligations to Eli Lilly (LLY) also worked out, and the intention of BMY and AstraZeneca (AZN) to collaborate on commercialization and development of AMLN's products after the acquisition has been completed.

The similar-sounding Amarin (AMRN) was also in the news. The company received a notification of a Notice of Allowance for a patent related to AMR101, the company's primary product for treatment of high triglycerides. In other news in the sector, Linde Group will acquire Lincare Holdings (LNCR) for $41.50 per share. This was 22 percent above the last session's closing price. NuPathe (PATH) investors did not like its new date for resubmission of its migraine patch.

Dell (DELL) acquired Quest Software (QSFT) for $28 per share. The premium was only slightly higher than Friday's close since this acquisition appeared to be in the works. Micron (MU) acquired Japanese chip maker Elpida. Amazon's (AMZN) cloud service experienced some disruptions this weekend due to storms.

Let's look at charts. Last week, the chart setups suggested that a few days of choppy consolidation might occur within a "noisy," chop zone, with prices waiting for an end-of-week catalyst to break them out. That's what happened. Such setups unfortunately make no predictions about the direction of the eventual break but they did give us some prediction of when the break would occur. It came right on target last week.

New rising regression channels could also be drawn by last Monday. Those were displayed on the charts, but it wasn't yet clear whether those were valid formations to watch.

The prior week's action shows their validity. Now we know to watch them for potential support and resistance. New bulls do not want to see those rising channel support levels breached. Such action would suggest that they're nothing more than bear flag formations. Whatever happens, chart watchers now have easier benchmarks to watch. Unfortunately, the dissimilar performances of indices such as the Dow and the RUT don't give us confidence in predictions of how the markets will behave when approaching the tops of those regression channels.

Charts

The RUT was the only one of the indices usually covered in the Monday Wraps that made it all the way to the top of its new rising regression channel. However, others, like the SPX, rose high enough within that channel to give the channel validity.

Annotated Daily Chart of the SPX:

On a Keltner basis, the SPX seemed to find resistance again at the top of its smallest Keltner channel, pausing at the test of the channel as it did last week. For now, nothing in the Keltner outlook precludes an eventual test of the top of the rising regression channel, with a current potential upside target near 1392-1394. However, maintaining that potential upside target depends on what happens on pullbacks.

Why am I speaking about pullbacks? After a big-range day such as Friday's, prices often trade in smaller ranges, digesting gains (or declines, if the range was to the downside). The large candle and the small-bodied candle or doji together make up two candles of a potential three-candle reversal signal. The small-bodied candle could also just be sideways consolidation before another rise. Nothing in the SPX chart tonight provides a definitive answer, particularly with the small-bodied candle being produced at resistance.

The action has to be waited out, perhaps even with another day of sideways consolidation. The more days of sideways consolidation, the more likely it's consolidation before another bounce toward the top of that rising regression channel rather than a reversal signal in the making. One day of consolidation does not give chartists any kind of prediction. Tomorrow or Thursday could produce a pullback instead of a gain.

If the SPX is strong and bulls firm, the SPX will find support on daily closes at or above the 9-ema and other support levels converging from about 1333-1340. If that support is lost on daily closes, a retest of the bottom of the rising regression channel may be in order, with potential support extending down to just below 1300. Bulls want this level to hold on daily closes. Otherwise a retest of the June low may be suggested.

The Dow's setup parallels the SPX's.

Annotated Daily Chart of the Dow:

As with the SPX, the Dow did not yet reach the top of its rising regression channel but appeared to stall instead at historical and Keltner resistance. As with the SPX, the Dow's candle was a small-bodied candle after a big-range day on Friday.

The Dow still has in place an upside target at the top of that rising channel. Maintaining that bright outlook requires that the Dow maintain support on daily closes at or above the potential support converging near its 9-ema, with that support ranging from about 12600-12700. A failure to hold support at that level suggests a decline to the bottom of the rising regression channel and perhaps even to lower support ranging from about 12340-12460. Failure to hold that support, either, suggests that the rising regression channel was a bear flag formation. Failure to hold that support would have more bearish implications for the intermediate term than a move down through the channel and a bounce from channel support. For the immediate future, it would suggest a retest of the zone from 12200 down to the June low.

The NDX looked a bit weaker than either the SPX or the Dow by the comparisons we're studying. Like the other two, the NDX's price action produced the expected small-bodied candle after Friday's large-bodied candle. Also like the other two indices, the NDX did not test the top of its rising regression channel. Neither did it scramble above the 6/19 intraday high, as both the SPX and Dow managed to do during intraday trading. The NDX also never reached the top of its smallest Keltner channel today, but turned back a little ahead of that channel line.

