Trader’s Narrative

At the risk of wearing out the welcome of this technical indicator…

Towards the end of June, something quite rare happened. Something that hadn’t happened in the stock market for more than 5 years!

… zero Dow Jones Industrial component stocks traded above their 50 day moving average.

The last time we saw this was in January and February 2003. Sure, there were many times that the percentage of Dow components trading above their intermediate moving average approached very low levels. And each of those times usually corresponded with an important inflection point in the index.

But zero? That makes you stand up and take notice.

Looking at this very long term chart, one can’t help but automatically assume that the percentage of Dow Jones components trading above their 50 day moving average and the end of the bear market coincided with each other perfectly.

However, zooming into the chart we see that things are not that simple:

In fact, once the percentage of Dow Jones stocks above their 50 day moving average reached zero, the Dow Jones index continued to fall. In fact, if you close your eyes and imagine, it must have been terribly frightening to have such a reliable indicator hit the most extreme levels and to have no foreseeable effect on prices!

Equities fell, almost non-stop for what must have seemed like an eternity but was only another month. The definitive bottom was reached in mid March 2003 but by then, as you can see on the chart above, the percentage of Dow Jones components trading above their 50 day moving average had already recovered.

Now, let’s fast forward to today’s market and zoom into the charts:

On June 20th 2008, there were zero Dow Jones components trading above their 50 day moving average. But the market continued to fall, just as it had after the same signal in 2003.

Of course, the only difference is that with the 2003 charts, we have the advantage of hindsight and know exactly when to call the definitive market bottom. With the more current charts, we are handicapped by the ‘hard right edge’.

Only time will settle the question of whether we have already seen the definitive market bottom already but it is rather uncanny to see such similarities, wouldn’t you say?

Continuing the installments of what conditions precede new bull markets, here is one that should be very obvious.

Jim Stack says that the Dow Jones Industrial should drop at least 20% from its top. Here’s a chart of the Dow Jones and the S&P 500 from their respective tops to the bottom in March:

Although the Dow is still the most commonly used index for the stock market, I also added the S&P 500 to the chart. Since it uses capitalization weight it is a better index.

The Dow Jones Industrial fell 16.4% from October 2007 to the March 2008 bottom. The S&P 500 fell a bit more: 18.64%.

If we exaggerate the constraints and rather than the close, use the high and the low, we get a 20% drop for the S&P 500. But still not for the Dow - it only reaches 18%.

In any case, the point isn’t to “cheat” to be able to reach some synthetic level. Lets face it, although most people put the classic definition of a bear market as one that has fallen 20% or more, there is nothing really magical about that level.

Much more important is the fact it represents a wash out of sentiment because if a major index like the Dow or S&P 500 falls 20% or more, then weaker stocks will fall much harder.

Conclusion
Technically, this condition isn’t met.

I don’t know how some get the impression that I’m a perma-bull. I’m human, so by nature I’m biased. However, what I try to do always is to allow the tools and indicators to speak for themselves.

For example, on Wednesday (February 27th, 2008) I wrote a cautionary note that based on overbought breadth of both the Dow Jones Industrial and the S&P 500, the mini-rally wouldn’t keep up the pace.

My hunch was that we’d schlep around until it worked off and then head higher. But in any case, overbought is overbought. When you have both the indices showing 80% of their components trading above their 10 day moving average, you have to rein in the longs and bunker down.

Dive, Dive, Dive!
But instead of meandering, the market worked off its overbought breadth by nosediving. For those keeping count, the last time the S&P 500 was down hereabouts was in early February but the breadth numbers were washed out. We had only 20% of stocks in the S&P 500 trading above their 50 day moving average. Now we have 31%. We had a measly 17.5% above their 200 moving average. Now we have 21%.

My point is that the market has rolled over (again) without first getting really overbought in anything over than the shortest time frame possible - the aforementioned 10 day moving average. I don’t like that.

CBOE Put Call Ratio
Something else which bugs me is that on Thursday when the market fell a fraction of today’s move, the CBOE equity only put call ratio spiked to 1.0 (or for the obsessive compulsives: 0.966).

But today, when red filled trading stations the CBOE ended up falling! It closed at 0.836 if you can believe it. So according to this gauge, the option traders aren’t afraid - even in the face of a 2.5%+ decline

This is odd, and disconcerting. Yet, it is part and parcel of the mystery that is the market. These counter intuitive days when the put call ratio walks with the index are rare but they do occur. Sometimes they paint a bullish picture and other times not.

ISE Options Data
The ISEE index shows a more congruent picture with a dramatic decline in the number of calls relative to puts. Friday saw the ISEE index fall to 75 from 97.

That’s about as low as it got in mid February 2008 when the S&P 500 was trading slightly above Friday’s close. In contrast to the CBOE put call ratio, the ISE Index is saying that option sentiment is anything but apathetic.

Market Internals
How did we go from expecting a 90-90 up day to put a nice bow on the rally to getting a 90-90 down day? That’s what I’d like to know.

Maybe it was the short term overbought that I mentioned on Wednesday or maybe something else. In any case, we’ve been jarred from the slow and steady recovery from the January spike low with horrible market breadth.

Depending on which market data provider you use, we got anywhere between 2340 to 2400 declining issues on the Nasdaq and 2700+ on the NYSE. This has only been exceeded during this year on January 17th, when the market made its swing low.

Taking a quick glance at the graph of declining issues, I noticed that usually a low was carved out two to three trading sessions after such a spike high. Curious that it didn’t match such a wash out decline in breadth:

Hurts So Good
To leave on a positive note, the same short term indicator that that flashed a caution on Wednesday is now saying the opposite.

Of the 500 components of the Standards & Poor’s Index, only 13% are now above their 10 day moving average. This is low “enough” but if it happens to fall to less than 10%, without causing a concomitant fall in the indices, then the bulls are in for real a treat.

That’s because whenever we’ve had a similar deep oversold condition, even on such a short term time horizon, the market has rebounded strongly - see Lowry’s research.