Trader’s Narrative

Market breadth is what goes on inside the stock market. Most people pay attention to price, like the Dow or S&P 500 index. Market breadth looks at the number of stocks that are advancing or declining within an index or an exchange. It is a great way to measure the “health” of the market. After all, if the majority of securities on an exchange are falling, we can’t expect it to keep rising, right?

Or can we?

Every once in a while the bears point to the “negative divergence” in the Nasdaq index and the Nasdaq cumulative breadth. They get worked up over the fact that market breadth does not correspond to the market price. Here is the recent Nasdaq breadth, showing a waterfall decline, in contrast to the Nasdaq Composite index:

It sure looks ominous. Once you zoom out though, you realize that there’s something seriously wrong with this way of looking at the market.

NASDAQ Cumulative Breadth
Just for kicks, let’s go back to 1998. From there, the Nasdaq cumulative breadth fell consistently until October 2002. That’s right. Even though the Nasdaq was screaming higher, then topping out in early 2000, its breadth just barreled down paying it no attention.

Breadth continued falling until it made a sort of double bottom in early 2003, just as the Nasdaq was ending its bubble bear market. The recovery in breadth was short lived because it again started to fall in early 2004 and has been falling consistently since!

So it is obvious from this slice of history that Nasdaq breadth and the Nasdaq composite are completely decoupled. In fact, if we go back further in time we see that breadth has been falling continuously since, well, since I have data for it.

NYSE Cumulative Breadth
The other broad measure of breadth, for the securities on the NYSE, is not all that different. From a top in 1998 it fell continuously until early 2000. For the rest of the year it stabilized and in late 2000 started to rise. NYSE breadth found a top in May 2002. Yes, you read that right! As the market was going to hell in a hand basket, breadth was rising! For some reason, it decided to not rise in 2002 - I guess in sympathy to the stock market. But then in early 2003 as the market was rising, so did NYSE breadth. And it has continued to rise to this day.

My point is that we have so many positive and negative divergences between breadth and indices they purport to represent that cumulative breadth is basically useless.

I agree that a trend simply can not continue if less and less securities are participating in it. Eventually it exhausts itself and crumbles under its own weight as it becomes unsustainable.

The problem is that no one knows when, exactly, this will take place. And cumulative breadth certainly provides no insight whatsoever into this.

This is why I prefer taking a much simpler measure of breadth: the moving average of net advancers and decliners:

The above chart is the 30 day moving average but you can use any number you like, as long as it doesn’t introduce too much lag into the equation. It gives you not only timely signals, but it also pinpoints most, if not all, intermediate bottoms with ease.

I’ll show the long term charts of cumulative breadth for both Nasdaq and NYSE in an upcoming post. It really is eye opening.

Although I was early, my skepticism about the growth story of Crocs (CROX) turned out to be right on the money.

The dream turned into a nightmare for the longs with an almost 40% gap down on November 1st 2007. Although it would have been very painful, the best option - in hindsight - would have been to sell right there and then.

That’s because when Wall St. turns on a one time growth darling… it can get very ugly.

Double Whammy
For one, no growth investor or swing trader wants to ride along with management when they were either blindsided by a slowdown or saw it coming and were coy and didn’t communicate it in advance.

As well, declining sales/growth reduces the valuation of a company. And it has the levered effect of also reducing the multiple used to value it: the price earnings ratio. So the company is hit with a double whammy.

Very few are able to recover from this. That’s why it is dangerous to fall in love with a stock, no matter how persuasive the arguments. A stock is a stock is a stock.

But with Crocs, I was a bit puzzled at how people could actually could like them, never mind love them (as a product or a stock). In any case, now that the whole sorry saga has played out, here’s the chart:

Other than the obvious line break (blue) that spelled the end of the run, it is interesting that each gap down was below the previous swing low. What more obvious sign that buyers were simply not showing up?

In other words, in each subsequent price realignment, it missed previously established support levels. Until finally, it is now trading below the first double bottom in 2006.

It is safe to say almost all longs are now underwater and unhappy. Which means that if a miracle delivers a rally, they will be so relieved to be able to get out with any semblance of break even, it will be a short lived rally.

Other than running away from former growth stock darlings, Crocs has other useful lessons. Study the first few months of CROX and notice how it built a base from which it launched a massive run. It almost looks like two back to back cup and handle formations. Now go and find stocks which have similar bases. IPOs are great candidates for growth but they are few and far in between these days.

