Trader’s Narrative

With today’s close the S&P 500 index arrived at a new high for the year. So far, it has risen 22.8% - not bad at all compared to the average historical return. And the year isn’t even over yet. If we look at the performance from the very bottom of the lows in March, it is even more remarkable at 63%.

But even as the stock market continues to power ahead, and longevity of this rally continues to strain all credulity, we can’t ignore that the market breadth is down right horrible. Usually, the measure of advancing vs. declining stocks rises and falls like a tide, keeping a rhythm with the indexes.

Right now however, the 20 day average of Nasdaq’s daily advancing and declining issues is acting the way it would at intermediate lows - even though we’ve well into an uptrend:

This means that fewer and fewer stocks are pushing the averages higher. When we start to see less participation from the wider spectrum of stocks trading on the exchange, we don’t have a healthy rally. My hunch is that most of gains can be laid at the feet of the large caps either because of their international sales exposure or because of the dollar carry trade (sell the dollar and buy anything risky). Check out the Russell 2000 - it has yet to confirm a new year to date high as the S&P 500 index. The same can be said for the equal weight S&P 500 index.

Another cause for concern is just how quickly the index has been able to rise on the back of fewer and fewer rallying stocks. For a bull market to be considered healthy, it has to have staying power. This is an endurance run after all, not a sprint. I measure the speed of a rally by comparing the closing daily price to the long term trend as measured by the 200 day moving average.

While the 200 day moving average has been rising, it hasn’t been able to climb as fast or faster than the price it tracks. So the distance between them as a ratio has increased. With today’s strong close, the S&p 500 index is now 19.3% higher than its long term trend line. That’s slightly more than the last time this same metric made me raise the caution flag: Stocks Have Little Room to the Upside.

That was 11 points lower than we are now. Running the numbers with a 20% and 21% ceiling, we get 1117 points and 1127 points respectively. So imagining that we leapfrog 8 to 18 points from here, we will have hit an invisible wall. Check out the previous link above to see a chart.

So odds are that we either correct here (again) to give the long term moving average a bit of time to catch up. Or prices meander to and fro, not really going anywhere and boring both bears and bulls. There is very little probability, from a historical study of the market, that we will see a rush higher.

During the cyclical bull market that started in early 2003, every time the market penetrated its long term moving average, it ricocheted off like a smooth pebble off a lake.

In hindsight, it looks quite orderly and beautiful (see chart). But each time the indices breach their 200 day moving average, it alarms a lot of investors and “experts” who start to pontificate about the importance of this simple technical indicator.

There’s nothing magical about it. In a bull market this behavior is normal. But in a bear market, the opposite is true - that is, the market is hardly given the chance to poke its head above the 200 day moving average and when it falls below it, it goes deep. In the summer of 2002, for example, it went more than 25% below.

The noticeable change is that since the intermediate bottom in August 2007, each subsequent trip below the 200 day moving average has been lower. After today’s shellacking we’re now -5.5% - a place we haven’t been in more than 4 years.

So is this it? Are we on the cusp of a new [gasp] bear market?

No one knows.

All I can do is to follow the technical and sentiment signposts that have been helpful in the past and try to use them to make some sense out of it all.

Although they never line up perfectly, most of the indicators I see are pointing to a correction. The most convincing argument is that investors and traders are reacting with complacency but fear.

I’ve already outlined the sentiment overview, and to that we can add today’s CBOE equity put/call ratio which reached 0.97 - a level that it reached before in mid November 2007, mid August 2007 and March 2007.