Trader’s Narrative

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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You know how, when you’re walking a dog it pays no attention to the path or sidewalk and instead, driven by the instinct to collect and archive as many smells as possible, zig-zags to the left, then pulls to the right? It takes as much distance on the leash and as much of your patience as you allot it. Then you tug it back onto the path and the whole routine starts again.

Well, the market is a lot like that. A moving average being the leash and price being the dog. Here’s a chart of the S&P 500 relative to its 50 day moving average - I haven’t included an actual price index but I’m sure you’ll have no trouble matching the inflection points to important market tops and bottoms:

The above graph can be misinterpreted. So let me clarify: just because it peaks and turns down doesn’t mean that price has to. It may, or the average can rise/fall to close the gap and/or the S&P 500 can meander sideways.

A good example of such an exception would be October 2006 when the market, by this measure at least, got really extended. But even so it was able to grind higher, almost methodically, for another four months.

So to be clear, I’m not saying that the market is now definitely extended too much above its 50 day moving average. Potentially it still has room to go up. But at the moment, if it keeps up this pace, especially the tone set yesterday and this morning, it won’t take too long for it to get there.

Just something to tuck under your hat. And by the way, this doesn’t necessarily eliminate the long term bullish prospects for the market. This technical metric is useful in the medium term, which means that we can use it to watch for pauses or corrections within a much longer term bullish rally - similar to this other market breadth metric.

The CBOE equity only put call ratio finally reached an extreme yesterday. This is the indicator which gave me a false alarm earlier. I’ve double and triple checked the data this time to be absolute sure.

Fear & Loathing
At the risk of sounding like a skipping record, this is an indication of a very oversold market. The put call ratio shows that there is some despondency in the options market, finally, as people rush to buy more puts and position themselves for a further decline. This is what we’d want to see because it indicates capitulation and creates a foundation for a rebound.

To see a higher put call ratio we’d have to go back to August 2004. Back then it reached 1.28 while now it is at 1.08. I’d like to see the ISEE sentiment index confirm this fear but since they measure slightly different option market activity, it may not.

To The Extreme
In any case Tuesday’s decline created further extremes in almost all technical indicators. For example, the percentage of S&P 500 stocks above their 50 day moving average decline to 14.20, which is a level at which it hasn’t been since the bottom of the bear market.

But we must defer to price action, not indicators. And while indicator after indicator has pressed into extremes which have seen the market bounce back before, the price action continues to be flaccid. That should also count as much as any indicator.

Looking at the Nasdaq advance decline numbers, I noticed that we are at a very deep oversold level here. It basically confirms what I outlined yesterday through other indicators.

I look at the 5 day simple moving average of the Nasdaq breadth numbers because I want something very short term and 5 is also the number of trading days in an average week. So the chart shows a rolling average of a week’s worth of trading (see below).

According to this measure of Nasdaq breadth, we are just a little bit better than the late February 2007 bottom. And to beat that exterme, you’d have to go back to the panic bottom formed after the September 11 attacks in 2001.

The NYSE advance decline numbers are even more stretched to the downside because it contains a lot of interest rate sensitive issues which have been getting obliterated. The 5 day moving average of the NYSE breadth in fact is almost as low as it was on 9/11.

So the probability that we are about to witness a bounce here is very high.

Click To Enlarge Graph: