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A Few Technical Reasons To Bounce Higher at Trader’s Narrative





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Below you’ll find a few technical reasons to expect higher equity prices. I look forward to hearing your own opinion and analysis, especially if you disagree.

Volatility
First, let’s start with the incredible jolt of volatility. I wrote about the relative VIX in late April, before the sell-off:

relative VIX compared to SPX May 2010

On May 7th, the VIX closed 101.25% above its simple 50 day moving average. We hadn’t seen something so spectacular since the darkest days of the last bear market in October 2008.

That made the previous 25.5% relative close above its 50 day moving average in late April look like a speed bump. As you can see from the above chart, this doesn’t necessarily correlate with higher prices as much as it demonstrates the sudden chaos that engulfed the market.

Contraction begets expansion. The VIX was lying dormant for a few months and then it came roaring back (relatively speaking). That’s the most important thing to key off from this indicator.

McClellan Oscillator
While the Summation Index for the Nasdaq is still too high, the McClellan Oscillator is just about ready to pronounce an important low for the market. For charts and further details see the previous discussion of the McClellan Oscillator.

Breadth
By now the work of Paul Desmond of Lowry Research on the importance of 90% down/up days is well known in technical circles. This award winning paper argues that major bottoms are made when market participants suddenly rush from selling to buying within a short period of time.

The recent market volatility contains this exact same characteristic. We saw 90% down days where almost everyone was selling. And then we saw a 90% up day where it seemed like everyone was buying.

Although Desmond’s work is about lows that are created at the end of a protracted bear market to lay the foundation of a new bull market, the principle of breadth thrusts still has validity for shorter time frames. For more, see Wayne’s work on similar capitulation days.

According to Jason Goepfert, a breadth thrust from oversold, similar to the one we just saw, is very rare. Since 1940 there have only been 6 other times when the market has wallowed in consecutive days of extreme oversold to then suddenly spring to life with a breadth spike. The returns in the short term (week) have been poor but extending the time frame to 3 months has provided good returns.

Percentage Above Moving Averages
At the beginning of the month we looked at combining two measures of breadth based on moving averages. One short term (the percentage of S&P 500 components trading above their 50 day moving average) and one long term (the percentage of S&P 500 components trading above their 150 day moving average).

During ‘normal’ markets, when the ratio falls below 0.50 we have the conditions for an intermediate low:
ratio percentage above MA compared to SPX May 2010

The most recent low was last Friday when the ratio fell to 0.255. To see a long term chart of the same, see: Finding Buy Points With Moving Averages

ETF Volumes
During times of stress in the market, traders flee to the safety and liquidity of ETFs. This ETF liquidity premium then becomes a good indicator for inflection points. Here is a chart of the S&P 500 index with the volume of the QQQQ ETF:

QQQQ volume compared to SPX May 2010

You can also see the same phenomena with SPY volume. Like our look at the VIX, it is important to look at the volume relative to its recent activity to help identify liquidity premium spikes.

New Highs vs. New Lows
Finally, we’ve discussed the role of new 52 week highs as “canaries in the coal mine” of a bull market. Here is a chart showing the ratio of new highs to new lows for the Nasdaq and how this has corresponded during this cyclical bull market with inflection points:

Nasdaq new high low ratio compared to SPX May 2010

Hope that gives you a better idea of the technical position of the market. I’m looking forward to the sentiment data from the various surveys to see just how much capitulation occurred from investors.

The one place where I was hoping to see capitulation, the options market, has not been cooperative. Both the ISE Sentiment index and the CBOE put call ratio have reacted but they haven’t been pushed far enough for us contrarians.

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14 Responses to “A Few Technical Reasons To Bounce Higher”  

  1. 1 PAUL MONTGOMERY

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    Thanks Babak - how do you create that Vix [for example] relative to it’s 50ma in Stockcharts ?

  2. 2 Rod

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    Babak, very true, but I am still afraid of pulling the trigger because all this bottom-picking is fine but it works until it doesn’t. IOW, the larger uptrend is in place until it’s not.

    This is reinforced by the article from Matt Claassen, who suggests that the top is not always a long, rounded formation, but sometimes it is a quick inverted V, and there is no advance warning from your breadth measures.

  3. 3 Babak

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    Paul, I use the PPO indicator (1,50,1 settings).

    Rod, you’re right. I’m just using the same guides that have been helpful so far. They will at some point stop being useful but until then.

  4. 4 PAUL MONTGOMERY

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    Brill ta Babak

  5. 5 Fibocycle

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    for a few more reasons to expect a bounce:
    * the 200 day exponential moving average is at 1099.51
    * the 2.618: 1 natural support line (NSL) is at approximately 1108
    * the low is in the area of the midpoint of the wave 4 decline that culminated at the February 5th 2010 low. Jan 11 high 1150.45 — Feb 5th low 1044.50: Midpoint = 1097.48
    * the 4.236: 1 NSL from the July 2009 low is at approximately 1060.00
    * 23.6 pct. of the range of the Feb-April rally is 1085.87
    * 78.6 pct. of the March 2009-April 2010 rally is at 1101.46

    for details and graphics see

  6. 6 Doctor Stock

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    interesting… looks like you got what you expected.

  7. 7 PJ

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    Hi Guy,

    What do you make of this 90% up volume vs down volume. Also what do you make with those 90% down volume with 10% up volume.

    The advance declines are 90/10 both ways up and down.

  8. 8 Wes

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    Babak,

    I don’t think the ISEE Sentiment Index is actually capable of telling us much right now, and I’m not at all certain why. Maybe you can help.

    Prior to 2006, this index moved over a much wider range. My first red line (getting pretty bullish) is at 180 and the upper red line (are very greedy) is at 220. The lowest green line (are very fearful) is 120 and my upper green line (getting pretty bearish) is 140. I use a 15 day MA.

    Prior to 2006, this indicator oscillated between those limits quite frequently. Since about May of 2006, it’s like these traders crawled into the bear cave and won’t come out. The oscillator hugs the 120 green line and hardly budges.

    Do you have an explanation of this ? Maybe I need to reset my limits. You think they may have all gotten into real estate ?

  9. 9 Babak

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    Wes, I hear you. I’ve been looking askance at the ISE data as well. But it didn’t pass my notice that the ISE Sentiment for all securities (including ETFs and indexes) fell to 59 which is the lowest since March 2008. I’m going to look at the difference between all securities and equities only and see if I can coax something out of it.

  10. 10 MatthewC

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    Re: 90% Down followed by a 90% up Day

    I would be cautious using this indicator as an absolute singal. There are many historical examples back to 1940 of the 90% Day pattern failing, including 10 occasions during the 2007 - 2009 bear market. It finally worked on the 11th occasion. Like any “indicator” it needs to be used in conjuction with the investing environment.

    The recent 90% up day is encouraging, but all the positive breadth pre-market and on open, more like a news event shock and short covering than real buying interest. Perhaps that’s what makes me less than comfortable with the current market; the news event risk is unusually high.

  11. 11 Babak

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    Matthew, thanks for pointing that out. I forgot to mention that the percentage of stocks trading above their short term moving average (10 day simple) fell below 10% which has been also a historically good signal according to this research from Lowry’s that I shared on the blog back in 2007.

  12. 12 DL

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    Yes, I think the market will be higher in 2-3 months. The more immediate question is, when does the SPX retest its low, and which low will it test? It could be the 1110 level, the 1090 level or the 1065 level. One should be wary about blissfully “buying and holding” until a retest of one of the “lows” has occurred.

  13. 13 thunderbird

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    Hey Babak,

    Regarding “strategic mortgage default”: this new strategy people are following in the US should produce an interesting effect, if only banks could be motivated to pay proper attention to it.

    Try this out: it’s 2007 and you’ve got an overheated housing market. People buy houses for $500k that are worth only $250k because of the bubble.

    Okay? Fast forward 3 years. Your $500k house is only worth $250k, and you’ve only paid $50k into the principal so far. So you do the wise business decision, cut your losses, and walk away.

    This risk was there in 2007 that this would happen, but the banks didn’t bother pricing that extra risk into their mortgage rates.

    OK? Now let’s assume the banks aren’t stupid. Still with me? Just play along, then.

    The next time a 2007-type bubble rolls along, and the banks see people paying $500k for $250k houses, if they’re smart they will charge a premium on the interest to cover the risk of future strategic default.

    Whoops! A risk premium on mortgage rates, dependent on strategic default risk, i.e. proportional to the chance the bubble will burst?!?

    Blammo, Babak. That is precisely a negative feedback mechanism that can keep housing prices from ever running away in a bubble.

    Well, unfortunately it requires a free market with no government bailouts, no government subsidy of mis-pricing of risk. Seems like a good idea though, no?

  14. 14 Steven

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    The last two major drops (Feb 2010, and Oct 2009) both had double bottoms with the second bottom lower.

    With option expiration next week, I wouldn’t be surprised if we get the second bottom by this Friday or Monday to clear out the longs and then a strong leg up to clear out the shorts by next Friday.

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