Trader’s Narrative

After six trading days wound tight into a narrow trading range, the stock market finally cracked decisively and fell lower. The range, as measured by average daily true range was extremely slim at 16 points (for the S&P 500 index). The range became a razor thin 5 points when we look at the highest and lowest closes.

Of course, we’ve been anticipating this for some time now. We’ve gone over the sentiment data, the seasonality argument as well as the pattern provided by the aftermath of bear markets throughout history.

As well, it was impossible to ignore how incredibly overextended the stock market had gotten. Take for example, the breadth as measured by the percentage of stocks trading above their moving averages. For the S&P 500 index, last week, we had 91.6% above 10 day moving average, 92.6% above 50 day moving average and 94.2% above their long term, 200 day moving average.

And it wasn’t just that index. Pretty much every single proxy for the wider market was stretched to the breaking point. For example the Dow Jones had every single component trading above the 50 and 200 daily moving average. And just one stock from the Dow didn’t manage to close above its 10 day moving average.

Other measures of breadth were also unbelievably extreme. For example, at 81%, the NYSE bullish percent was higher than it had been for at least 22+ years!

Even more alarming, looking beneath the numbers, the lowest quality stocks were not only participating in the rally, they were leading the charge.

While the S&P 500 managed to peak over the June highs momentarily, its recent action is reminiscent of mid-June. Then, as now, the index managed to eek out a win over the previous swing high (in early May) and then entered a narrow range. Only to break down lower.

Another interesting observation is that while the S&P 500 index was higher in August, the number of new highs did not continue to expand. Since the spring the recovery was supportive of a higher and an increasing number of stocks were making highs but then the music stopped:

Lowry’s Intermediate Market Call
A few weeks ago I mentioned an important market call from Lowry Research. While at first Lowry’s intermediate buy signal may have sounded as if they were suggesting their clients to go wildly bullish, that wasn’t the case. They were recommending adding exposure after a correction. And that may be exactly what we are about to see unfold.

The S&P 500 has weak support just above 975 and much stronger support at 875. So those are areas to watch. As well, I’ll be looking at how fast we drop as well as looking for specific stocks that will display relative strength by bucking the general tone of the market.

Here is a recent interview with Tracy Knudson of Lowry Research in which she further explains their recent market call and delves into their analysis of the market. If you haven’t already, I suggest you listen or read Lowry’s intermediate trend buy signal first and then listen to this newer interview.

To listen, press play and then pause to allow the audio file to completely buffer, then fast forward to the 40 minute mark:

One of my favorite breadth charts is the Bullish Percent Index. It isn’t as common as advance decline measures because it is based on point and figure charting.

Point and figure charting itself is based on pure price action and ignores both time and even small price movements. In P&F charts the X represents demand (or bid or buying) and the O supply (or selling). Unlike candlestick or bar charts, it is perfectly normal for a point and figure chart to not need to be updated (when price doesn’t move beyond a threshold either up or down). This is the great advantage of point and figure charts.

Other than that, the basics of technical analysis such as support and resistance apply to point and figure charts. Also, point and figure charts can provide systematic buy and sell signals - something that ‘normal’ charts leave open to the traders discretion. The simplest buy signal is the chart to the left - when price breaks above a previous high (without the column of O’s breaking below their previous low).

So to calculate a Bullish Percent Indexes, we simply take a look at each and every stock compromising an index and track how many of them out of the total constituents are in a point and figure buy signal. If, 120 out of the 500 stocks in the S&P 500 index are in a buy signal for example, then the Bullish Percent Index for the S&P 500 for that day would be 24%.

Doing this by hand would be extremely cumbersome, but thankfully we have computers that can do the calculations in a fraction of a second. Here is the chart of the Bullish Percent Index for the Nasdaq Composite:

According to the traditional interpretation, a Bullish Percent Index of 70% and higher is considered overbought. And if there it experiences a 6% (or more) decline, it will offer a sell signal. Personally, I prefer to not wait for the sell signal. Once you know that the market has weak legs, you can use other indicators to give you more short term guidance.

Right now we are seeing almost every single measure of the market provide extreme breadth levels from the Bullish Percent Index. Normally seeing the bullish percent indexes for so many markets and sectors reaching this high in synchronicity would be a red flag. However, there is an argument for such strong momentum to be a signal of a protracted rally.

This was the same concept that I shared earlier this week about incredibly powerful thrusts measured from the advance decline breadth. These short busts of powerful buying are usually precursors to lasting uptrends. Think of it as a turbo booster on a rocket which lifts it through the heavy atmosphere before it can glide easier through the thin air of space.

Consider that the last time the Nasdaq composite BPI was this high was back in 2003-2004 during a powerful bull market. It is the same case for the NYSE, and the Nasdaq 100 index. This is how oversold can become meaningless.

Bullish Percent for Major Indexes:

• NYSE Index — 77%
• Standard & Poor’s 500 — 83%
• Nasdaq Composite — 70.55%
• Nasdaq 100 Index — 90%
• Dow Jones Industrial — 77%

Bullish Percent for Sectors:

• Financial — 86%
• Consumer Discretionary — 79%
• Consumer Staples — 73%
• Energy — 60%
• Healthcare — 79%
• Technology — 87%
• Industrial — 71%
• Materials — 85%
• Telecom — 56%
• Utilities — 62%
• Transportation — 75%

Well, is it?

