The Gilmo Report

June 5, 2011

June 5, 2011

As the market pushes to lower lows, one has to to wonder whether it will pull the proverbial rabbit out of its hat and suddenly turn back to the upside as it did on March 16th. Certainly the nascent rally attempt that started last week has now been completely snuffed out (although I thought it was pretty much DOA last Wednesday, as I wrote in my report then) by the NASDAQ Composite Index moving to a lower low on Friday. Friday’s action undercut the lows of late May (Low #2), but it is not clear to me that this will necessarily lead to an upside rally based on the undercut since Low #2 had already undercut a prior low from mid-May (Low #1), as I show on the daily chart of the “NAZ” below. As I wrote on Wednesday of this past week, lower lows looked like the higher probability, and so by Friday they became not a probability but a fact. The market looks to be making a move towards the lows of this trend channel within which it has been working its way lower, as I’ve drawn on the chart, and we shall see whether it remains in the channel or breaks through to the downside. With further deterioration occurring in leading stocks, the market’s ability to bounce back may be compromised. However, with QE2 still alive until month-end nothing would surprise me and we could see more volatility and “zig-zagging,” For now I think it is best to be in cash or short selected target stocks.

NASDAQ Composite Index Gilmo Report Chart

Friday’s jobs number came in extremely weak, with only 54,000 jobs added to non-farm payrolls – well below the 165,000 that were expected. However, this was no surprise given that on Wednesday the ADP employment report came in with 38,000 jobs vs. estimates of 175,000. The bottom line is that while QE is still out there in the current form of QE2, it hasn’t done much to create any organic jobs growth in the economy. What the market started to figure out on Friday, as I see it, is that QE is losing its ability to do much more than prop things up. In my view the monetization of astronomical budget deficits in the U.S. and broad will continue, simply because there is no other option given the lack of any political will to cut spending, thus it is likely that QE3 will occur in some form. It just may not be good for stocks. Obviously, more conclusive evidence is necessary in the coming days as we approach the end of June. Note, however, that gold ended Friday on the upside, only about 2% off of its highs of $1,577 per ounce achieved intra-day on May 2nd. Meanwhile the SPDR Gold Shares ETF (GLD) looks to be forming a little cup-with-hande on its daily chart, shown below, after picking up some support on Thursday by closing well up off its lows and in the upper half of the trading range.

SPDR Gold Shares ETF (GLD) Gilmo Report Chart

The strength in gold in the face of Friday’s market sell-off can likely be attributed to the fact that the U.S. dollar, shown below on a daily chart of its proxy, the Powershares U.S. $ Bullish Fund (UUP), streaked to a lower low on Friday as it appears to be making a run at its early May lows. Despite the dollar’s dive, stocks did not respond positively on Friday, and it may be a clue that the market is beginning to consider the potential for more QE and thus more downside for the dollar as something that is not good for the economy and for stocks. As the rubber band of debt and money printing stretches ever more tautly the market is beginning to sense that a breaking point may be rapidly approaching. The breakdown in the dollar over the past eight days puts commodities and, specifically, precious metals, back into play on the upside. It is usually thought of as a “doom and gloom” mentality to speak of a “run on the dollar,” but we must always remember that the reason President Richard Nixon closed the “gold window” in 1971 was to prevent a would-be run on the dollar as other countries holding dollars moved to redeem those paper dollars for gold.

Powershares U.S. $ Bullish Fund (UUP) Gilmo Report Chart

Look at a long-term chart of gold and you will see that once Nixon closed the gold window in 1971, preventing holders of dollars from redeeming them for gold through the U.S. Treasury, the price of gold shot rapidly higher from around $38 to $195 per ounce by late 1974. One major correction from there down to $103.50 an ounce occurred before gold turned again and rocketed to $873. As I see it, that entire move in gold was brought on by the deficit-spending policies of Nixon and his immediate predecessors, and cutting off a source of gold supply, the “gold window” at the U.S. Treasury, fueled that decade-long rise from $38 to $850. Thus I think that currently the stage is set for further highs in precious metals, and if gold continues higher it will drag silver along with it. The daily chart of the nearest silver futures contract, below, shows that silver found strong short-term support off the $35 price level on Friday. Volume in the futures was strong, while “retail” buyers of the iShares Silver Trust (SLV) were somewhat timid. While I am generally loathe to call a bottom in anything, I believe that silver has likely put in a low, and while I think it is buyable here with the $35 price level as near-term support, a pocket pivot type move up through the 50-day moving average at 39.22 would cause me to get much more aggressive on the buy side of the white metal.

