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