Trader’s Narrative

Today’s viciously down market made me think of how this bear market would stack up compared to the previous one we just went through a few years ago.

As you can see from the chart below, the last bear market had six major counter rallies. Two of them were 10% and the rest more than 20% each. After all was said and done, the market fell 49% from its peak in 2000:

In contrast, we’ve seen a much more brutal decline in this current bear market. As of today’s close, the market is down 50% from its October 2007 peak. But while the drawdown is similar in magnitude, it has occurred in a much shorter time frame. While it took the S&P 500 index 1833 days to once again reach a new high from the depths of the 2002 bear market bottom, it has taken it only 489 days to lose it all:

And we’ve only seen four major counter rallies, with the last one being the largest. So what does this mean?

For one, before a bear market is spent, it needs to suck in as many bulls as possible. It does this by fooling them into believing that the worst is over; by dangling the alluring bait of hope before their screens. What better way to convince you that it is safe to venture into the market than by showing you a tantalizing +20% rally?

But this bear market seems to be different. It is relentless. Merciless. And while sentiment would suggest that people are actually complacent, we haven’t seen much push back from the bulls.

A 50% decline is certainly a psychological ‘line in the sand’. Beyond that, from a technical point of view, it is an important level at which reversals take place. And yes, it is also a Fibonacci level. But of course, this doesn’t mean that the market has to do anything.

Compared to other markets, the US has held up quite well. For example, Ireland’s ISEQ index has already fallen 78% from its peak in early 2007.

Oil has corrected sharply. And so have the majority of commodity markets. But in contrast to the financial sector which has the news in a headlock, the energy sector is not only being mostly ignored, it actually presents exhaustive selling and is setting up a pattern which has seen it bounce higher.

This is a chart of the bullish percent index for the S&P Energy Sector:

After yesterday’s close the bullish percent closed up but on Tuesday, there were less than 6% of the component stock showing a buy signal according to point and figure charting. This is a sign of extreme exhaustion within the group and as you can see, it has presaged some important inflection points. The lower the bullish percent, the more powerful wave of selling that hit the sector. If anything, right now I would play this group as a whole (through an ETF like XLE) or components like Valero (VLO), Chevron (CVX) and Halliburton (HAL) for a bounce.

The last time this happened was in January 2008 when immediately after, the whole sector bounced back with a vengeance. Of course, in these situations, one has to be mindful whether it is more of the same or a whole new ball game. That is to say, if we are seeing yet another correction within a secular bull market, or whether the major trend has changed and the “oil bubble” has been pricked.

But I would argue that at this junction, if any sector is in “washout” mode, it is the energy sector and not the beleaguered financials. At least they aren’t there quite yet - although there is a lot of wailing and gnashing of teeth.

Wednesday’s market performance took us down to a seldom seen place: only 10% of S&P 500 Index components closed above their 10 day moving average.

Chart from indexindicators.com

That is oversold but according to Lowry’s research, when the market reaches below 10% for this indicator, we have a setup for a powerful snap back rally that most of the time transforms into a full blown bull market rally.

The good news is that the S&P 500 Index (SPX) is approximately 60 points above its March levels here while it has pushed the percentage of stocks above their short term average to these low numbers. The bad news is that technically, we didn’t go below 10% but actually reached 10.2% and recovered.

Looking at the Nasdaq advance decline numbers, I noticed that we are at a very deep oversold level here. It basically confirms what I outlined yesterday through other indicators.

I look at the 5 day simple moving average of the Nasdaq breadth numbers because I want something very short term and 5 is also the number of trading days in an average week. So the chart shows a rolling average of a week’s worth of trading (see below).

According to this measure of Nasdaq breadth, we are just a little bit better than the late February 2007 bottom. And to beat that exterme, you’d have to go back to the panic bottom formed after the September 11 attacks in 2001.

The NYSE advance decline numbers are even more stretched to the downside because it contains a lot of interest rate sensitive issues which have been getting obliterated. The 5 day moving average of the NYSE breadth in fact is almost as low as it was on 9/11.

So the probability that we are about to witness a bounce here is very high.

Click To Enlarge Graph:

Trying to peer into the fog of future price action, I looked at the advance-decline numbers for Nasdaq. Here’s a chart of the Nasdaq along with the daily A-D numbers smoothed over a 7 day moving average:

As you can see, sharp spikes down are usually good spots for a trend reversal (a bottom, either short lived or intermediate). In the past 3 years we’ve had the following spikes (reading below -700):

• mid-March 2004 - small bounce
• May 2004 - small bounce
• mid-July 2004 - small bounce
• August 2004 - intermediate bottom
• mid-Jan 2005 - small bounce
• April 2005 - intermediate bottom
• October 2005 - intermediate bottom
• May 2006 - small bounce
• June 2006 - small bounce
• July 2006 - intermediate bottom
• March 2007 - ???

So a spike in that territory usually defines some sort of oversold. But what determines if it is a bounce or a more solid bottom?

A good tell is the % of stocks above daily moving averages. In each case of an intermediate bottom, both the long term (200 day MA) and the short term (50 day MA) were quite low. This is just a back of the napkin calculation, so what I mean by low is anywhere between 30%-20% or lower.

The only time that this didn’t happen was in last summer (June 2006). Then we had both short term and long term % stocks above MA very low but we had to wait another few weeks for the definite bottom to be carved.

Right now, we just don’t have that. The % of stocks above moving averages is sitting quite high at around 50% and 35% (for long term and short term respectively)

My conclusion after all this is that we are probably seeing a short lived bounce here. We need more capitulation to launch another leg up. So be careful out there.