iShares Silver Trust (SLV) Gilmo Report Chart

So while I am bullish on silver and gold, the “Burl Ives Investment Strategy,” as I like to call it (recalling that old song from the original stop-action animated “Rudolph the Red-Nose Reindeer” Christmas program), I am not so bullish on stocks. In fact my report of this past Wednesday discussed some playable short-sale targets, and among them was Travelzoo, Inc. (TZOO), shown below on a daily chart. As I wrote on Wednesday, TZOO looks to be set up in a “pin-head & shoulders” (PH&S) type of topping formation that comes on the heels of a “double-climax-top,” which I jokingly refer to as a “porn-star top.” Hopefully, the humor there is self-evident, so I won’t get into it any more than that! J TZOO bounced once up into its 50-day moving average on Thursday before stalling out and turning lower on Friday when it broke down through its 65-day exponential moving average. Notice that TZOO had found support around the 65-day e.m.a. in mid-May and also intra-day on Thursday. If you were able to get a short off around the 50-day moving average, the stock is now down 10% and I would only re-short or add on a rally up into 70 from here.

Travelzoo, Inc. (TZOO) Gilmo Report Chart

As long as we are on the topic of climax tops, we can look at Chinese internet “hot stock” Sina Corp. (SINA) which staged a confirmed climax-top in mid-April, as we see in its daily chart below. At the peak day when the stock went up through the $140 price level the stock was up 7 out of 9 days in a row and had seen the largest one-day point move in its run that one can argue began in September of last year. Since then the stock has broken down below its 50-day simple and 65-day exponential moving averages and then rallied back up above them as it tried to form another base. On Friday, however, the stock reversed on a massive-volume outside-reversal that looks quite ugly and which I would classify as a potential late-stage failed-base type of short-sale set-up. Ideally I’d like to see the stock push back up into its 50-day moving average at around 118-119 as a rally to short into. Note that the stock stopped right at its 65-day exponential moving average on Friday, so a bounce from here might be logical. If that occurred and we saw the stock push up towards 114-115, then I would be happy to short the stock with a 3-5% upside stop.

Sina Corp. (SINA) Gilmo Report Chart

Anyone who is short Las Vegas Sands (LVS) was likely frustrated this week as the stock held up just beneath its 200-day moving average in the face of the market making lower lows this week. LVS had its own climax top back in November of last year, and since then tried to build an entirely new base but in early May a large-volume gap-down tagged the stock as a potential late-stage failed-base (LSFB) situation. The stock is likely getting near-term support on the basis that the Macau Gaming and Inspection Coordination Bureau reported year-over-year revenue growth of 42.4% in May. I tend to think that if that was such great news for LVS the stock would have cleared its 50-day moving average by a decent margin on big volume, but instead it stalled out and closed back below its 200-day moving average. I say the stock is still potentially shortable, but may require some patience, using the 200-day or 50-day moving averages as upside guides for stops. While next quarter’s estimates call for 153% earnings growth, subsequent quarters show a deceleration to 32% and 14% respectively, and despite reporting 429% earnings growth in early May LVS still gapped down on huge volume as we see in the daily chart below. Thus I would rely on price/volume action here as the defining criteria, not “fundamentals.”