That’s what a lot of people are wondering (which has the built in assumption that this is a bear market rally and not the real thing). To get some perspective on this, I decided to look at a long term view of the Nasdaq Composite Bullish Percent Index.

If you’re unfamiliar with this type of index, it is created by looking at what percentage of the components of an index (in this case the Nasdaq Composite) are exhibiting a certain bullish pattern according to point and figure charting. To see how I use this as an indicator, check out: How to Time the Market with Bullish Percent Charts.

Here’s the long term chart of the Nasdaq Composite compared to its Bullish Percent Index:

By the way, I used the Nasdaq Composite because it is very broad with about 3000 components and it excludes a lot of the junk found in the NYSE (CEFs, convertible debentures, ETFs, preferred stocks, rights, warrants, etc.) which can skew the index, especially because of their sensitivity to interest rates.

The chart shows the tech bear market and the latest one which started in late 2007. Almost every single bear market rally top was flagged by the Bullish Percent Index (BPI) - indicated by the red down arrows. It also did a good job of finding exhaustion points during the good times - with one important exception.

The red box shows the span of time that the BPI went above 60% and stayed there. During this time, the normal relationship we otherwise see between the two charts broke down. The only argument I could think of to explain this, is that this time period was the start of a new (albeit short lived) bull market. All kinds of indicators, breadth readings and overbought metrics went into the red zone and stayed there as the stock market powered ahead - seemingly oblivious to them.

The other difference between this most recent bear market and the last is that the counter rallies we’ve seen this time around have been much less powerful than before. As you can see marked by the orange down arrows, they don’t even reach 50% BPI.

The latest BPI reached slightly higher than 62% - that the highest since early 2007 and before than, early 2004. Obviously, this latest run up is different from the previous ones. Going back to 1996 (not shown on the chart) it was rare for the Nasdaq Composite Bullish Percent Index to reach or exceed 50%. So this level is clearly significant.

So what we have to consider is, if this is just a run of the mill bear market rally, then it is over. But if it the real thing, similar to what we saw in 2003 (the red box) then the market will confound everyone and keep going higher.

According to the long term market direction guide known as the Coppock Curve, the Nasdaq is already on a buy signal (from last month). But since it tends to whipsaw much more than the Standard & Poor’s 500 Index (SPX), I’m waiting until it gives a signal. There are only 8 more trading days left in the month and if the S&P 500 can stay above 874 (3.74% lower from Tuesday’s close) then the Coppock Curve curls up.

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If you’re not familiar with Bullish Percent charts or how they are calculated, check out my previous post on How To Time the Market With Bullish Percent Charts. I use them to find inflection points, which is different than their creator’s intention.

The Nasdaq Bullish Percent Index reached a recent high of 51.36% and more importantly, it has hovered at or above the 50% level for 5 consecutive trading days:

Even more alarming, this is the corresponding level that we last saw in October 2007, just as the brutal bear market was about to descend into Wall St. In the past 10+ years, the Nasdaq Bullish Percent Index has had a tough time going higher than 50-60%. The only exception was in 2003 when we saw BPI pushed to 78% by the powerful new bull market.

So not only are we back to Bullish Percent levels where the bear market started, we are at levels which have historically marked tops in the equity market. The only justification for new long positions here, or continuing to hold on to existing long positions, is the expectation that we are going to see yet another powerful non-stop rocket ride as in 2003.

Anything is possible but considering everything, I think that scenario is highly improbable.

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Yesterday, the market flirted with the lows that we saw back in November 2008. So that’s the question on everyone’s mind. Will support hold, or will we see another waterfall decline?

If you were watching the action, you would already know that it was horrendous. Breadth was extreme: out of all the securities on the NYSE, less than 10% were able to close higher than the previous trading day.

We’ve already touched on many sentiment gauges which show an alarming amount of complacency. But what is truly astounding is that in the face of such horrific performance, small option traders plowed their money into call buying. The ISE sentiment index (equities only) moved up slightly to close at 135, meaning that after everything was said and done, 135 calls were purchased for every 100 puts. That, needless to say, is not despondency that carves out lasting floors in market prices.

And yet, even after yesterday’s carnage, we aren’t really close to a complete washout, from a technical point of view. Take the percentage of stocks trading above their moving average, an indicator which shows where we are in terms of breadth. Yesterday, 21.6% of the S&P 500 index component stocks closed above their 50 day moving average:

That might seem low to you but consider that although 20% is the ‘magical’ demarcation in normal, healthy markets, it isn’t so for bear markets. In fact, just as we saw a few months ago, this indicator can go much lower. That is almost exactly where it fell in late 2002

Looking at the bullish percent index, we find the same thing. For the S&P 500 index, yesterday’s reading was 39.60% but the last time market prices where at these levels - in November 2008 - the bullish percent was just 8.6%.

Everything is possible… who knows, the fabled Plunge Protection Team may decide to show up and rescue the day (remember them?) or we may just get a reprieve by a good old snap back rally. But even so, the market internals and the sentiment do not paint a pretty picture.