A Lower S&P by Yearend?

Technical analyst Paul Cherney of Cherney Market Analysis sees it that way. Here he explains why, and where he thinks investors should look now

The history of the stock market suggests that, on the numbers, this will be a down year, says technical analyst Paul Cherney of Cherney Market Analysis. Specifically, he sees the Standard & Poor's 500-stock index ending the year 5% to 9% lower than where it began in January.

Cherney bases his forecast on a study of the first year of a Presidential term following two consecutive yearly gains in the S&P 500. That would mean a close for the index between 1159 and 1103 -- it's currently at 1198. Under these conditions, Cherney suggests investing in defensive issues such as health care and in energy because of global demand.

As a technical analyst, Cherney looks primarily at buying and selling demand and at his charts, but he also tracks market fundamentals, looking for consistent patterns of price behavior and of market volume.

These were a few highlights of an investing chat with Cherney presented June 9 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat (AOL subscribers can find a complete transcript at aol.businessweek.com/chats):

Q: Paul, what's the broad market outlook you derive from technical analysis at this point?


I like to look back at the history of the markets, and currently we are in the first year of a Presidential cycle. If you look back to the first years following two consecutive yearly gains in the S&P 500, historically it's not likely to see gains for this calendar year. A 5% to 9% loss on the year for the S&P 500 is the average under these conditions. This would mean a close somewhere between 1159 and 1103.

Q: Paul, what do you take from Alan Greenspan's congressional testimony today?


He introduced nothing that the markets didn't already know. It's interesting that we've had speculation that the Fed is near the end of the current tightening cycle, because I have researched the ISM Index during the Greenspan Fed years, and they have never raised the Fed funds target while the ISM has been below 50. It is currently 51.4, and the trend has been lower.

So, expect 25 [basis] points on June 30, but if the ISM drops below 50 when it's reported in the following week, I don't think the Fed will raise again, unless there is some exogenous condition.

Q: So if you're expecting a loss for the year, are any sectors likely to do better in your analysis?


Defensive issues, like health care. I think a secular bullish case can be made for energy, due to global demand. Historically, you're supposed to stay away from consumer discretionary.

Q: Do you have any favorites in the energy sector?


The oil and gas drillers probably have good potential. The most conservative way to play it would be to have some exposure to Exxon Mobil (XOM ). Oil and gas drillers include Diamond Offshore Drilling (DO ), Ensco International (ESV ), GlobalSantaFe (GSF ), Transocean (RIG ), and Noble (NE ).

Q: If you're bullish on energy, which means higher prices and inflation, would it send interest rates higher also?


This is a most unique time in terms of interest rates, especially as measured by the 10-year [Treasury note]. Months ago, I searched historically to see how often the Fed had been in a tightening cycle for at least three moves, and how often the 10-year yield had moved lower. As I recall, it was only once, and only very briefly. So Greenspan calls it a "conundrum," and it is a unique situation. I think ultimately interest rates will move higher if we continue to see energy moving higher.

Q: Which stocks in health care do you recommend at this time?


Health care is a unique situation. While many strategists have recommended accumulation of traditional health care, as represented by large-cap Big Pharma, the real move in the sector has occurred in the service providers and payers. WellPoint (WLP ), Aetna (AET ), Cigna (CI ), UnitedHealth Group (UNH ), Pacificare Health Systems (PHS ), and Coventry Health Care (CVH ) are all good ones.

Q: Where does the Nasdaq composite index stand -- is it in a bullish or bearish trend?


The lift since the middle of April has produced good measures of accumulation, and right now I think the index can move up and have a close at 2119 sometime before the July 4 weekend. The markets, though, are running out of participation as measured by volume, and the summer, especially after the end of July, has great potential to be a snoozer.

Q: What do you see for the tech stocks, many of which reside on the Nasdaq?


Right now the Nasdaq is outperforming the S&P 500. Historically, when that's the case, both indexes go up, but money tends to focus on the techs in the Nasdaq. Right now, the buying interest has not started to wane, so I think that there is additional upside, but not a huge amount, left to come.

Q: What areas of technology have been looking the strongest by your indicators?


When the Nasdaq takes off, the hot money has been conditioned to buy Internet-related stocks in the first leg up, and the market also focuses on buying the semiconductors, which are the traditional leaders of a Nasdaq advance. But all of the Internet-style stocks -- software, service providers, etc. -- tend to do well when the Nasdaq lifts up off a bottom like it did in the second half of April.