Las Vegas Sands (LVS) Gilmo Report Chart

Many analysts and commentators like to tout Google’s (GOOG) Android operating system for mobile phones and how that is the next big driver for the stock going forward – hence the stock is a “buy.” Unfortunately, the price/volume action of GOOG doesn’t argue in favor of this thesis as the stock gapped down through its 200-day moving average in mid-April. Since then the stock has not been able to rally above the lower boundary of the “falling Window” (highlighted area) that occurred on the gap-down day and to me appears to be “ledging,” e.g., building a bearish flag or consolidation as it prepares to “breakout” to the downside and lower lows. At the very least I would revise my upside stop to 545 at the bottom of the falling Window. If I preferred to use tighter risk management then I think the declining tops trendline I’ve drawn on the chart might serve as a near-guide for an upside stop. Near-term I tend to see the 530-532 price level as resistance. Remember that GOOG is a $500-plus stock, and a move from 523 to 545 is all of 4%, hence a reasonable stop-loss from a percentage perspective.

Google's (GOOG) Gilmo Report Chart

As I wrote in my report of this past Wednesday, I would have seen any little rally in Finisar Corp. (FNSR) following Wednesday’s sharp downside break as a shorting opportunity, and indeed the stock staged a tiny upside move on Thursday before closing slightly down on the day. Friday saw the stock break down more decisively as it “broke out” to the downside and through this downward-sloping trendline support I’ve drawn on the chart. While I don’t interpret H&S topping patterns on daily charts, preferring instead to rely on the weekly charts in this regard, it is interesting to note that this little downward-sloping trendline I’ve drawn also looks like it could be the “neckline” of a tiny head and shoulders formation where the “S” at the peak of this last rally (the right shoulder in the “big” head and shoulders formation) forms the “head” of this small H&S formation. Volume picked up 44% above average on Friday, making this a bona fide downside “breakout.” FNSR reports earnings on June 15th, but at this point I’m not sure it will make that much difference. If you are short this stock there is no reason to cover just yet.

Finisar Corp. (FNSR) Gilmo Report Chart

I’ve been keeping an eye on Aruba Networks, Inc. (ARUN) ever since it broke down on huge volume a couple of weeks ago after announcing earnings. As I see it, that massive-volume break defines the right side of a “head” in a possible head and shoulders topping formation, and this two-week rally off the 200-day moving average, roughly, may be the makings of a right shoulder within an overall H&S formation. ARUN hit my initial alerts up around the 28-29 price level on the first bounce into the “zone of resistance” I’ve highlighted on the chart, but it could potentially move higher to the 30 price level, or even as high as the 50-day moving average, currently running through the 31.62 price level. That is not clear just yet. ARUN got an analyst upgrade to “overweight” on Friday, which created a small rally in the stock right up into resistance where it stalled out. Right now I am willing to test a short position into this rally, using the high of four days ago at 28.98 as a near-guide for an upside stop. ARUN is allegedly benefitting from the increased use of iPads on corporate networks by providing an easy security solution for such devices, but I would simply say that if the stock can’t get above the 28.98 high in this potential right shoulder then the next stop is likely the 200-day moving average.

 

Aruba Networks, Inc. (ARUN) Gilmo Report Chart

As discussed in my Wednesday report VMware, Inc. (VMW) is looking like a late-stage failed-base (LSFB) set-up on the short side, but Friday’s selling lightened up a bit, so one must absolutely use the 98.55 breakout point as your quick upside stop on any VMW short position…

VMware, Inc. (VMW) Gilmo Report Chart

…since Baidu, Inc. (BIDU) in November 2006 shows that a massive-volume breakout failure doesn’t always spell doom for a stock:

Baidu, Inc. (BIDU) Gilmo Report Chart

Investors should always recognize that the short side of the market is far more difficult than the long side, and if this choppy and sloppy market action that we’ve seen since early February has made it tough on the long side, then we can expect the short side to be just as difficult, if not more so, until the market sets off in a bona fide, discernible trend again. So far the action of 2011 has been mostly trendless, and this could certainly continue through the summer. Thus one can also take the path of simply sitting in cash. Of course, if one chooses to sit out the market then that does not mean one should ignore it, since the next big window of opportunity will set up when one least expects it. Hence monitoring potential leaders on the long side and potential former leaders breaking down on the short side is critical, and The Gilmo Report does a lot of that work for you in very specific terms.

