Trader’s Narrative

Breadth is an important element of technical analysis that usually gets ignored for pure price action. But every once in a while, it is helpful to pop the hood and take a look at what is driving the price action in the indexes.

A simple way to measure breadth is to look at new 52 week highs relative to new 52 week lows. A healthy bull market will have a persistent bias towards new highs as most shares on exchanges trades to make new highs.

The indicator below is the New Highs New Lows Index for the Nasdaq. And it is based on a basic formula: new 52 week highs divided by the sum of the new highs and the new lows. It varies from zero to 100. When it is zero, it means that we have absolutely no new 52 week highs (with every single stock trading at a new 52 week low). This is a very rare and exceptionally oversold market. The reverse would be 100 with all shares at 52 week new highs.

Naturally, it is a very good timing indicator which I’ve used before to find inflection points in the market: Can the New High New Low Indicator do it again?

Since it can be rather volatile, I’ve used a 10 day simple moving average to smooth it out and provide a more meaningful chart:

We’ve moved very quickly from the extreme lows in March (where the 10 day moving average was 0.48%!) to 88% in recent trading.

Historically, when the 3000 or so constituents of the Nasdaq Composite start trading at 90% new highs, the market has a tough time moving up. We either enter into a range to work out the overbought or fell lower. Often times significantly lower.

The only exception to this in recent history was the powerful new bull market in 2003. New 52 week highs, relative to 52 week lows, as measured by this indicator continued to levitate at the extreme edge, reaching almost 100% for about 12 months as the stock market powered ahead.

The other interesting portion of the chart is the divergence shown in 2000 as the market was topping. Even as priced reached for the heavens, there was a complete collapse in the number of stocks reaching 52 week highs. You can see a similar divergence happened in mid 2007 as the S&P 500 once again climbed over 1500.

So the question continues to be: is this another bear market rally or like early 2003, the start of something much more?

The only way to know is to watch for price action in the face of overbought indicators like this one. If the S&P 500 continues to trade higher, shrugging off this and other indicators pointing to an overbought condition, then it is clear that what we are seeing is not just a regular bear market rally.

The market is bumping its head against a resistance range from 1400 to 1450. This area was of course, support just a few months back.

Starting from April 18th, I noticed a change in the market tone. Whereas pretty much every single indicator had been flashing buy in January, February and March, one by one, they started to point to caution:

• too many stocks above their 10 day moving average
• a fourth attempt at the 1400 level
• AAII sentiment back to October 2007 bullishness and the ISE call put ratio too high
• trading volume low enough to cause concern
• 78% of S&P 500 stocks above their 50 day moving average
• “Sell in May and go away!”
• market stretched above its 50 day moving average
• AAII sentiment inches even more to bullish excitement
• number of S&P 500 52 week highs compared to 52 week lows signals caution

The best scenario for the bulls would be for the market to pause here and digest this overbought condition and then continue to move higher, breaking above the flag or pennant formation.

About two weeks ago I brought up an indicator, the New Highs/New Lows on Nasdaq eventhough it wasn’t really telling us anything interesting back then. It is a ratio measure of stocks within the Nasdaq making 52-week new highs and new lows. It is a percentage so it ranges from 0-100%. When it is low, it means that very few Nasdaq stocks are making new highs while the vast majority are making new lows.

Back then it had fallen to 30%. Low but not really extreme. It was worth watching because of its uncanny ability to find market bottoms.

As I mentioned, for a good solid floor under the market this indicator needs to reach atleast 10%. In the past, this level has coincided with significant market bottoms.

As a result of last Thursday’s heavy downday, this indicator finally breached the 10% line in the sand to hit 9.4%. On Friday, eventhough the market continued to sell off heavily, this indicator surprisingly went up 2.18% percentage points.

Which means that while the indices were getting clobbered Friday, actually less stocks were hitting 52 week bottoms and more were making 52 week highs. This is the sort of divergence that I’d love to see more of.

I didn’t include a chart of the S&P 500 but I’m sure you recognize all of those points in time with the green arrows as major market bottoms.

So after warning you that we were headed into some shaky grounds on Monday morning (premarket) when the S&P 500 stood above 1540. And after the market fell to around 1510, saying that we had still some more room to the downside… Let’s see if I can continue this streak.

Lowry’s 90/90
No question today’s market action was severe. No doubt it was a Lowry’s “90/90″ day - where 90% of the points and 90% of the volume are on the downside. From the 3417 issues on the NYSE, 3144 of them closed down. That’s 92% to be exact. Meanwhile, volume on the NYSE was 95% to the downside.

Can you say e-x-t-r-e-m-e?

This is the sort of panicked, thorough selling that market inflection points are made of.

New Highs New Lows
This week I mentioned a few indicators that I was watching. The Nasdaq’s New Highs/New Lows indicator told me that we had more room to fall as it was still above 10. Today’s devastating decline took this indicator to just below, at 9.39. At these levels we can start to seriously look for a bottom.

Today, the New High/New Low Ratio also fell to extreme oversold levels. According to these two indicators, the number of 52-week lows (compared to highs) presents a compelling argument to go long.

Leaving aside market internals, a simple glance at the chart of the S&P 500 gives us a hint that the market may find its footing here. The February 2007 top which previously acted as resistance but can now become support:

Usually I leave volume off my charts but check out the volume today! Notice how in previous market inflection points, the surge in volume coupled with a wide range dark candle tends to signal a change in trend?

Most common indicators swung to extremes: The volatility index (VIX) spiked above 23 and met my request to go a tad higher. And the put/call ratio also spiked to a bullish extreme.

But the indicator of market health that I give a lot of weight to still hasn’t reached the kind of wash-out extreme that I’d like to see:

I’d prefer to see a real washout that would be a reading of 20-something. Similar charts for other percentage of stocks above 50 day moving average for indices like the Nasdaq 100 are also low but not low enough yet.

We could still bounce from here, especially as a gap up open tomorrow morning. That’s why right after 3pm I bought a bit of Ultra S%P 500 Proshares (SSO). The last hour of trading is known as “contra-hour” for good reason

What I’m most interested in seeing is how sentiment reacts to this recent decline in the markets. If we have real fear (increase in bearish sentiment), then we are probably all clear for another leg up in the bull market. But if people are complacent and do not flinch, things could get ugly.

Last week the Nasdaq new highs, new lows indicator was just under 30 and I mentioned that although it had dropped it had yet to reach an extreme level which would presage a bounce.

After yesterday’s red day, it fell to just under 15. That’s low, but still I’d like to see it reach below 10 and move higher. In the past this is what we’ve needed to set up an intermediate bottom. For detailed information on this indicator, check this out.

Such a reading would mean that almost 90% of the stocks reaching 52 week extremes are doing so by hitting new 52 week lows.

Another way to look at the same sort of data is to look at the Nasdaq high/low ratio. That is simply divide the daily Nasdaq new highs by the daily Nasdaq new lows. This indicator shows pretty well the same thing. The market is oversold, but not yet to an extreme level.

We may get a feeble bounce today as the market reacts but for a really good washout, we need more work to the downside. That may happen quickly or over the next few days and into next week.

However it works out, atleast through the looking glass of this indicator, we aren’t there yet. As you can see on the graphs below, we need to reach the green areas outlined:

Nasdaq New Highs New Lows Indicator:

Nasdaq New Highs Lows Ratio: