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.

At the start of the week we contrasted the strange pessimism that has gripped the US retail investor to the levitation act of Wall Street. It is almost as if Wall Street threw a party and other than institutional investors, a few day traders and algo quant jocks jamming high frequency trades, no one else showed up. If you ask Paul Desmond, of Lowry Research, this is a real bull market that will last another 3 years.

With all due respect to Desmond, today I wanted to entertain some bearish counter arguments to temper that cheery outlook and delve a little deeper into the market condition both in the short and longer term.

While considering the same ICI fund flow data, it is conceivable to come to bearish conclusions. Take for instance the fact that domestic equity funds have attracted less than $8 billion of fresh capital since the lows in March. Had this rally provoked the same pattern of retail investor participation as previous ones, we should have seen $150 billion flow to equity mutual funds, according to TrimTabs.

Maxims ad Nauseum
While it has become an accepted maxim repeated ad nauseum that a bull market likes to climb a “wall of worry”, the historical evidence is otherwise. The stock market actually tends to float higher on gradually increasing levels of optimism - until that optimism reaches a crescendo and then the whole thing unwinds. And we start all over again. So generally speaking, the stock market performs better following periods where there are net inflows of funds.

Whether retail investors are acting intelligently by avoiding this rally or more accurately, by selling this rally, is something that only history can answer. It isn’t hard to imagine though, the possibility that they are reacting emotionally. Think of it. Having first experienced severe loss in their portfolios and watching Wall St. insiders ride on a cushion of bonuses, insult is added to injury when they have to fend for themselves in a new harsh economy.

What if we are seeing the rejection of the great “equity culture” and the almost religious belief in “buy and hold”? What if the record inflows to bond funds are being driven by a traumatized populace seeking the one shelter of income investing?

So far, this has been so relentless that it has pushed the fixed income share of US household wealth above 6% once again. But if you notice, the last time there was a similar increase happened during one of the strongest bull markets in equities:

However, what is undeniable is that if the US retail investor doesn’t return to equities eventually, what we could see is another lost decade; where markets flop around like a dead fish, but don’t really go anywhere. This is what happened before the great super-bull market was launched in 1982.

The completely stark scenario is one where retail investors continue to ratchet up their sales of equities and push the stock market lower as a cascade effect takes place where gloomy sentiment and fear feeds on itself. Think of it as the great unwinding; or the negative wealth effect.

Technical Weakness
Returning to more present and short term matters, the market came perilously close to the invisible 20% distance from its long term moving average. Yesterday I mentioned that stocks have little room to the upside and while I’m not surprised to see the weakness today, it by no means guarantees that we won’t see a final push to 1120.

On Monday 94% of the S&P 500 stocks closed above their 10 day moving average. That’s the highest since mid July. Since then this measure of breadth has backed off slightly but is still hovering above 90%. Other negative technical considerations are that prices are pressing against the downtrend line at 1100 - from the top of the bear market (in October 2007). And that other major market indexes like the Nasdaq, Russell 2000, the Philadelphia Banking Index (BKX) and the Semiconductors (SOX) are still below their previous swing highs. Finally, volume continues to be anemic as it has been for most of this whole trip.

Gold has the wind at its back right now. Not only has it cleared the challenging $1000 resistance level, it has support from lax monetary policy as central banks around the world clearly hold the health of their economy in higher priority than the health of their budgets or their currencies.

The recent purchase by the central bank of India is being interpreted widely as a vote of strong support for the precious metal. Although I don’t argue against a secular bull market, it is amusing to me that a decision to buy gold at above $1000 is deemed to be a ’smart’ move when just a year ago they could have made the same purchase for 30% less. The fact that almost any news is interpreted as positive for gold has more to do with the prevalent sentiment than with facts.

In any case, before we get to the short term sentiment for gold, here is the recent commentary from David Rosenberg of Gluskin Sheff on the monetary backdrop for a secular bull market in gold:

All India did was bring gold to a 6% share of its total FX reserves from 4%. Fifteen years ago, that representation was closer to 20%. China has increased its gold holdings by 76% over the past six years but they are a mere 1.9% of the aggregate 2.2 trillion of reserves and Russia’s gold holdings is just under 5%. This is not the 1990s when Bob Rubin was running a hard U.S. dollar policy, U.S. fiscal deficits were vanishing and gold production was on the rise. Today’s world is exactly the opposite. Policymakers beginning in the 1990s wanted disinflation and got it. Now they want inflation — it will take years, maybe a decade, but it will come. For the near-term, we are still optimistic on Treasury securities but be forewarned that this view has an expiry date that is earlier than the peak we are likely to see in gold.

It is very clear that central banks are behaving in a way that would suggest that gold is now again being considered a currency within the global monetary system. As we said before, it is all about relative scarcity and a well-defined supply curve — fiat currency at this juncture does not share that quality.