Annotated Daily Chart of the NDX:

Whether those are just minor differences or a warning that the typical momentum stocks weren't getting the trust levels that the staid Dow and SPX big caps were getting remains to be seen. Otherwise, the chart setup was the same: a climb last week through a new rising regression channel and a potential upside target at the top of that rising regression channel, with a Keltner target near there, too. That setup also includes the admonition that maintaining the upside target requires maintaining daily closes above the support levels converging near the NDX's daily 9-ema. Those support levels now converge from about 2560-2580. The automatically drawn rising regression channel for the NDX is shaped a little different than that drawn for the other indices. The bottom of the channel nearly coincides with the multiple support types converging near the 9-ema. Perhaps it's drawn incorrectly or the NDX price action just produced a different setup. If that support is broken, a test of the bottom of the rising channel isn't far below. The channel now crosses just above 2545, and further support is just below that, at just above 2500.

Benchmarking the most important support becomes a little more difficult with the NDX, then. Which is the support that marks a failure of this rising regression channel. Certainly we know that a break of 2500 for more than a couple of hours intraday or at the close would signal a failure of that rising regression channel. That would suggest a retest of the June low.

As is often true of the RUT, this index charged up ahead of the other indices, touching the top of its rising regression channel in early trading. It's a lead-the-way kind of index. That's a good thing for bulls. If it had failed to lead the way to the upside, extra worry would be added for bulls.

Then there came the end-of-day push that complicated matters. The end-of-day push ensured that the RUT would not be part of the small-bodied candle crowd, since the daily candle was a sturdy full-bodied candle. Furthermore, the RUT clearly broke out of its rising regression channel to the upside, pointing out the possibility that other indices could do the same.

What are we to think, however, when this action occurred in the last few minutes of trading, with the RUT's last 15-minute candle producing a five-point gain all by itself?

I never completely trust end-of-day short-covering moves although that certainly didn't stop me from flattening out my upside risk when it was needed this afternoon, but this is the RUT and the RUT is sometimes a special case. Obviously, the RUT's move was outsized when compared to other indices, especially the staid Dow which produced the expected doji candle today. Does this RUT action presage fund manager's willingness to embrace more risk, feeling that markets are more settled or did some RUT component raise earnings expectations late in the day or were rumors of M&A activity in a component stock driving this move, triggering short-covering activity that will be reversed pronto tomorrow morning? My research did not uncover the reason for this outsized move in the RUT. We should remain cautious tonight about any predictions of new strength to come while remaining cognizant that the RUT does sometimes lead the way and this could represent some kind of asset reallocation.

The less-liquid RUT stocks could be the first dumped if some geopolitical event prompts fund managers to seek more safety. Perhaps by the time this newsletter is published, the reason for this outsized move will already be known, but I just could not locate a reason beyond the obvious reason that it broke out of the rising channel and was holding 800 as the end of day approached, perhaps triggering buy programs.

Annotated Daily Chart of the RUT:

The RUT currently has a potential upside target set by the Keltner channel system near 818-820. However, that target will seem a less viable one if the RUT cannot maintain daily closes above the top of the rising regression channel that it just broke above. The viability of that upside target becomes even more questionable if it can't maintain daily closes above the 9-ema and the other potential support converging near 777-783. If that support is lost on daily closes, a retest of 761-764 and maybe even the bottom of the rising regression channel, now near 750, may appear more likely than a rise toward 818. For now, it shows strength. You can't assume that it "has" to turn around and hold onto losing trades that you should dump. It doesn't have to do anything. I shook my head all the time I went about moving a butterfly and buying a call debit spread to flatten risk, but I performed both actions anyway, shaking my head or not. The position is safe overnight, but I'll close it down for a small loss or a small gain if the RUT continues upward and do some asset reallocation of my own. If the RUT then reverses and my trade would then have reached full profit potential, so be it. It's part of the business of trading.

Even before the ISM number had come in or our cash markets opened, articles had begun noting the flight to U.S. treasuries and a drop in yields. A Bloomberg article by Daniel Kruger pointed out that so far this year, bidders had offered $3.16 for each dollar of $1.075 trillion in Treasury auctions of U.S. notes and bonds, compared to offers of $3.04 for each dollar for 2011. Yields are being driven to record lows as the U.S. financial system appears more stable when compared to other systems across the globe. By the close of the European bond markets, the Spanish Ten-year Yields had bounced enough to close up by 0.046 at 6.375 percent, pointing to the differences in the yield behaviors on the two vehicles and the relative demand for the two. So far, this kind of action does not engender great confidence in an equity rally, but again, we trade what we find when we come to work.

