The Street's "Line in the Sand"

Technical analyst Chris Johnson of Schaeffer's Investment Research sees the market at a critical point between bullish and bearish

"We're seeing a tug of war between the buyers and sellers, the outcome of which has a great deal to do with where the market will go for the next few months." That's one aspect of the current stock market as viewed by Chris Johnson, director of quantitative analysis for Schaeffer's Investment Research. Johnson looks at the market from a technical standpoint but also considers fundamental factors, such as earnings and the state of the economy.

His charts show the Standard & Poor's 500 and NASDAQ composite trading at their 20-month moving averages, and the Dow Jones industrial average below its 20-month mark. "These indexes must remain above these moving averages to avoid falling into what will be a bear market," Johnson says. If the S&P falls below 1168 and the NASDAQ below 2025, he warns, the sellers will win the tug of war. Johnson himself is watching the numbers day to day to indicate the direction for the rest of the year.

Meanwhile, Johnson advises investors to take a hard look at their portfolios to decide what to hold and what might be sold to lock in a profit, and also suggests that "cash should pretty much stay cash" awaiting buying opportunities.

These were a few of the points Johnson made in an investing chat presented Oct. 20 by BusinessWeek Online on America Online, in response to questions from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat.

Chris, the market did another number on us today. What's the big picture you see on stocks now?

I've been calling the market a must-win situation for the last week and a half for a few reasons. First of all, the market has now moved back down to long-term technical support. The S&P 500 and NASDAQ are trading at their 20-month moving averages, the Dow below this. As a result, we're seeing some technical buyers supporting the picture.

These indexes must remain above these moving averages to avoid falling into what will be a bear market. So there's a lot riding on the market bouncing from current levels.

We're also beginning to see investors who are capitulating from their optimistic outlooks of a few weeks ago. This is throwing selling pressure onto a market that's trying to bounce from these technical support levels. We're seeing a tug of war between the buyers and sellers, the outcome of which has a great deal to do with where the market will go for the next few months.

That's the technicals. As for the fundamentals, we see an economy that has growth coming at a cost of increasing inflation. This has the Fed worried, and as a result we've seen messages coming from the Fed hinting at further rate hikes. This is throwing investors a curve ball, because they believed that we were in the ninth inning of the rate-hike game. Now that game's in extra innings, and there's uncertainty as investors are bracing themselves for higher rates.

At the same time, earnings are coming in in line with expectations overall. We're not seeing these outlooks blow back investors' hair, however. So their outlook is still a bit too optimistic for the technicals and fundamentals out there. As a result, I've literally been waiting day to day for a sign that either the market is truly putting in a tradeable bottom, or whether we're going to move to lower levels with accelerated selling.

While I can't look into my tea leaves and say where the market's going to go over the next couple of days, I can tell you that if the market breaks below the S&P 20-month and the NASDAQ 20-month, I'll be taking short positions and pulling long positions off the table, as I believe this will set the terms for the next year's activity. The levels that you should be watching are 1168 on the S&P 500 and 2025 on the NASDAQ. Dramatic moves below those levels will likely indicate that the sellers are going to rule the last quarter of this year.

Given the uncertain direction, what should the individual investor do?

At this time, I've been telling individuals to take a good hard look at the winners in their portfolio and what sectors those winners lie in. For example, investors heavy in utilities (an outperformer through 2005) will want to watch the pullback in that sector, but there's still pessimism and solid fundamentals in that sector that can drive some growth through the year. So I'd stay a holder in that sector.

But I would look at those sectors with some exhibited weakness, including tech (semiconductors, to name one), that will be high on people's radars to sell at signs of a bear market. If I had made profits here, I would look to take profits if I have them. Those that I have losses in would go through a great deal of scrutiny to stay in my portfolio.

Cash should pretty much stay cash at this time, until a great buying opportunity arises. Some individuals will run out on a day like today, when the market's down 100-some odd points, and grab it up while it's "on sale." If you want to buy, I would average into those stocks by buying allocations over the next few weeks.

If you're looking to hold a stock for the next six months, you're not going to lose out by waiting a little while and buying somewhat higher. However, you'll end up saving a great deal if the market hasn't truly bottomed (which I believe it hasn't).

Finally, many people ask about gold in these times. Gold has come back into favor over the last few months. As we saw in September, gold futures have been at all-time highs. If one were to look at gold as a potential insulator in their portfolio, I believe there's a leg to stand on with that argument -- especially if you add in inflationary pressures to the current soft market.

To sum it up, I would avoid tech and others high on investors' radar, as they have ample sell potential, and I would be increasing my cash and potentially gold positions and rooting out overly strong sectors.

What sort of gold positions do you recommend -- the metal or an ETF [exchange-traded fund] or gold mining stocks?

Actually, either of those become attractive as the large population of investors reacts to the price of gold through actions in the price of the mining companies. You can see this by looking at the correlation between the XAU [index of gold mining stocks traded on the Philadelphia exchange] and gold prices, which usually shows some lockstep movement. Some individuals prefer to buy the metal itself.

The ETF, (which is still relatively new to the market), offers the individual investor an attractive alternative way to get gold in their portfolio. When you look at the mining companies, you need to remember that they're highly correlated but don't always reflect the price of gold, due to hedging and other activities. So make sure you look at the individual companies before investing

Google (GOOG ) is already hugely popular, and it reported a huge profit increase today. How do it and other Net stocks look to you?

Well, taking a look at the big three -- Google, Yahoo! (YHOO ), and eBay (EBAY ) -- Google announced mind-blowing earnings results this afternoon after the close, and as a result is trading up a little more than 6% from yesterday's close. Google continues to be a stock that excites investors, despite the fact that it has tracked sideways for some time.