While the transportation sector has been going strong, the airline industry - a sub-sector of transports - is scraping the bottom of the graph at multi-year lows.

Imagine how well the transportation index would be doing if the airlines had been contributing or at least keeping up with the rest of their peers. Accounting for almost 11% of (dead) weight, the following airlines are in the Dow Jones Transportation Index:

• AMR Corp. (AMR)
• Continental Airlines Inc. (CAL)
• JetBlue Airways (JBLU)
• SouthWest Airlines (LUV)

Recently there’s been some turmoil in this sector with a few bankruptcies, fleets being grounded and just today, Northwest Airlines and Delta decided to merge. This sort of shake up is common place in this sector and it happens ever few years. Airlines are a notorious black hole for capital - even the sage of Omaha, Warren Buffet lost his shirt when he strayed too close.

But do the extremely “cheap” airline stocks mean that this sector is a buy? or put another way, are they cheap enough?

From a fundamental point of view, I can’t say that I have a clue. But from a technical perspective, I don’t think so. Here’s why:

The really important double bottom that was formed in the end of the last bear market was at 30. In January 2008, the AMEX Airline Index (XAL) ricocheted higher after grazing the same level. But in contrast to before, the ensuing rally was short lived and it subsequently fell below that important support line.

So right now the index is approaching the 30 level again but now it is facing it from below, as resistance, rather than support. That’s an important distinction.

Also, it is no longer in step with the parent sector (transports). The bullish percent index for the Dow Jones Transportation Index is at 55% while it was at 15% and lower in 2003. I am too lazy to look up the Airlines bullish percent index but my hunch is that it would be wallowing in the 10-20% range.

So I wonder… why does the market shrug off all the reasons why the land and sea transportation companies’ stocks should be sold (high energy costs, recession, etc.) but not the airlines?

Finally, taking a look at the component stocks tells me that they are either below or far away from a base or support level. Take for example, JetBlue (JBLU): In March 2003, when the airline sector put in its major multi-year bottom, JBLU traded at $10/share. It is now trading at $5.18/share. Almost half that level.

The opposite could be said of AMR because it traded at $2.50/share in 2003; which means that it still has a lot of potential room to fall from its present level of $9.34/share.

Now that the Bear Stearns (BSC) saga has ended with their absorption into JP Morgan (JPM) for $2, I wanted to go back to the previous time that I looked at the stock, back when it was trading at ~$140 (!).

I sounded a warning note because, in contrast to the previous multiple times until then, BSC had broken down relative to its long term moving average (see graph in link). And even if it was able to claw its way back, the damage had been done. There was a tremendous amount of resistance overhead. Of course, hindsight is 20/20 and we now know it never traded at those levels again - and never will.

I know you want to avert your eye, but can’t. So here’s an analysis of how the whole thing went down (literally):

Not only has Bear Stearns already decoupled from its long term moving average but basic technical analysis is showing that this stock is heading down. The down trend is not only supported by the medium (50 day) moving average in blue and the long term (200 day) moving average in red, but also by the way that both successive tops and bottoms are lower than the previous ones. At each attempt to rally, price is smacked down, unable to mount any real threat to the general down trend.

The most serious attempt to put a floor under BSC was during August 2007 when everything under the sun made an intermediate bottom. But in Bear’s case it quickly melted away. If you were watching BSC in February, you had to wonder if more of the same was in store for this beleaguered financial stock.

In March, prices are once again scraping the $70 level. Will it hold and carve out a triple bottom? or break down? You have to remember the general principle that every time a price level is hit, it becomes just that much more fragile. Think of it using the analogy of a glass floor. It may hold one or two times, but if you keep jumping up and down on it… eventually it will crack and you’ll fall through. Which… is exactly what happened:

At this point, if you were still holding long (in keeping with the triple bottom thesis) you had your chance to get out with a small loss. The market had clearly put in a lower bottom and outside of technical analysis, the news and rumors about Bear Stearns’ health couldn’t have been more negative. That is if you were listening to anyone except Bear Stearns executives (never listen to corporate spin from any company).

And if you didn’t listen and bought or held on to your shares… well, the market tried to talk to you. But you simply weren’t listening.

