Trader’s Narrative

Let’s face it, this market has been driven by technicals not by any real fundamental health. So what happens when the same folks leave and take their rationale with them, fundamental investors may not be as keen to support the bids.

The recent softening in bids shouldn’t be a surprise. On October 15th the S&P 500 briefly traded 20.81% above its long term moving average. Now, it is only 14% above it. It was back on September 16th that the S&P 500 index first reached the 20% Maginot Line. Between then and now we had 4 other instances where price briefly pierced minutely above the 20% barrier only to be pushed back. Compared to historical precedence, this is part for the course.

As I presented in the detailed historical research report (What Happens This Far Above The 200 Moving Average?), usually when price moves this much away from its long term trend it has been unable to continue at the same pace. That’s what we’re seeing today as the S&P 500 is now below where it was trading on September 16th.

In this short video you can see the headwinds arrayed against the S&P 500. Both by the breaking of the uptrend line from March 2009 and the approaching downtrend line from the top of the bear market (October 2007):

One of the most important sectors, the Philadelphia Banking Index (BKX) has broken this uptrend line. We are also seeing some serious breadth (advance decline) weakness which is never really good but especially bad news while the market is so near a top.

Two institutional money managers have turned negative on the market recently. Jeremy Grantham of GMO Partners and Bill Gross of PIMCO. Click here for details on Grantham’s reasoning and to download his full quarterly report. Gross goes further than Grantham saying: “almost all assets appear to be overvalued on a long-term basis”. You can read his full commentary here.

For those who like to look at fundamental data like the quaint P/E ratio, here is a very long term chart, courtesy of Prof. Shiller:

As you can see, a lot of air was let out of the bubble. But, to mix metaphors, the pendulum didn’t swing back enough. During previous important market lows, the P/E ratio has fallen to much humbler depths. Thanks to the 60% rally from the March lows, we are once again back above the long term average. Which is unsettling, especially when you remember that Shiller uses a 10 year smoothing of the earnings data to iron out short term noise.

October’s P/E earnings, according to Shiller’s methodology is about 20 - well above the long term historical average of 16. Normally, a P/E ratio of 20 corresponds to economic expansion in its 5th year, not a major recession like the one we’re experiencing now. So understandably, Prof. Shiller is skeptical of the recovery in the equity market making the inevitable comparison to the aftermath of the 1929 crash and saying that “it can’t be trusted to continue”.

And turning our attention momentarily to the options markets, the equity only ISE sentiment index came in today at 191. Which means that while the equity market had a negative day with red all over the monitor, retail option traders tenaciously clung to hope and bought almost twice as many calls.

And if all that wasn’t spooky enough for you, to coincide with Halloween this year we have the 80th anniversary of the Great Crash of 1929. Boo!

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You’ve probably already noticed this since the pattern completed in late July and early August. In case you haven’t, the Philadelphia Banking index (BKX) has carved out a fairly decent reverse head and shoulder formation:

Of course, the technical pattern in the above chart mirrors the one visible in other sectors as well as the general S&P 500 index itself. No surprise there since most stocks take their cue from the major index, rising and falling like the tide.

The one fly in the ointment is the left shoulder (see red exclamation mark on chart). Although the left shoulder is fully formed, I’d prefer to see a more symmetrical one to the right shoulder. That would have only been possible if the year end rally would have taken the Banking index a bit higher to reach the neckline. So it isn’t a picture perfect inverse head and shoulder pattern.

Back in June I mentioned that the financial sector was losing relative strength and the baton had been passed to the Semiconductor Index (SOX). Since then the banks have continued to lag the S&P 500 and the tech sector has been the engine of the stock market.

We’ve got considerable resistance ahead at the 50 level (on the BKX). But the measured move target is 74 - which takes us to the next significant support/resistance level. Needless to say, the reverse head and shoulder formation is the quintessential reversal pattern in technical analysis.

The spring rally began in early March with the financial sector taking leadership and rising from a death spiral. The Philadelphia Banking Index (BKX) rallied with such a ferocity that in about two months time it had more than doubled.

In fact, by early May 2009, the financial sector had gone up by an astronomical 135%! Meanwhile, the wider market index, the S&P 500, had only managed a 35% increase. On its own, that was very impressive rally but it pales in comparison to the banks.

