A "Cranky" Market Stuck in a Range

That's a reason why Chris Johnson, Schaeffer's Investment Research's head of quantitative analysis, advises holding large cash positions

Investors in the current market would be wise to maintain large cash positions, focus on stock sectors that can outperform, and possibly use options as a defensive play. So counsels Chris Johnson, director of quantitative analysis for Schaeffer's Investment Research. As for sectors, he would focus on energy and housing and avoid technology.

Johnson says he would describe the market as "cranky and remaining in a trading range," with "still some fundamental and technical bugs to be worked out." However, he notes that the market seems to have discounted terrorist activity, judging from its mild response to the London bombings of July 7.

Using technical analysis, he sees some signs of strength in the S&P 500-stock index at the moment, as it seems to struggle for a technical bottom, although some weakness in sentiment for the future also exists, and he sees vulnerability in the Nasdaq composite.

Johnson made these and other points in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online during an investing chat presented July 7 by BusinessWeek Online on America Online. Edited excerpts from this chat follow. AOL subscribers can find a full transcript at aol.businessweek.com/chat.

Q: Chris, the U.S. stock market seemed to shrug off the terror attacks in London. How do you interpret that -- and how do you see the macro market outlook?


We can take two interpretations, the first being for the short term. Investors have seen a market that's struggling to make a technical bottom. We saw signs of the S&P 500 posting some signs of strength starting two weeks ago, and the market has been hell-bent on avoiding signs of weakness. The battle cry before the bell rang this morning was that any weakness would be a buying opportunity. It seems that investors listened, to some degree.

However, we didn't see the large surge of volume I'd really expect to see were this to be a vote of real confidence in where the market's going in the short term. I feel there are still some fundamental and technical bugs to be worked out of this market.

From the longer-term perspective, today's price activity was somewhat of a vote of confidence in terms of the market's ability to look beyond a terrorist act. While today's act wasn't as large as what we saw on September 11, 2001, it still leads me to believe that the market has discounted the expectations that we will have continued terrorist activity going forward. Essentially, this is a sign of some resolve in the market's ability to withstand these events.

Q: What are the bugs you see as needing to be worked out of the market?


When we look at the current market, we see one that, at best, can be described as...cranky and remaining in a trading range. The Goldilocks situation between rising interest rates, a flattening yield curve, and questionable economic growth leads to many potential bumps in the road, from a fundamental perspective.

With that in consideration, it's not too surprising that this market remains in somewhat of a trading range for 2005. The 1,200 mark continues to be Death Valley, or at least Death Peak, for the S&P 500, and it's hard for investors to get excited about corporate earnings when it seems as though a slowdown once potentially on the horizon may now be getting closer. Crude oil prices are still going up, which will show up on bottom lines for various companies sooner or later.

We need to see some resolution on these various issues before the market will begin any new movement to the upside of the range. With volatility indexes and other indicators showing that some optimism remains present in the market, I've been recommending that investors step cautiously as the market works through these bumps.

Large cash positions, as well as exposure to those sectors that continue to outperform, should be the focus of investors' portfolios, while those investors who have experience trading options might take the opportunity of the lower premiums to at least add some protection to their portfolios in the form of "protective puts."

Q: Where do the S&P 500 and Nasdaq stand in terms of technical strength?


Let's look at the short-term perspective, and the S&P 500 first. Today's intraday trading activity saw the S&P 500 test its 50-day moving average. This is normally considered a line of demarcation between bullish and bearish activity for the institutional investors. When the S&P 500 moves below the 50-day average, institutions begin to sell. Above that number, they buy. The fact that the S&P 500 was able to rally above that moving average shows some signs of technical strength in the short term.

When I pair that with the fact that the 20-day moving average of the S&P 500 is rolling over and looks to be declining in the next few trading days, the picture begins to look like that which we saw in mid-March to early April of this year, in which the S&P 500 traded to the 1,150 mark, which I would not rule out if we don't see some market strength come in the next few days.

Looking at the Nasdaq composite, some strength in sectors such as semiconductors has held the Nasdaq above its 20- and 50-day moving averages. There has been some consolidation around the 2,100 mark, which, if not broken through, will see an increase in selling, which will be rapidly followed by a break in the 20- and 50-day moving averages.

I would expect that we'll see a Nasdaq composite that could reach down to the 1,900 level before we see any kind of tradable bullish activity. Our sentiment indicators have pointed to continued weakness in the Nasdaq, while the S&P 500 is also showing some signs of weakness.

Q: What's your favorite option play for the next 30 days?


Looking at potential option plays, there are a good deal of opportunities that can be found for the bulls in the crowd by looking at small-cap stocks. What I usually look for in these stocks are the top 25 to 50 in terms of option activity of the Russell 2000.

A few names that pop up on that list as potential bullish plays include USG (USG ), Goodyear Tire & Rubber (GT ), and Beazer Homes USA (BZH ). These three stocks all fit the criteria of our expectational analysis approach as bullish contenders, due to their strong price activity and negative, or pessimistic, sentiment. The pessimistic sentiment indicates that there are buyers who remain on the sidelines who can drive prices to higher points in the near future.

Q: Where do you see defense stocks going?


There have been some rumblings from the Administration over the past few days that we may begin to see some increase in domestic defense spending. Obviously, this is something that would bode well for this sector. Taking a broad view of the sector, using our expectational analysis approach, we see a sector that does have some signs of pessimism amid some technical strength.

Right now the average score for the defense-sector stocks, according to our Schaeffer's scorecard, is nearly a 6 on a 1-10 ranking. This is one of the higher-ranked sectors according to these ranks. So, overall, I would see this as one of those sectors in which you can find some good opportunities. Lowering the microscope a bit -- to find a couple of names that rank higher than others according to our scorecard -- reveals that ITT Industries (ITT ) and United Industrial (UIC ) are two companies poised to outperform in the sector.

Q: What's your view of tech stocks?


I'm not normally the popular guy in the crowd when we talk about tech, as this is a sector that overall I have been avoiding -- avoiding at best and, in some cases, shorting heavily. The semiconductor sector, which is normally the first that comes up in a tech discussion, has failed to impress as we've seen it continue to gyrate in a trading range that has the SOX [Philadelphia semiconductor index] locked between the 385 and 445 level. It has been a sector that's somewhat leading the market, and a top in that area has preceded a decline in both the Nasdaq and S&P 500. But it's yet to take a role in leading the market higher.

Other sectors that fall in this category [tech areas to avoid] include the networkers and the software companies as well. Many investors continue to think that these are the companies that will once again ignite a bull market rally such as those seen in the late '90s. The problem with that thinking is that these companies, for the most part, have the signs of being overloved by Wall Street and Main Street, which leads you to the conclusion that there's little to no sideline money to drive these prices up in the future.

Let's look at the poster child of overloved stocks, which would be Microsoft (MSFT ). This is a company that has 16 analysts ranking it a strong buy, 7 a buy, with only 2 analysts ranking it a hold or lower. In other words, 92% of the analysts who cover the stock are at buy or stronger.

Include this with the fact that short interest remains at extremely low levels and that the stock fails to break above its longer-term moving averages, and we continue to see a lack of innovation that could drive the value higher. You have a recipe here for a stock that you should try to avoid. This type of scenario stretches far and wide across the tech sector, which is why we remain very cautious toward this group.

Q: Do you see Costco Wholesale (COST ) going higher than its current level of $45?


I do see Costco as a stock poised for some upside movement and likely to outperform the retail sector. A brief rundown of the sentiment and technicals: A put-call ratio above 1 and at relative levels that indicate pessimism. The current short interest of 12.5 million and short interest ratio of more than 4 indicate that the short-sellers have been active in the stock, [and] while not to the extremes that are blatantly pessimistic, they're still off their lows.

Their analyst rankings have 16 of 17 (94%) ranking the stock a hold or lower. There are obvious signs of the wall of worry, which is what we like to see. Pair that with the fact that Costco is seeing a good deal of support at its 20-week moving average and is getting ready to break back above its 10-month moving average. It's trading over its 20-month as well, which gives us the signs of a technically strong stock with negative sentiment, equating to a bottom-line rank of 8 out of 10 on our scorecard. [This] leads me to the conclusion that Costco will continue its leadership role against the overall market.

Q: You shared views on defense and tech sectors -- what do you see as the best (and worst) sectors now?


I hate to drill it down to one of each. Were I pressed, though, I would have to say that I would be avoiding the semiconductors (which I addressed) and find myself most attracted to energy and housing stocks. In addition to that, to go outside of the question, we do believe that a lot of opportunities for investors can be found by focusing on the small-cap area. When we compare the Russell 2,000 to the S&P 500, the Russell has led, on a relative strength basis, since 2000, and has continued to grow in strength.

It takes a little more work to find the diamonds in the rough in a trading range, much less when you're looking at small-cap stocks. But we really think that the effort and work put into this area will pay off handsomely in investors' portfolios.

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