Trader’s Narrative

For economic and market news and to see what interesting reading you may have missed last week, check out the list below. To see it all, go to news.tradersnarrative.com:

• Bill Moyers interviews James K. Galbraith
• Market Is Strong, But Correction Should Continue
• Contrarian analysis remains bullish
• Goldman’s long term borrowing cost 0.92%
• Get a FREE Subscription to SFO Magazine (US residents only)
• EU to break up Lloyds, RBS and Northern Rock
• Schwab Creates Watershed Event with Commission-Free ETFs
• CNN Interviews Robert Shiller on Economic Recovery
• EWI FreeWeek almost over, hurry! Learn more about FreeWeek, and download your free reports here
• Mother of all carry trades faces an inevitable bust
• Four Simple Ways to Fix the Broken System
• Clever fools: Why a high IQ doesn’t mean you’re smart

The above is a small sample, for the complete list, follow the graphic link below to news.tradersnarrative.com:

And remember to check back during the week as there are interesting links added throughout the week. If you are a twitter user, add the news.tradersnarrative.com twitter stream to get new stories in real time.

The Week Ahead:

Well, that didn’t take long. The S&P 500 is only down less than 5% from last month’s peak and already we’re seeing signs that this shallow correction has reached important levels.

Take for example the percentage of stocks closing above their 10 day moving average. This simple breadth measure is surprisingly accurate at finding inflection points, both in the short and intermediate term. According to a study from Lowry Research which I shared with my readers a few years ago, it has an almost perfect track record: Latest Research Report From Lowry Research (2007).

The key level to watch is 10% - which we breached on Friday. Here is a chart of this breadth measure for the components of the S&P 500 index:

This wasn’t limited to just the most popular stock market index. Other indexes provided a similar outlook. Take for example the Nasdaq 100 index where 9% of the stocks closed above their 10 day moving average. Lowry’s operating company only version of this breadth measure was 8.13%, which is the lowest since March 2009.

We can add to this the McClellan Oscillator which is another measure of market breadth. If we strip out the ETFs, CEFs, and other ‘junk’ from the NYSE and just consider real corporations, this operating company only index’s (Ratio Adjusted) McClellan Oscillator is as oversold as it was in March 2009.

But other metrics like the short term average of the daily Nasdaq advance decline numbers are still quite high. So is the percentage of S&P 500 components which closed above their 50 day moving average. In an important bottom, this number can fall to 20% (and lower) but so far the lowest it has reached is a lofty 53.6%.

A note of caution before you jump to conclusions. Interpreting this type of data can be rather tricky. That’s because these measures of internal market breadth act differently during different market conditions. In strong bull markets they can levitate for prolonged periods of time at atypically high levels. While in bear markets they oscillate with much more volatility.

The best way to look at this market juncture is to see it as a litmus test of the spring rally. Just as we went over when we updated Lowry Research’s latest views on their intermediate buy signal, this correction was expected. The best way to take advantage of it is to see how the market reacts to it and specifically how the market internals deteriorate in the face of a decline in stock index prices.

A shallow correction followed by a sharp rebound with very limited damage to the underlying breadth of the market would be a tell that this is a real cyclical bull market and not just a prolonged bear market rally.

With the second year anniversary of the 2007 market top coming up in a few weeks, here is a video which points out that the S&P 500 index’s date with destiny is also marked by two major technical forces:

The reason for a correction are piling up. We’ve already talked about sentiment and Lowry’s expectation of a correction. This is yet another reason to rein in any bullishness (at least in the short term).

While this rally has gone on longer than even the most optimistic bull predicted, don’t forget, we are still mired in a secular bear market. As the video mentions, we have yet to put in a higher low to denote that we have a change of trend.

The semiconductor index (SOX) is a high beta sector which can be a leading indicator of the health of the market. It found a floor in late November of last year, much earlier than the S&P 500 index. From there it continued to power ahead with consistently better relative strength:

But in August, while the general market powered ahead, the semiconductors started to lag. That by itself wouldn’t be a major negative for the market. After all, there are naturally short periods of time when the SOX gives up leadership. What stood out at that time was that the trend line starting from November’s bottom and stretching for months and months had been broken.

I wasn’t the only one who noticed. Dave, a reader, contacted me then:

I just realized yesterday that my canary-in-the-coal mines, my lead husky SOX is out-of-sync with SMH, XSD, PSI, IGW, & USD, vis-a-vis their June highs.

Again, by itself, that wouldn’t ring any alarm bells. But considering everything else that we’ve covered which paints a picture of a market dangerously overextended, this just adds to the many other reasons to be positioned for a correction.

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: