Trader’s Narrative

This week the financial giants Goldman Sachs (GS), Bear Stearns (BSC) and Morgan Stanley (MS) will be releasing their quarterly earnings reports.

I’ve been patient and hopeful with this sector since it has been showing the classic signs of oversold extremes.

But each time it is given a chance to bounce back, it only musters a meager step or two forward… and then falls back.

You can see this in the bullish percent index of the sector:

In July it reached an extreme oversold level of 25% but couldn’t gain any traction. Then again this November the index fell to 20%. But after a feeble “dead-cat” bounce it has rolled over again. This behavior is a marked contrast to the previous years when the bullish percent index remained at very high levels and only sporadically dipped lower.

Looking at the price chart itself (the Philadelphia Banking Index) we see the same thing. A classic downtrend pattern of lower lows (green) and lower highs (red):

No question that things are downright ugly. Within the sector, only 17% of the component stocks are now sitting above their 200 day moving average. This is extreme. But it has been the case for most of the time since the swoon in July. Only 4% closed above their short term, 10 day moving average and a paltry 13% above their 50 day moving average.

But when oversold levels don’t lead to lasting rallies, you know something is wrong. The banks and financial stocks are acting very tired here and I would either wait to see a dramatic washout (the kind that has you gasping) or a miraculous sign of strength before giving them the benefit of the doubt again.

At the end of July I mentioned that it was time to consider the battered financial sector. Back then, the bullish percent chart for the sector approached 25%, a level which usually means oversold. But yesterday, this same indicator dipped to just 16.13%:

After I mentioned the opportunity to go long the sector, banks and financials did recover but in a very limited way. Even so, the paltry rally was enough to push the bullish percent index to almost 80% - which was a sign that things had swung to the other extreme and it was time to exit.

Getting back to the present, the bullish percent index has not been this low since early 2000 - when the Philadelphia Banking Index (BKX) was more than 30% lower:

Things are very stretched to the downside here and we are ripe for a snap-back rally. Although it is extremely difficult, the best time to buy a bargain is when everyone else is running for the hills, screaming in fear.

See this link to learn more about how I time the stock market using bullish percent charts (based on point and figure charting).

A few weeks ago Maoxian was going over his call in mid September 2006 to lighten up on the energy sector. As it turned out, that was the time to actually put money to work. I piped in saying that if you were watching the bullish percent chart for the sector, you would have noticed that it was very oversold (at around 20-30%).

In case you missed it, earlier I went over how you can use the bullish percent indicator to time the market.

In any case, the Chairman brought up a great point in reply: that bullish percent charts can misguide at times of major trend change. As I mentioned before, a bullish percent chart can go all the way from 0% - that is, no component of the index being in a point and figure buy formation; to 100% with all of them being in bullish formation. So eventhough we key off specific extremes like 20-30% for lows (bottoms) and 70-80% for highs (tops) there is no reason why the indicator has to bounce off those levels. Or any reason why it can’t simply sit at a level and remain there for as long as it wants to.

S&P 500 Energy Sector Bullish Percent Index (1999-2002)

Looking back through time, sure enough, we find examples where the bullish percent chart of the energy sector did fall below the 20% level. In fact, in July 2001 it fell to 10.53% and in the aftermath of September 11, 2001 it fell to an unheard of 3.80% !! Within a year, it was back at those “unheard of” levels: 6.58% (July 2002).

So we obviously can’t just push “BUY” when it hits 20%. I don’t think you should consider any indicator, no matter how great its historical performance, in isolation and let it dictate your trading decisions by itself. Although it makes matters more complex, we increase the chances of success by layering several indicators on top of each other and only going long/short when there is maximum agreement among them.

But assuming that you had gone long on a signal (at the 20% level) as a trader you would only have lost as much as your stop loss. You do have a stop loss, right? In late July 2001, when the energy bullish percent index and the sector itself continued lower you would have had a logical rethink. Your losses in that case would have been quite limited.

In the broader market, in recent years the Nasdaq (COMPQ) bullish percent’s “low” extreme has usually been around 35% while in the years 1999-2002 it’s low was 20%-25%. This isn’t surprising when you consider that recently we have been in a bull market, while back then we were in a bear market. In a bull market, we are apt to see more shallow pullbacks and to see the indicator spending much longer meandering in the higher ranges as overbought leads to more overbought. So you shouldn’t treat the bullish percent levels as absolute, but rather as guidelines which give a feel for how overbought or oversold the market is.

Nasdaq Composite Bullish Percent Index (1999 - 2002)

The most important point I can leave you with is that in order to get the most out of the bullish percent indicator, we must first recognize whether we are in a bull market or a bear market. That may seem to be a tall order but with a few tricks, tips and indicators it isn’t that difficult. Of course, nothing is guaranteed but being on the right side of the market isn’t as impossible as economists and EMH theorists would lead you to believe.

There is especially one little known indicator which has an uncanny ability to point out the genesis of bull markets. Care to guess which it is? I’ll cover it in a little while if you can’t anyway (hint: it starts with a “C”)