A Yellow Light for Investors

S&P's Mark Arbeter says many of his technical indicators are bearish or may soon turn bearish -- so he urges a defensive stance

"A recession could be in the cards," with the chances between 30% and 50%. That's one of the possibilities emerging from the charts studied by Mark Arbeter, chief technical analyst for Standard & Poor's. Like a number of fundamental analysts, he urges caution and a defensive stance on the part of investors.

That would mean, in Arbeter's view, staying "with utility stocks, some areas of health care, energy stocks, and then within health care, biotech stocks right now." He points out that another four-year-cycle low is due late in 2006, and going back to 1970 those cycles have tended to coincide with lows in both the economy and the market.

Arbeter adds that a number of intermediate- and long-term technical indicators of market action are either already bearish or close to turning bearish. And he thinks the market has to go lower before it can rise again.

These were among the comments Arbeter made in an investing chat presented on Oct. 25 by BusinessWeek Online and Standard & Poor's, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow:

Note: Mark Arbeter is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.

Mark, how does S&P see the market? Hasn't S&P recently changed some of its targets and recommendations?

Yeah, we recently lowered our yearend target for 2005 and also cut our midyear target for 2006. We've also made some changes to our sector weightings, taking on a more defensive stance.

Your specialty is technical analysis. How do things look on your charts?

Technically, I'm very cautious on the market for the rest of this year and into 2006. Many of the major indexes have put in topping formations. We're seeing a lot of head-and-shoulder reversal formations on many indexes, as well as bearish rising-wedge formations.

In addition, we're seeing a lot of internal deterioration in many of the price and internal indicators, and also, from a longer-term perspective, there are a couple of major cycle lows that are due in 2006. So, needless to say, I'm very cautious here.

So what does that mean for the individual investor's strategy?

I'd keep a fair amount of money in cash. If I were to venture into the market, I would stay on the defensive side. I would stay with utility stocks, some areas of health care, energy stocks. And then, within health care, I still like biotechs.

What would have to happen to change your (and your charts') view? And how likely would that be?

I think we're going to have to see either a fair amount of price weakness over the short to intermediate term to complete some of these negative formations, which I think is the likely scenario. I think we have to go lower before we can go higher.

The chances, I think, of breaking out strongly to the upside (which might tilt my hand to the bullish side) are very thin. If we were to take off from here with more volume, stronger and broader participation in conjunction with a decline in energy and crude prices, not to mention a decline in short-term interest rates, that might turn me a little more bullish.

What indicators are giving you the negative signals?

First off, chart formations are very negative. Many price-momentum indicators are negative. Many internal indicators are negative. As an example, the number of new highs divided by issues traded has shown some deterioration over the past few years, even though the index has seen some new highs.

The MACD [Moving Average Convergence Divergence indicator] on a weekly basis has given off multiple negative divergences over the last two years, and the monthly MACD is very close to giving a long-term sell signal. The last sell signal we got from the monthly MACD was back in the year 2000, so there are some intermediate- as well as long-term indicators that have either given bearish signals or are very close to turning bearish.

Are you seeing any notable trends or movements in particular sectors? Do you think energy still has momentum?

Yeah, I'm still bullish on energy stocks in general. Many of the oil indexes, as well as individual oil stocks, have corrected back to long-term support areas.

I do expect energy stocks as well as crude-oil prices to head back up. Crude oil has corrected from slightly over $70 to a bit under $60 recently. During that time, we've seen a shift among futures players toward the bearish side, and I think that suggests from a contrarian view that crude oil can once again rally and possibly move up to the old highs.

And then, like I said before, I would stay defensive. Utility stocks have also pulled back to good support areas. And despite the fact that utilities have had a terrific run since their bottom in 2002, sentiment among utility analysts is at best neutral, which suggests that many of them have missed a big part of this move up. It gives the utility market a lot of room for potential upgrades in the future.

I would stay away from consumer-discretionary stocks. Many of the subindustries within discretionary are very weak. I would also stay away from telecom services, which is also very weak. I selectively like some of the health-care stocks. My favorite in that area is, as I mentioned before, biotech.

What about financial stocks? Will higher rates hamper them?

Yeah, for the most part I'm bearish on the financials, especially the banking stocks. For instance, the S&P bank index has put in a head-and-shoulders reversal pattern over the last two years, and I think we could see some decent-size downside in the banking area.

Like I said before, I'm expecting short rates to continue higher, and I expect longer-term rates to move higher as well. The 10-year Treasury closed at a six-month high today, around 4.51%, and I think we could easily see 10-year yields well over 5% next year.

But not everything in the financial sector is negative. Some of the insurance stocks have been doing pretty well -- they look good on a technical basis. The investment-banking stocks and the asset-management stocks have also done well and look good from a technical standpoint.

Do you see any chance for a recovery in technology stocks?

I think the majority of tech stocks are likely to trade sideways over the foreseeable future. There are always areas in tech where you can make money, but for the most part these stocks still have a ton of overhead supply to deal with from the bubble days. So I would generally stay away.

To what extent do you look at economic and market fundamentals? Some of them must have a visible impact on the technical side.

Basically, I'll turn that question around and say that the technical work I do is actually a great tool to predict the economy. For instance, the CRB [Commodity Research Bureau] index put in a massive double-bottom reversal formation back in 1999 and 2001. Since that time, the CRB index has almost doubled in price in conjunction with a big selloff in the dollar during that time. This could certainly lead an analyst to predict an end to deflation and an increase in inflation, and that's exactly what has happened.

Another example would be to watch what's going on with short-term interest rates. We continue to see short-term rates move higher, and we can then expect the Fed funds rate to continue higher. Along with all this, if we start to see major breakdowns in economically sensitive sectors and stocks, we can make an educated guess that a recession could be in the cards. So I use my charts to give me a framework -- what I think the economy is going to do.

What's your outlook for the defense sector?

If you look at the small- and mid-cap region, it has done well -- a lot of constructive chart patterns in the small- and mid-cap defense stocks. I like the area on a technical basis. I would stay away from the large-cap defense stocks -- in the smaller areas we're getting more price performance. I'm going to stay away from giving you individual names here. But I would say I would favor the area in 2006.

How do the charts of some of the big Internet outfits look, such as Google (GOOG ), eBay (EBAY ), and Yahoo! (YHOO )?

Google looks very strong on a technical basis. The stock recently broke out of an almost five-month base. The breakout occurred on a price gap and on huge volume, which is positive from a technical perspective.

EBay has been trading in a range that looks neutral from a technical perspective at this point. Yahoo has also been basing, but it's much closer to its 52-week high. If it can break out above the high seen late last year, that would be constructive from a technical perspective.

So where should I go to get a primer on technical analysis?

I would go out and buy what's considered by many to be the "bible": Technical Analysis of Stock Trends, by Edwards and Magee. I would also probably read or start reading Investors Business Daily and pick up any book by William O'Neil.

In addition, John Murphy has written some very good books on technical analysis, and there are also many free Web sites where you can do your own charting.

You said earlier a recession could be in the cards. What are the odds?

I would say, based on the action of the major indexes, as well as bonds, oil, and commodities, that the probability of a recession next year is between 30% and 50%. To add to it, the other reason that I believe there's a potential for stock-market weakness and economic weakness next year is that the four-year cycle low is due late in 2006.

This four-year cycle has been extremely accurate in predicting major stock-market lows, which just happened to coincide with economic weakness -- i.e., recessions. If you go back four years to 2002, then 1998, 1994, 1990, we've had stock-market lows in all those years, as well as economic weakness. That cycle could easily be taken back to 1970.

Are you seeing normal patterns of individual stock movements after a company reports earnings? This season there seem to be some wild swings in prices.

I think the key is to watch the reaction to news as a technician. If the company reports better than expected news and still sells off, not a good sign. If the company has been reporting weaker than expected results and then acts better even with the negative news, it could suggest a bottom in the stock.

As of late, the market seems to be selling off on good news, which is definitely not good.

What about semiconductor stocks? Texas Instruments (TXN ) was weak today.

I'm neutral on semiconductor stocks. SOX [the Philadelphia semiconductor index] has been trading in a wide range over the last four years because of the bubble back in 1999 and 2000 -- there's a lot of overhead residual resistance these stocks have to deal with. The typical action after a bubble is for many, many years of sideways action.

So the bottom line for investors would be to stay defensive -- which seems to be the advice of many fundamental analysts, too. Comment?

Yeah, I would keep your powder dry, stay on the sidelines, and wait for the market to tell you when it's time to get in. That will be at lower prices sometime in the later part of 2006, I think.

Edited by Jack Dierdorff

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