Turning to the breadth in the gold stock sector, you can see that we’ve seen a sudden and dramatic jump from a week ago. The chart below compares the percentage of gold stocks trading above their 10 day moving average with the Philadelphia Gold Bugs index (HUI):

If you’re interested in timing the gold market, then you would be concerned that 82% of gold stocks are trading above their short term moving average. But you would also be alarmed that just a few days ago, that number was below 10%. Historically, gold shares have a very tough time continuing to climb when faced with such short term headwinds.

Turning to sentiment in the gold sector, on Monday when we looked at the arguments that Paul Tudor Jones II presented for his case of a secular bull market in gold, we also digressed a little to check the Hulbert Gold Sentiment index. That sentiment measure was showing a majority in the bullish camp; which from a contrarian point of view means that gold probably will have difficulty in advancing in the short term.

In a similar vein, here is a chart, courtesy of Elliott Wave, which shows the price of gold with the Daily Sentiment Index (DSI). The most recent DSI is 91% which is just about where previous short term tops have been formed:

Similar to the breadth measure (shown earlier) the DSI increased to 91% in a sudden jump (an 8% point jump over a day). Accoding to Elliott Wave, which tracks the DSI, this was the single largest increase since March 19th 2009 (11% point jump from 75% to 86%) when gold made a two month high at $960. With Elliott Wave, not only do you get their analysis of various markets but they do a good job of monitoring DSI, which is a proprietary sentiment metric from trade-futures.com and by itself would costs about $2000/year.

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Back at the beginning of August, we looked a study of momentum thrusts which showed that historically, when the 10 day ratio of NYSE advance decline was pushed to an extreme the market tended to enter a protracted rally.

There were only 10 instances in the past 4 decades, with 2 of them occurring this year. Since some time has passed, I wanted to update the table and look at where breadth stands now:

From March 23 2009, the market rallied about 12% in 3 months and almost 30% in 6 months. And forward 3 months from July 23rd, the market rose 18.6%. That’s in line with the previous returns historically (or slightly better).

When Wayne shared this historical study with me, my initial concern was that this is relying on NYSE breadth data. As I’ve stressed several times before, NYSE market internals are now skewed by the increasing number of non-operating company securities trading on the big board. While the NYSE is the most well known stock exchange around the world, increasingly ETFs, municipal bond funds and other CEFs and even bonds have started to take a larger and larger share of trading.

But, if you look closely at the Nasdaq data, it corroborates the last two momentum thrusts that are shown above. In late March and late July you can see two distinctive spikes:

So far, so good. Or more accurately, in line with historical norms. Lately though, the breadth has been horrible. We haven’t seen market internals this bad since the beginning of the year - just before the spring rally was launched.

While I think the S&P 500 has more room to the downside, the bounce today wasn’t unexpected. If you listen to the mainstream media, the explanation is the the positive GDP numbers, which at 3.4% blew away expectations.

While it will take a few days for the whole report to be dissected, it is more likely that it was an excused used to run up prices, rather than the actual rationale. Especially since many have pointed out reasons at the beginning of the third quarter why the recession may be over. I attribute the bounce today to the extremely oversold breadth - in the very short term.

One of the best measures for this is the percent of S&P 500 stocks above their short term (10 day) moving average. This metric sharply fell to just 6% yesterday. At the start of the week it was 20.4% and on Tuesday it was 14.4% and then it fell below the important 10% level which marks extreme short term oversold levels. This is the level that was mentioned in the recent Lowry report: Turbulence Ahead.

The oversold level was clearly visible across many important sectors. Many of which had equal or worse breadth than the general market proxy. The transports were especially hard hit for example. As were the gold stocks, which as I’ve repeatedly mentioned, tend to follow the general market.

Another measure of short term breadth is the ratio of daily new highs to new lows on the Nasdaq:

As the chart shows, the last time new lows increased this much and new highs dissipated this much was back in early July, which launched the second leg of the spring rally. As Lowry’s report mentioned it is quite possible to experience a short term set back within a primary uptrend. Things to watch for are how the market responds to this oversold condition. If the market weakens significantly in spite of poor breadth, then it will need to trade lower to find a strong bid. If on the other hand, the S&P 500 can rally immediately off such a short term extreme, then we know that the uptrend is intact.

An important part of this is the medium term outlook. The percent of S&P 500 stocks above their 50 day moving average has managed to put in higher lows each time as the chart below shows:

Since October 2008, medium term breadth for the S&P 500 index has been stair stepping higher. It needs to remain above 30% to maintain the uptrend, which it seems to have done already.

And the very long term breadth measure - the percentage of S&P 500 components above their 200 day moving average - remains at peak levels. With today’s strong showing, it moved once again above 90% where it has been since August 2009. This is reminiscent of the rally we saw in late 2003. I’ve detailed this here: Comparing Market Breadth To 2003’s Bull Market.