Yields on the Ten-Year Treasuries:

Tomorrow's Economic and Earnings Releases

What about Tomorrow?

We'll be looking at 60-minute charts tonight.

Annotated 60-Minute Chart of the SPX:

The SPX stalled its climb this afternoon just below the morning's high and the smallest Keltner channel's potential resistance on 60-minute closes, near 1366. As long as the SPX maintains 60-minute closes above its rising red 9-ema, now at just under 1361, it maintains an upside target near 1370, but I would be protective of bullish profits if either that upside target is reached or if the SPX can't maintain 60-minute closes above that 9-ema. That caution is particularly needed if the SPX can't maintain closes above about 1355, as that sets a potential downside target near 1343. Other targets are marked, too.

Here's what the setup looks as if it might produce: a bounce attempt up toward 1370, although it's not certain that the SPX would get that far, a pullback, perhaps to 1361 and perhaps even lower, to about 1355-1356. Then, unless the SPX barrels lower through that zone, another bounce attempt might be the one that would tell us how strong the SPX rally might be. Remember that the SPX is approaching the top of a rising regression channel on the daily chart, and resistance might grow stronger as that's approached, too. I don't think we'll know how deeply the SPX will retrace through that rising regression channel until it begins to retrace, unfortunately.

Annotated 60-Minute Chart of the Dow:

The Dow did not pierce the morning high in the afternoon bounce, a bounce that seemed to be RUT specific. The Dow appears equally likely to fall back and retest the red 9-ema or rise to attempt to test the resistance marked at the green oval. Bulls want to see the Dow either rise into that test or else, if it pulls back, maintain 60-minute closes above the 9-ema or, failing that, support near the 12800 level. While the SPX appeared as if it might attempt an upward push, the Dow's 60-minute chart just doesn't produce the same impression, and that should question the SPX's chart, too. I checked the Dow's sister index, the transportation index ($DJT), and it certainly gave no confidence in the bounce possibility, and the SPX, OEX, and Dow often move in concert and often in the same direction as the transports.

Annotated 60-Minute Chart of the NDX:

While not as impressive as the RUT's chart, the NDX's 60-minute chart does display strong bounces from the red 60-minute 9-ema. That's just what bulls want to see to confirm the potential upside target now near 2640. Bulls want either an immediate push toward that upside target with pullbacks finding support on the 9-ema or else support found on 60-minute closes at that 9-ema if there's an immediate pullback. At any rate, bulls want support near 2600 to hold. Otherwise, there's the possibility of a drop to 2572-2586.

If the NDX rises immediately tomorrow morning, be aware that it's approaching the top of its rising channel on the daily chart. While the RUT pushed right through that channel and perhaps set the stage for other indices to do so, be especially wary if the RUT has dropped back through the channel.

The RUT's chart will be a busy one. In addition to the Keltner levels I usually study, I've included a Fibonacci bracket to help pinpoint levels to watch if the RUT should pull back immediately. It's in breakout territory, with no upside targets available on this chart. When this happens, it's in a momentum run, and it stops when it stops and not when a chart says it might. However, bulls should always be cognizant that prices may be forging ahead on waning strength.

Annotated 60-Minute Chart of the Russell 2000:

We can see the importance of the 60-minute 9-ema (red) on this chart, and if we extended it back further, we would see that the RUT often trends higher on the back of this moving average or that of the 30-minute version. Something happened when the RUT pushed through 800 this afternoon, and whether a late-day rumor spiked the price and then triggered buy programs that will be unwound first thing tomorrow morning or whether the RUT's strength presages more strength on other indices, I don't know. It's clear that we should watch the RUT tomorrow for clues, although it may be Thursday before we get a good feel for what's happening. Tomorrow may be about holding the prices steady ahead of the early close and Wednesday's holiday. It could be a throwaway day as far as meaningful price action.

You can see many convergences of Keltner and Fibonacci levels on this RUT chart, and they should be watched for potential support on pullbacks. If the RUT pulls back, support near 800-801 looks strong, as does support near 797. If the RUT sustains 60-minute closes beneath 794, however, I would consider the possibility of a stronger pullback, to at least 789-790 or perhaps even 783-785.

In addition to watching the RUT, I would put the RLX, the S&P Retailers, on my radar screen. The RLX also rises on the back of its rising 60-minute 9-ema and the strength of the retailers says something about the perceived strength of the economy. With car sales to be reported tomorrow, the RLX may give us insight into how investors weigh today's disturbing ISM news against other news. Are they still shaking off bad news? Bouncing when they get good news? Or doing the opposite?

Happy Independence Day a day late to our Canadian subscribers. Happy July 4th to our U.S. subscribers a couple of days early!