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Jeff Saut: Another Round of Chop-and-Flop?

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Markets may not re-rally till end of third quarter.

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Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

Rob Robbins, eponymous captain of Robbins Capital, wrote:

"The following graph highlights my proprietary short-term technical indicator displayed with a chart of the Dow Industrials.



"You can see that it has done a very good job of identifying the March and July lows and turned bearish in June as the market was attempting a breakout through 950. It is now at a severe negative reading and this is why I am in a maximum defensive position. With the frenzied pace of buying that we've seen in the markets I could see an air pocket develop over the next several weeks. Caution and patience are recommended at this time."

Clearly, the 5-month stock surge has left Rob's indicator, as well as most of the other indicators I admire, in their most overbought condition in years. Consequently, caution is advised.

Indeed, in today's letter, I've included yet another chart that counsels caution. Said chart plots the S&P 500 (SPX), the Baltic Dry Freight Index (BDIY), and the Shanghai SE Composite Index (SHI). In past reports, I've referenced the Baltic Index's ability to telegraph the future direction of the S&P 500. Recall that the BDIY fell below a key support level roughly one year ago, right before the stock market turned nasty.



Last week, the Baltic breached another key support level at 3000. Also included in the chart is the Shanghai Index, which, like the BDIY, seems to have the ability to foretell the direction of the SPX. As the excellent King Report notes, the BDIY leads the US stock market up and down by about one month, while the SHI leads by 1 or 2 weeks. Both of these indices turned down a few weeks ago.

Then there's my day count sequence. Friday was session 25 in the typical 17- to 25-session buying stampede, which is only interrupted by one- to 3-session pauses/corrections before resuming the upside skein. The melt-up is therefore pretty long in the tooth.

Furthermore, the leading index from the March lows has been the NASDAQ Composite (COMP). On Friday, the COMP decisively broke below its 10-day moving average. Since my buy 'em trading call of July 14, I've been using the 10-DMA as a fail-safe point: When the 10-DMA is broken, trading positions should be reduced and/or hedged. Yet while the COMP and SPX have violated their respective 10-DMAs, the Dow Jones Industrial Average (DJIA) has not. For the record, the Dow's 10-DMA currently resides at 9317.46.

To be clear: This isn't a bearish call -- it's just another call for near-term caution, much like the one I made at last May's momentum peak. Following those cautionary comments, the major indexes flopped/chopped around for 2 months, but never gave back more than 7% before they reenergized and re-rallied. I think there's the potential (again, the potential) for another window of flop-and-chop before the equity markets re-rally, with the carrot in front of the horse being easy third- and fourth-quarter earnings comparisons.

As GaveKal suggests:
"What investors will likely want to see going forward is stabilization in employment and a pickup in global trade. Confirmations of such could still be a few months off, leading to some nervousness in equities? . . . Similarly, there is little doubt that investors will want to see more than efficient cost-cutting. Companies able to deliver a genuine pick-up in sales, and not just in profitability, will be richly rewarded. But will there be many such companies in the next 3 months?"
Adding to the potential for a flop/chop window are rising inflation concerns. While I think such worries are misplaced, at least until the back half of 2010, the past few weeks have seen most commodities rally sharply. Combine that with surging fiscal deficits and loose monetary policies around the world, and is it any wonder inflation fears are increasing? Hence, I'm once again timid on a short-term basis -- though I hope I'm wrong.
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No positions in stocks mentioned.
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