The banking sector is now 13.35% of the S&P 500 - it reached a low of 8.57% on March 6th (to see more historical data and graphs check out: Historical Weight of Financial Sector.)

But while the S&P 500 went on slightly higher in June, the financial sector as measured by the Philadelphia Banking Index (BKX) started to lag. This was the first time in many months that it didn’t move in lockstep with the general market.

So if the Banking Index (BKX) has given up leadership, which sector is driving the market higher?

Currently the Semiconductors (SOX) is going strong with Information Technology being the largest sector of the S&P 500 at 18.3%. As well, Transportation and Energy sectors continue to have relative strength. The question is, is this a normal sector rotation or does the weakness in the important financial sector mean that the market has lost an important leadership sector and will weaken as a result?

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Here’s a novel way of looking at the Philadelphia Banking Index (BKX).

Turn it upside down!

Credit: Yes and Not Yes

And voila! the parabolic move is suddenly so much more recognizable. Keep in mind the parabolic move is obvious even when the chart is logarithmically scaled. Of course, when any market trends with more and more intensity, it approaches an eventual exhaustion point. We’ve seen this in every single bubble formation - no matter what the underlying security being traded: gold, bonds, stocks, tulips, etc.

The last time I mentioned this type of technical formation was last year when we looked at the price of crude oil. The price chart of oil had the unmistakable characteristic of a bubble, taking less and less time to increase more and more. It took one more month for the oil bubble to be pricked.

The chart above would suggest that the exhaustion point for the beleaguered US financial sector is near. No one knows if what we’re seeing is yet another short lived counter rally or if it is really the blow off. What is clear, however, is that the trend has very little time left to breathe (if it hasn’t given up its last gasp as of yet).

The Question
Here’s an interesting video which covers the question on everyone’s mind: is this rally the real deal? or another run-of-the-mill bear market rally? It also uses Fibonacci levels to provide some levels to watch for next week.

Yesterday’s +3% snap-back rally was one of the famed Lowry 90%-90% days. For those unfamiliar with the term, these are climactic days coined by a research report by Paul Desmond written in 2002 (you can find the original report in the free trading resource section - in the Articles and Reports section).

90-90 days are defined by two conditions:

1. Volume is extreme so that 90% or more is either devoted to downside volume or upside volume.
2. Points are so extreme that they are 90% or more either gained or lost to the downside.

These days are significant because historically, every single major shift in the nature of the market has been presaged by the presence of one or several 90-90 down days (representing panic selling) followed by 90-90 up days (panic buying).

We’ve seen quite a few of both 90-90 up and down days during this vicious bear market. So much so that they have tended to be given less and less attention. Yesterday’s extreme up day was even more significant because it was on the heels of a 52 week low. We’ve seen these before too:

But before you get excited, consider that for all its glory, the rally was an inside day. That’s hard to believe since it was so powerful. But it still didn’t engulf the previous candlestick.

As well, the volume was nothing to write home about. It was higher than the previous session’s but compared to the November low, it came up short.

Most of the impetus for the rally came from a massive short covering rally in the financial sector. The Philadelphia Bank Index (BKX) was up almost 14%.

As well, Lowry Research continues to be unimpressed by the market’s behavior. In a recent reports, Paul Desmond says:

“A lot of investors were hoping the market would hold at the November 2008 low. As those hopes were broken, investors tend to panic. We’re really at a critical stage.”

Until the market eliminates those investors who bought high but are still reluctant to sell and take a loss, it will not achieve capitulation. A sign of approaching capitulation will be a slowdown in the rate of selling. That will set the stage for investors to begin looking at opportunities. We’re still into a healthy bear market.”

For all its significance and predictive qualities, the concept of 90-90 days is just one of the many tools that Lowry Research uses to analyse the market. Their most important indicators are proprietary and measure buying power & selling pressure. According to these indicators, Lowry Research is still advising clients to stay on the sidelines because investors aren’t done selling.

Check out my previous in depth report to find out more about Lowry Research and a sample of their analysis of the market (including charts of their proprietary Buying Power and Selling Pressure indicators).