Markets & Finance

Time to Get Defensive


By Mark Arbeter The stock market made a clear break to the downside last week as crude oil prices surged to another record high. With the historically weak months of September and October looming, and a poor technical backdrop, we at Standard & Poor's remain in a defensive mode with respect to equities.

In our view, the persistently high price of oil is finally starting to take its toll on the stock market. Crude oil prices have remained above $60 per barrel since the end of July, and climbed to a closing record of $67.49 on Aug. 25. The surge in crude oil on Wednesday, Aug. 24, took its toll on the stock market as some of the major indexes broke key short-term support levels.

What is particularly worrisome to us is that it appears that investors are starting to shy away from economically sensitive stocks, due to concerns about oil, and are moving towards a more defensive posture. Some of the leaders during the last 6-12 months have rolled over, and many of these issues are considered growth stocks. Historically, when the leaders start heading lower, the overall market becomes vulnerable. Readers should note that past performance is not necessarily a valid indicator of future results.

During the last couple of weeks, there has been a very distinct breakdown in many economically sensitive subindustries. Many retailing stocks have rolled over with weakness also seen in chemicals, homebuilding, advertising, steel, aluminum, forest products, and construction materials. Investors have been rotating some funds to the oil sector, but have also moved into agricultural products, utilities, tobacco, and distillers and vintners. These are traditional areas of the market that usually benefit when investors are concerned about the market.

The S&P 500 broke key short-term

support in the 1217 area on Wednesday, and the pattern of lower highs and lower lows is still in force. From the close on Aug. 16 to the close on Aug. 23, the index finished in an extremely narrow range of four points. We believe the S&P 500 traded in this tight zone for so long because there was an abundance of support that was very close together. The 50-day exponential

moving average, chart support, as well as

trendline support all came together to provide support at this point. With the breakdown on Wednesday, this area now becomes important, short-term

resistance.

The next concentrated area of support for the index lies between 1183 and 1205. Chart support, from the small consolidation in June and July, occurred within these two levels. The 150-day exponential moving average is at 1198; the 200-day simple lies at 1195 with the 200-day exponential average at 1190. A 38.2% retracement of the rally from April to early August targets the 1204 level while a 50% retracement of the recent rally targets 1191. Intermediate-term trendline support, drawn off the August 2004 and April 2005 lows, comes in around the 1190 area. So at the very least, the 1183 to 1205 range should, in our opinion, provide some support for the index during the current pullback or correction.

Technical indicators based on daily prices have moved to an oversold condition, suggesting the possibility that a countertrend rally could take place over the next week or so. The 6-day relative strength (RSI) indicator fell to 25 on August 24, equaling the level hit during the pullback in late June. The daily stochastic oscillator has fallen to its most oversold level since April, which was the last intermediate-term bottom. However, weekly technical indicators are in far different position, and in our opinion, it is not pretty. The weekly stochastic oscillator has rolled over after getting overbought, and has issued an intermediate-term sell signal.

In our view, the weekly moving average convergence/divergence (MACD) indicator is in danger of giving another sell signal. The weekly MACD has traced out a series of lower highs since the beginning of 2004, putting in place numerous negative divergences. The last series of weekly MACD divergences occurred during 1998, 1999 and early 2000. The 14-week RSI is not even close to being oversold, and has also traced out a pattern of negative divergences. So while we could see a short-term bounce, the intermediate-term picture remains decidedly bearish to us.

The recent action, in our view, continues to worsen, as more evidence mounts that institutions are on the one hand, rotating to more defensive groups, and on the other hand, lightening up on their stock holdings. Wednesday's intraday reversal was nasty, and continues a pattern of intraday rallies that fail. In addition, weak market days continue to be accompanied by an increase in volume, while rallies have taken place on light volume. Our accumulation/distribution models on the NYSE and the Nasdaq remain in bearish configurations, and we believe this will lead to further downside action.

Market sentiment is starting to back off from its extreme bullish levels, and eventually, we think this will be good for the market. However, when market sentiment gets extremely bullish, and then starts to turn more cautious, that is usually when the market heads lower. It is not until sentiment has moved to the bearish side of the fence, in our view, that we can expect a potential market bottom. When the majority of investors are bullish, they have only two options: hold on during a decline or throw in the towel and sell. Intermediate-term market lows usually occur when the majority of investors have thrown in the towel. Unfortunately, that will take some time and lower prices in our view.

While crude oil has been blamed for some of the recent weakness in the stock market, we are actually looking for a correction in oil prices over the next couple of months. There is a seasonal pattern of weakness in the fall for the overall stock market as well as for oil prices. It will be interesting to see if there can be a concurrent correction in stocks and oil prices. Remember, for the last couple of years, stocks have risen along with rising crude oil prices. Why can't they both go down during the weak seasonal period that is just around the corner? Crude oil prices hit an all-time closing high of $67.49 last week, slightly exceeding the peak in mid-August. Crude oil is up a whopping 44% since May 20, and we believe some profit taking is overdue. Both daily and weekly technical indicators are very overbought, suggesting that a pullback or correction could take place, in our view. Near-term trendline support lies at $63, with decent chart support down at $57. Long-term trendline support comes in around $50.

Since peaking at 4.42% on August 8, the 10-year Treasury bond has rallied nicely, and finished the week yielding 4.19%. The 10-year has moved back to chart resistance that starts in the 4.19% zone. The bond has also retraced about 50% of the move from June to August. We believe some of the recent strength in bonds has come at the expense of the stock market. When investors get defensive, one area they frequently move to is bonds. Sentiment towards the bond market has once again moved to fairly bullish levels, with MarketVane showing 70% of traders in the bullish camp. While bonds could benefit from further weakness in the stock market, we think that with sentiment already so bullish, yields could reverse and head higher once again.

Glossary

S&P STARS: Since January 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.

S&P Earnings & Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:

A+

Highest

B

Lower

A

High

C

Lowest

A-

Above Average

D

In Reorganization

B+

Average

NR

Not Ranked

B-

Below Average

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Standard & Poor's Equity Research Services: Standard & Poor's Equity Research Services U.S. includes Standard & Poor's Investment Advisory Services LLC; Standard & Poor's Equity Research Services Europe includes Standard & Poor's LLC- London and Standard & Poor's AB (Sweden); Standard & Poor's Equity Research Services Asia includes Standard & Poor's LLC's offices in Hong Kong, Singapore and Tokyo.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, NY, NY.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; and in Sweden by Standard & Poor's AB ("S&P AB").

The research and analytical services performed by SPIAS, S&P LLC and S&P AB are each conducted separately from any other analytical activity of Standard & Poor's.

Disclaimers

This material is based upon information that Standard & Poor's considers to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute Standard & Poor's judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Prices, values, or income from any securities or investments mentioned in this report may fall against the interests of the investor and the investor may get back less than the amount invested. Where an investment is described as being likely to yield income, please note that the amount of income that the investor will receive from such an investment may fluctuate. Where an investment or security is denominated in a different currency to the investor's currency of reference, changes in rates of exchange may have an adverse effect on the value, price or income of or from that investment to the investor. The information contained in this report does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

For residents of the U.K.: This report is only directed at and should only be relied on by persons outside of the United Kingdom or persons who are inside the United Kingdom and who have professional experience in matters relating to investments or who are high net worth persons, as defined in Article 19(5) or Article 49(2) (a) to (d) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001, respectively.

Readers should note that opinions derived from technical analysis might differ from those of Standard & Poor's fundamental recommendations. Arbeter, a chartered technical analyst, is chief technical strategist for Standard & Poor's


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