Come to think of it, the Bear Stearns’ implosion is very similar to the E*Trade (ETFC)example that I went over a few months ago.

The only difference is that rather than languish at low single digits, it will be swapped for 0.05473 shares of JP Morgan common stock.

Tsk, Tsk
Oh and this video is making the rounds on various blogs and forums:

At first glance, it seems Cramer was incredibly wrong. After all, the video shows BSC trading at $62.97 (March 11th, 2008). This was just 2 days before the stock fell to $30… and three trading days before it opened at single digits.

But what people miss is that the question wasn’t about Bear Stearns stock but about its solvency.

So yes, Cramer was correct: the funds and securities deposited with BSC were not in danger.

But if you actually bought the stock, like this poor guy (on margin!!), then that’s a whole different story.

Double Bottom Thesis
One of the technical patterns everyone has been watching for during the recent market action is one of the most common and well known ones: double bottoms.

Thanks to yesterday’s rocket ride, it looks like this pattern now has a chance. What we need to look for next is that the low isn’t violated (obviously!) and two, that we can successfully take out the resistance levels just underneath 1400 on the S&P 500 index.

Lowry’s 90-90 Day
Everybody is emailing me asking if Tuesday was one of those famous Lowry’s 90-90 up days. I don’t have confirmation from the keeper of this measure but I’m 90% (no pun intended) sure that it was indeed a 90-90 day. It certainly looks like the market is getting ready for a running of the bulls.

In case you’re unfamiliar with the nomenclature, a 90-90 day is when we have such a lopsided day in the markets that 90% of the volume and 90% of the points are on the same side (either up or down). Research by Lowry’s has shown that historically, important market inflection points are preceded by extreme crowding to one side, then the other. If you’d like to read the original version (and save $10) download the research paper from my free trading resource section.

The best scenario for the bulls would be another extremely strong day which would be as or even more lopsided than yesterday’s. If we get that within a reasonable time, like a week or two, the chances of a solid bottom increases exponentially.

Sentiment
Yes, I know I’ve been harping on this for a while now but until recently we hadn’t really seen any truly extreme readings in the usual sentiment measures. Sure, they were gloomy but now we’re finally seeing some bearishness of epic proportions. This is a vital element, as the market approached the January 2008 lows, to determine if we are going to simply cascade lower or carve out a double bottom.

I’ll write up a full report covering the various sentiment measures in detail for the weekly sentiment overview on Friday.

Put Call Ratio
We had a historic reading in the commonly followed CBOE equity only put call ratio - the highest in years. As I mentioned then, for some strange reason, it seems that an inflection point doesn’t coincide with such panics in the option markets but instead follows a few days after. Well, it is a few days later.

Percentage Above Long Term Averages
This market is oversold. Is that too simple? Here’s a weekly chart of the small caps, Russell 2000 Index (RUT) showing the percentage above their 150 day moving average:

And here’s a daily chart of the large caps, Dow Jones Industrial Average (INDU), showing the percentage of stocks above their 200 day moving average:

The last time we had 10% of Dow Jones components trading below their long term moving average was when we were just finishing up the bear market of 2002-2003.

“Dumb Money Confidence”
One of the most important proprietary indicators that I watch from SentimenTrader.com is the “Dumb Money Confidence” index. It is an aggregate of many indicators and along with the “Smart Money Confidence” it shows where we are along the market cycle.

The most recent reading is 13 (the indicator runs from 0 to 100) which is extremely low. This is a result of the abysmal sentiment out there but it also reflects how extremely oversold we are now. The previous times we’ve had such a low reading has been in August 1998, October 1998, September 2001, July 2001 and February 2003.

Financial Sector
Since a huge portion of this market decline is related to financial stocks (through the mortgage credit crisis), it is vital that they be the ones to lead any rallies. We’ve seen this sector jump around on the rumor du jour but what we really needed was something substantial.

Which we got on early Tuesday. While the general market rallied 3%, financial stocks were up 7%. This was an obvious reaction to the Federal Reserve’s new $200 billion intervention. The number is puny compared to the nominal amounts at stake in the financial markets. But what is important is that for the first time during this crisis, the Fed is using a scalpel rather than a sledgehammer.

Stock and Bond Dislocation
I’ve already mentioned that these two important markets were becoming more and more dislocated: stocks were cheap and bonds expensive When the two markets become disjointed it usually flags an important inflection point.