If we continue to muddle along in an environment that sees QE3 or some mutant/variant of quantitative easing continuing, I would expect that precious metals, both silver and gold, will offer some of the best opportunities in a continued declining-dollar environment. While silver is lagging gold currently as it still sits beneath its 50-day moving average, I think silver is playable by keying on the action of gold. Gold is in a much better technical position only 2% off its all-time highs, but any move to the upside will likely drag silver along with it, which is why I would look for some sort of pocket pivot move on the part of silver as it eventually tries to retake its 50-day moving average in an attempt to follow gold higher.

However, should we see a situation develop where a liquidity crunch develops similar to late 2008, then gold and silver could get dragged down with stocks as they did during that period. Both silver and gold, however, recovered much sooner than stocks and gold moved toward new highs as the stock market was merely bottoming in March 2009. My guess, however, is that the Fed will do whatever it can to prevent another similar crisis, and that at least for the next few months this will lead to the mutant offspring of QE1 and QE2.

Consider that, allegedly, the “Taylor Rule” serves as the model whereby the Fed forecasts the appropriate Fed funds rate given prevailing levels of inflation and unemployment. Theoretically, the Taylor Rule says that the Fed funds rate should be -1.65%. Thus, by their own model, the Fed’s current monetary policy is “restrictive” given current levels of inflation and unemployment! Of course, this all depends on how one measures inflation and unemployment, and anyone with half a brain knows that the government fudges all their numbers with the explicit intent of making inflation seem lower than it really is in order to justify looser monetary policy which in turn helps to monetize continued and now astronomical budget deficits. Nevertheless, if the Fed can come up with a “rationale” to continue with QE, in my view it will readily do so.

While Fed officials pay lip service to the idea that QE is no longer necessary and that other forms of stimulus are needed from other sources (e.g., the government) to get the economy going again, I don’t believe they will just pull the rug out from underneath the economy. They might back off on QE2 to see how the economy and the markets react, but current economic data already show that the economy is weakening very quickly, thus bringing on some sort of “QE3 factor” into play sooner than later. QE3 vs. a feeble economy could mean a choppy environment for stocks, but perhaps a better opportunity will lie in precious metals and commodities. For now the bottom line is that the market remains in a correction until further notice, and investors can choose to remain in cash, try to play the short side, or, as I prefer, look to play precious metals if a mutant QE3 rises from the grave of QE2.

Gil Morales

CEO & Principal, Gil Morales & Company, LLC

Principal and Managing Director, MoKa Investors, LLC

At the time of this writing, of the stocks mentioned in this report, Gil Morales, MoKa Investors, LLC, and/or Gil Morales & Company, LLC held positions in ARUN, DGP and SLV, though positions are subject to change at any time and without notice. Gil Morales & Company, LLC (“GMC”), 8033 Sunset Boulevard, Suite 830, Los Angeles, California, 90046. GMC is a Registered Investment Adviser. This information is issued solely for informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. Information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. Past performance is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to GMC, its members, officers, directors, employees, customers, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. Additional information is available upon written request. This publication is for clients of Gil Morales & Company, LLC. Reproduction without written permission is strictly prohibited and will be prosecuted to the full extent of the law. ©2011 Gil Morales & Company, LLC. All rights reserved.

Gil Morales & Company, LLC (“GMC”), 8033 Sunset Boulevard, Suite 830, Los Angeles, California, 90046. GMC is a Registered Investment Adviser. This information is issued solely for informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. Information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. Past performance is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to GMC, its members, officers, directors, employees, customers, agents, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. Additional information is available upon written request. This publication is for clients of Gil Morales & Company, LLC. Reproduction without written permission is strictly prohibited and will be prosecuted to the full extent of the law. ©2008-2018 Gil Morales & Company, LLC. All rights reserved.