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At the beginning of the month I wrote about the emerging trend in equities, with lower lows and lower highs. At the end, however, I referred to the extreme RSI level, adding a caveat to expect higher prices in the short term:
This makes me expect a short term relief rally. Sentiment is also reflecting quite a bit of pessimism - more about that in tomorrow’s weekly sentiment overview. But I don’t expect such a rally to be very strong or sustained.
And the bounce arrived right on cue taking the S&P 500 index higher by about 80 points and almost reaching 1100. The rally ended abruptly last Friday with most indexes dropping sharply. From the looks of it, we’re setting up for yet another lower high after quite a few lower lows and lower highs.
This is the definition of a downtrend and we can see the same general pattern emerge if we look at breadth indicators like the percentage of stocks above a moving average. I’ve referred to the longer term breadth measure (percentage of S&P 500 components above their 150 moving average) more than a few times. The most recent was when I mentioned that while current breadth was bad, it usually gets worse. Here is a zoomed in version of the same chart I showed in that previous message:
Everything was going relatively well with the vast majority of stocks trading above their longer term average but then came along the May 6th “Flash Crash”. That started the trend of lower lows and lower highs for this breadth indicator. It may be a bit difficult to see on the chart but the January 2010 top was slightly under the highs of September 2009 and the April 2010 top was slightly under the one from January 2010.
The most recent bounce from the start of this month has only continued that pattern. If it does continue, then the historical norm is for it to eventually go below 10%. To see a longer term chart showing previous times we’ve fallen to these low levels, check out: When Breadth is this bad, it usually gets worse.
The same pattern of lower lows and lower highs can be seen in the cumulative advance decline lines for both the S&P 500 index and the NYSE. So overall, I’m not really seeing any technical reasons to expect anything other than continued weakness.
From the sentiment data, the thing that concerns me is that generally speaking, sentiment is too quick to shift back to the bullish side. We did see some genuine fear and loathing at the end of June and early July in the NAAIM and AAII indicators. But then both of them quickly jumped on the rally bandwagon and forgot their worries.
A break in this pattern of lower lows and lower highs would certainly change the tone of the market. But that all depends on what sort of market we find ourselves in at the moment. One of the first steps traders and investors take is using tools like RSI, sentiment and breadth. But the next stage of development is recognizing that these metrics behave differently under different market conditions so they can’t just be taken at face value. Among the lessons in this stage is to watch for how a market behaves coming out of extreme oversold conditions.
If the bulls are unable to mount a decisive move, then they’ve betrayed their weakness. That has been the characteristic of this market since April and until it proves otherwise, I would advise caution for those who are long.
And to be perfectly honest, it makes me rather uncomfortable to find myself in disagreement with such giants of technical analysis as NDR and Lowry but since I’m dedicated to thinking for myself and making my own mistakes rather than becoming an automaton, I suppose that is the price that is to be paid.
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