We watch the sentiment and the technicals on Google. On the sentiment perspective, we see some pessimism on the options side. From our perspective, this adds to the attractiveness of Google as an investment, because it tells us that all of the investors haven't jumped from the sideline into the stock, which means potential buyers are still waiting in the wings for the next opportunity. At this point, I would be a holder of Google.

Let's talk about eBay for a moment. The company hasn't been as strong technically as Google, as we've seen it pull back over an intermediate-term time period. The stock has actually lagged a bit compared to others in the field, but still has some relative strength against the NASDAQ. From a sentiment perspective, eBay is just coming from some low readings on their open-interest put-call ratio, which indicates that option investors have been somewhat optimistic on the company.

In addition, short interest on the company, and the short interest ratio on the company, aren't showing signs of extreme pessimism. If I were a holder of eBay, I might be looking for a stock that was a bit stronger on performance.

Yahoo pleased investors recently, and thus we've seen the stock trade from the $34 range to breaking above $35. From a technical perspective, the stock is tracking right on its 20-month moving average, which has fallen in line with support during September and October. This puts Yahoo in the same position as the discussion we had on the market in general, as, if it breaks below support, it could come under the sellers' control.

At this point, I would favor Google over Yahoo and would likely not even hold Yahoo, as I think we could see some selling if we have the weakness in the market which was discussed earlier.

What's your view of health care? Pfizer (PFE ) got slammed today -- and usually this can be a defensive area.

Well, taking a look at the drug sector, Pfizer and others have been punished not only recently but since March of 2004, as we've seen the likes of Pfizer and Merck (MRK ) trend lower. Looking at the drug sector as a portion of health care, I think it's a sector many should stay away from, as there continues to be not only a seeming lack of new products coming through the pipeline but also a deluge of litigation that seems to hit the tape on a daily basis.

Pfizer is clearly a technically weakened company, as it has been trading well below its long-term moving averages. And on occasion when we've seen a rally, it has been rejected on these same lines. At the same time as we're seeing technical weakness, we're seeing investors in the options market increase their bullish bets, telling us there's a good deal of optimism when it's not really warranted from a technical or fundamental perspective. This is a perfect example of a stock to avoid, because investors have essentially been putting good money into a poorly positioned stock.

Drug companies, as they move in a herd, remain unattractive to me. Put simply, I don't think of health care as a defensive area. From the defensive-area perspective, as I see this sector as a lagging sector, I would not include it in anything I would consider remotely defensive in this market.

Are there any sectors that you think will become leaders if the market takes a turn higher?

One sector that I continue to watch, as it has not only tipped a hand in terms of where the market's going to go but has also provided leadership on upswings, is the semiconductor sector. I know I mentioned it in the beginning of the chat as a sector I would avoid, but that's from an investing perspective, as I think any bounce from current levels is going to be short-lived and part of a turn to the downside.

In this environment, I look for those that will bounce a little farther than others. Based on the fact that the semis have showed signs of leading the market, I would say there are some good short-term trading opportunities in the sector, were there to be a bounce.

Another sector that has come up on my radar screen as one that's likely to outperform the market if there's a bounce is the broker-dealer sector…. There are some decent earnings statements coming out from their core business, and there's plenty of pessimistic sentiment, which again tells me that there are more potential buyers on the sidelines. On a relative basis, the broker/dealers have continued to lead the S&P 500 since bottoming in late April and early May, and this leadership is likely to continue and be in step with the market in general.

For defensive investing, where would you look now?

From a defensive perspective, I still think there are going to be some opportunities in those energy/utility companies, as one of the negatives of this market has been energy prices and their overall effect. We've seen crude oil, natural gas, and other energy commodities drop in value recently, leaving investors guessing as to whether this is the beginning of a new trend or just a buying opportunity, like those we saw in May of this year and again in July.

As we continue to see crude oil prices and those other commodities well above long-term support, I tend to favor them as continuing to hold stronger than the market. Should that happen, it will obviously add to other areas and help these companies. Therefore, I will continue to consider energy and utilities somewhat defensive areas for the current market.

From your earlier answer, it sounds like you're preparing for the market to rebound, as long as the indexes don't fall to certain levels.

Absolutely. The levels that I mentioned earlier -- the S&P 500 20-month moving average and the NASDAQ Composite 20-month moving average -- should be seen as make-or-break levels not only for the short term but for the longer-term picture. These levels act as "lines in the sand" between technical bull and bear markets -- thus a break below them is likely to bring out more selling.

Normally, if the 20-month moving averages of these indexes were trending up, we would perhaps expect to see a little more strength. But as it stands now, the 20-month moving average of the NASDAQ and S&P 500 are in the process of rolling over and starting to change their direction to trend downward. This tends to potentially weaken the technical strength that we might see from those trend lines, which only increases the risk for the market if we break below them.

As I noted before, the Dow Jones industrial average is already trading below its 20-month moving average, which has rolled over recently. Add that to the fact that we could see failing support for the S&P 500 and NASDAQ composite, and this picture doesn't seem too encouraging for the long term.

I should underscore what I believe I pointed out before, which is if we see a bounce from current levels, I think there's a good chance that it will be reversed, and we will again be testing these same levels that we're currently at. In other words, cheaper stock prices look as though they could get cheaper again in the coming months.

So unless you're a trader who can take advantage of these short-term swings, it's better to either hold your positions and look for better buying opportunities, or if you're not into too many positions, continue to hold that larger portion of cash and wait for those better buying days that will eventually follow.

    Before it's here, it's on the Bloomberg Terminal.