Is this the end of the much maligned and hated cyclical bull market? or is it just another correction like the ones we’ve seen before? I don’t pretend to know what is going to happen in the market (my crystal ball is back at the shop being polished). What I try to do is look at the market as well as common sense indicators that have provided insight in the past.
A breadth indicator that fits that description is the percentage of S&P 500 components trading above their 50 day moving average. It offers a guide in the medium term time horizon and is useful for finding significant lows. But like many breadth indicators it acts quite differently depending on the type of market we are in. This can throw a lot of people off and fool them into thinking that the indicator is at fault, not their understanding of it. So let me explain what I mean when I say that equities are at an important low… if we are still in a (cyclical) bull market.
At the start of this week this indicator fell to 17.6% and recovered slightly yesterday. As you can see, when it breaches the 20% level, it usually indicates an important low. However, that only happens during bull market conditions. In a bear market, it falls much lower and as we saw recently, can even go to zero (which is rare):
And if you want to get all second derivative, consider this: start with the percentage of S&P 500 components trading above their 50 day moving average as above but then add a 50 day moving average to it. And then chart the relative movement of the breadth indicator to its 50 day moving average. Got that?
Right now, we are at an important juncture for this second derivative indicator. As with the first derivative, it is flagging a significant inflection point in the market. The only time that this signal fails and goes even lower is during bear markets when oversold gets even more oversold. This is what we saw in late 2002 and 2008.
Furthermore, when the percentage of stocks trading above their 10 day moving average drops below 10% it indicates an important low (see Lowry’s report on this). This week we saw this shorter term indicator drop to just below 10% for the S&P 500. The last time it did so was in early November 2009 and March 2009.
So the message is to expect a bounce here. But if we don’t, then this could be a strong indication that the cyclical bull market we’ve been riding for almost a year is finished because the nature of the market has changed.
The uber-bearish Chief Strategist at Royal Bank of Scotland, Bob Janjuah, outlines what could happen in a recent note:
I now think we have begun the 3rd and final leg of the multi-yr bear mrkt which began in 2007 and which SHOULD, hopefully, finish late this yr, but which COULD (hopefully not) drag on deep into 2011. This new bear leg SHOULD see S&P trade sub-1000 this mth. After which we can bounce a little (back up to 1080/1100) over late Q1/early Q2. However, this I think will then be followed by a move down at least into the low 800s in Q2/H2 10, and depending on how policymakers behave, potentially down towards/to New Lows
As a caveat, keep in mind that while Janjuah is a favorite of the bears, he has been consistently on the wrong side of the market since March 2009. Also, I’m surprised that a 7.8% decline would impress on Janjuah this conviction since the correction last summer was deeper (9%) than what we’ve currently seen. But to be fair, I’m sure that he is taking into account other fundamental concerns like the European debt crisis.
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