Q: You're a technical analyst. Do you take fundamental factors into account to any extent?


Absolutely. I primarily rely on technical assessments of buying and selling demand and chart observations, but I'm not an ostrich with my head in the sand. More people react to fundamental headlines than they do to a crossing of a MAC-D indicator, so I try to keep my finger on the pulse of the fundamental headlines that affect the markets. And I do research the history of fundamental reports, looking for consistent patterns of price reaction, as is the case with my recent study on the ISM and the Greenspan Fed.

Q: Paul, you left Standard & Poor's last month and launched Cherney Market Analysis (paulcherney.com). What do subscribers get on this service?


Right now, we offer real-time intraday analysis of support and resistance, and I update my view of the more intermediate-term picture, in terms of support and resistance. People, readers, with a more intermediate-term time horizon enjoy when I recognize and explain why the risk/reward on an intermediate-term basis favors establishment of longs, because it gives them the opportunity to ride an intermediate-term trend.

Soon we will have an ETF [exchange-traded fund] analysis that is intermediate-term exclusively, identifying the ETFs that we feel have the best potential for intermediate-term gains. Then, for subscribers who want the stocks that are driving the ETFs, we'll do technical analysis on those for a shorter-term trader.

Q: Are ETFs the main drivers of the market action these days?


One of the most interesting aspects of the market for the past two years has been the consistency of moves in the ETFs. My theory is that this is directly related to the enormous impact that hedge funds now have in the marketplace. I also have seen that there's increased money going into ETFs almost on a monthly basis. I think these are the wave of the future, due to their low cost in terms of management fees, and the ability of someone to treat it as an intermediate- or a long-term investment, or a shorter-term trading vehicle, because you can buy and sell them like a regular stock.

Q: Have short-term interest rates ever been higher than long-term rates? In market jargon, an inverted yield curve.


Yes, inverted yield curves usually precede recessions, and as ironic as it might sound, most of the time when there are inverted yield curves, the investment that works is to buy the longer-dated bond, because if you think about it, the yield becomes inverted because the Fed is raising rates, and they only control the short end.

Once the Fed stops, easier money means lower yields and higher prices for the longer-dated bonds. This has been the case historically, but I think it's important to point out that nominal rates have usually been much higher than they are today, so we might be in a unique situation that has no real precedent right now.

Q: Do you also track money flow into funds, particularly index funds?


My measurements of participation in the markets, and the aggressiveness of buyers vs. the aggressiveness of sellers, is based primarily upon measures of up volume vs. down volume on the NYSE and the Nasdaq. You can also, though, make similar measurements by looking at the ETFs, which I would use as a proxy for the mutual funds.

Q: What do you make of the recent rally in bonds? Do you think the 10-year note will hold under 4% for much longer?


This situation is a great curiosity to me. Part of the move lower in yields probably has to do with the trade balance, as foreign countries are awash in dollars, and have to put it to work somewhere. I think that real estate and homebuilders will have problems if the 10-year yield moved back above the 4.25% level. Right now, I see it just moving sideways, but a move above 4.25% would start to raise concerns for rate-sensitive sectors.

Q: What are the chart readings you pay most attention to? So if I'm using your charts, which technical indicators should I focus on? For individual stocks, I mean.


For individual stocks? Well, I like to use a MAC-D, which is a moving average convergence/divergence. This just measures one moving average of price relative to another. A break above the zero line is usually a pretty good sign that the stock is doing well. It's important, though, to couch the performance of any stock relative to the overall market conditions and concerns. But MAC-D is a good indicator.

Q: And how do you gauge those overall market conditions and concerns in your own analysis?


Mostly I measure the up volume and the down volume at the major exchanges. When you have consistent up volume greater than down volume, the market is telling you that buyers are being more aggressive than sellers. What tends to happen is, if you look at a 20-year moving average of up volume divided by down volume, the first lift puts in a big rise as everyone enthusiastically jumps in.

Then there tends to be profit-taking, and a dip, and then prices resume the uptrend. And that second leg up, if your measurements of volume don't exceed the previous levels, is telling you that participation is waning, and it's more important to start to think about protecting yourself on the downside in the event of sustained profit-taking.

Edited by Jack Dierdorff

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