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By now I probably sound like a broken record but the evidence for a ricochet off these levels is building up. Let’s run through it quickly:
Today’s close gave us a beautiful “hammer” candlestick formation. Its long tail is trailing right where the S&P 500 index found support back in February of this year:
While not a guarantee, a hammer candlestick is a strong indication of higher prices because it demonstrates that sellers were exhausted and beaten back by the buyers. The important distinction is that while prices were pushed lower during the day, they closed higher, near their intra-day high. As well, prices are right under the 200 day moving average (not shown on above chart) at 1103.59. If prices do move higher sharply, this would be the ideal “bear trap”
Volatility has spiked higher, especially when we look at it relative to its trend to normalize for recent price patterns. Since volatility is a sign of fear, this is a clear contrarian indicator as it cycles back from expansion to contraction again.
Bullish sentiment has sharply dropped off from the extremes seen last month. We aren’t seeing every single gauge register critical levels but then again, that never happens. The important development is that as a consequence of lower prices, investors and traders are not persisting in their optimistic tendencies but instead hightailing it out of dodge.
The decline in optimism is no where more marked than in the Hulbert Nasdaq Newsletter Sentiment index. This is a measure of the portfolio recommendations by a group of newsletters which attempt to time the Nasdaq market. At the end of April, this group of market timers was recommending that their clients have +80% exposure long to the Nasdaq. That raised a lot of eyebrows since it was the second time they had been this bullish - the previous time was during the peak of the tech bubble in the summer of 2000 (when they went as high as +90%).
As the market started to tumble, however, this group quickly abandoned all hope. By May 6th it was down from 80% long to just +42% long. Then a few days later on May 14th they were basically neutral at +3%. Fast forward to today and they are actually recommending to their clients to be short the Nasdaq! The average exposure they are recommending is -45% (or 45% of the portfolio short).
As a contrarian, this is exactly the sort of thing we patiently lie in wait for. There is nary a whiff of complacency or tenacity from the bulls. Had they instead stamped their feet like children, staying long and demanding that the market rise to satisfy their positions or worse, if they had increased their long exposure as they did during the tech bubble, then it would be a very different story altogether.
Breadth is continuing to be extremely negative - the sort of negative extreme where selling is exhausted and buyers step in to pick up bargains. For example, the percentage of S&P 500 constituents trading above their 50 day moving average is still scraping the bottom of the barrel at 7% (a tad higher than the recent low of 6%). And the percentage above their short term, 10 day moving average is just 3%.
The long term breadth measure is showing a weakening of the market and an end to the cyclical bull market. Most S&P 500 stocks has given up their long term trend lines and are trading well below them. Only 38.6% of S&P 500 stocks are above their 150 day moving average and only 50% above their 200 day moving average. As I mentioned before, this points to a shift in the general tone of the market. But even so, the short term opportunity is quite clear and undeniable based on trusted indicators.
I’m hearing rumblings out of Lowry Research which suggest that they are getting ready to shift away from identifying the primary trend as being up. After arriving a bit late to the party, Lowry gave an intermediate buy signal in August 2009. Since then, their bias has been upwards for the market. They believed that we were in the first phase of a cylical bull market or “primary buying phase” marked by momentum and relatively low risk. The next phase is a more sluggish uptrend which has more risk. Their buying and selling indicators are shifting down from their turbo overdrive, reflecting the change in the tone of the market we discussed earlier.
Even if we are entering a more sideways market, it is important to remember that bear market rallies are vicious and intense. As shorts cover their positions from much higher, they are joined by momentum players who pile on and drive prices much higher. And then there are the late comers who think that this is the real deal and buy at the last minute to hold the bag. So at this point, I’m keeping my time horizon short term and relying on basic support, resistance and the indicators mentioned above to find low risk buying opportunities - especially if the S&P 500 is able to close above the hammer candlestick’s top and clear the congestion at ~1080.
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