Trader’s Narrative

Almost a year ago I asked rhetorically, is the REIT bull market over? My own take on it at the time was that what we were seeing was yet another correction and not a top, as it actually turned out to be - in hindsight.

So where did I go wrong?

For starters, unlike the Canadian REITs (which I was also wrong on by the way) the US REIT index had an ominous head and shoulder formation. I downplayed this because of its “obviousness”.

But the head and shoulder pattern completed and price broke through the neckline. This same level corresponded to the bull market trendline. So because of this multiple significance it was important what price did near this level.

Back when I wrote about US REITs last, the breadth in the sector was really bad with only 20% or so above their 50 day moving average. This is a short term metric however and does not provide signposts for a longer term outlook. The REIT index did snap back sharply into June 2007. But from then on it was on a continuous and relentless decline.

The next rally created a lower high and the subsequent reaction a lower low. REITs were now in a clearly new market condition. As you can see from the chart, a bull market means that price stays well above its long term moving average. It only sporadically comes back to meet or pierce the 200 day moving average. The previous time that the REIT Index was “under water” this long was prior to the final base building in 2002-2003.

Trend Change or Correction
It is extremely difficult to pinpoint a major change in trend - at least I almost always find it extremely challenging. I have enough trouble with short to medium term inflection points. So I prefer to assume that there isn’t a major trend in store unless I’m proven wrong.

I prefer this not only because of the difficulty in separating a major trend change from a normal run of the mill correction but because the former only happens once in a blue moon while the latter occurs much more frequently. So I’m more than happy to take my chances because probability is on my side.

Powerless Fed
My other mistake was in attributing too much power to the Fed. I correctly thought they would soon start to lower interest rates. But my mistake was in thinking that this would be able to halt or reverse any weakness in the housing market. The rot in this sector was beyond the imagination of even the most die hard shorts.

What Now?
The only positive “spin” I can put on the abysmal REIT performance is that unlike most investments in the stock market, REITs are specifically built to be income vehicles. So while your holdings may be underwater, as an investor you are continuing to earn monthly or quarterly income from holding them. And depending on the particular REIT in question this can be a substantial amount. But this is only consolation for the long term investors, not the nimble short term traders.

Until we see the REIT Index (DJR) or the REIT iShares (IYR) or similar proxy carve out higher highs and higher lows, I can’t say it has flipped into bull mode. The disadvantage is that while by that time we may be confident, the inflection point will be far gone and with it, a good chunk of price performance.

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.

Like other times of inflection in the stock market, we are seeing technical studies and indicators light up like a Christmas tree. So why not throw another couple stats on the pile? Below are the charts of new 52 week lows for the Nasdaq and the NYSE.

Similar to other indicators I’ve mentioned recently, this one spiked to a multi-year high last Tuesday (January 22nd 2008). In fact, you’d have to go back to the market turmoil we saw in 1998 to find a higher number of new lows!

The NYSE graph looks different mainly because a significant portion of the securities traded there are non-common stock but rather bonds, municipal bond funds and structured funds which are sensitive to interest rates. Nevertheless, we can see the same pattern.

As with the weight of all the indicators that I’ve looked at, this one is saying that it is time to look for buying opportunities, rather than selling or selling short.

I was unavailable yesterday due to travel. Thanks for the kind messages

Yesterday the market tumbled on sustained selling which according to the pundits was due to the release of low consumer confidence numbers by the Conference Board. It was the largest drop and the lowest reading since September 2005 which was right after hurricane Katrina.

While the market’s decline can’t really be traced to the release of this data point, the correlation does cause some to incorrectly conclude causation. But I suspect the market needed to give something back after a breathless sprint upwards last week.

Last year I mentioned the Michigan Consumer Sentiment Survey and how paradoxically, the low readings seemed to coincide with inflection points in the stock market.

After all, significant bottoms are formed when all seems darkest and hope is for the most part, abandoned.

Mark Hulbert mentions the same in relation to the Conference Board sentiment survey:

The historical record shows there to be a slight tendency for the market to move inversely to consumer confidence, with high returns following periods of low confidence and below-average returns following periods of high confidence. In addition, big monthly drops in the index are more often than not followed by market gains than market losses.

By the way, the Michigan survey dropped to 83.3 in August - its lowest reading in a year. So both surveys are showing significant consumer reaction.

Basically, sentiment surveys provide more insight on what has happened and how the consumer is now responding to previous economic situations (the sub-prime mess for one). They do not really provide any insight into the future, except as a contrarian signal.

I don’t see anything catastrophic to cause me to give up on the bullish correction thesis. In fact, this weak consumer confidence reinforces it. Had the consumer been sanguine, that would have given me a new worry.

I’m not really sure what to call this indicator. The new highs/new lows indicator sounds awkward. I wish some technical analyst with a cool sounding name had created it so we could be saved from such banality.

Whatever you wish to call it, this indicator looks at the 52 week new highs and the 52 week new lows. It is calculated by taking the new highs and dividing by the sum of the new highs and the new lows.

So when it returns zero, there were no new highs and when it returns the other extreme (100) we know that were no new lows. And when it is at 50, this means we had the shocking circumstance of exactly the same number of new highs and new lows. Simple, right?

On with the analysis. Let see what this indicator can add to our understanding of the market. Because it can be a bit jittery, I like to smooth it out with a very short term moving average (5 day). So when I mention the indicator below, I’m really referring to this moving average.

Bottoms Up!
For one, new highs new lows (NHNL) does a phenomenal job of pointing out inflection points after a downtrend. Historically, when it breaks below 20, the market has taken enough of a beating and finds a bottom either immediately or within a short period of time. Of course, there is no reason why it can’t go right down to its minimum of zero.

Last time this happened was in July and September 2002 - the darkest (and final) days of the bear market. But it reaches such extremes rarely. Usually it reverses at or around 20. The last time it did that was last year (July 2006) which marked the last great buying opportunity of the summer doldrums.

Shallow Retracements
But inflection points don’t necessarily even need a reading of 20 on this indicator. For example, this year’s early March bottom was formed at a reading of only 40. Shallow retracements are a hallmark of strong bull markets. Take for example what happened in 2003. After bottoming in just below 10 in the early months of the year, both the market and this indicator shot up to much higher ground.

From the summer onwards however, the indicator saw almost no more real retracements. Eventhough the S&P 500 didn’t go straight up, each time it faltered, the new highs new lows indicator only dipped minimally. And then recovered right away. It spent most of the time hugging the 100 line. And its largest retracement only reached only 80. On it went like that for the rest of 2003 and into 2004.

Now that’s a strong bull market!

Another characteristic of this indicator that I noticed is that shallow retracements have different meanings. It depends if they happen after an extreme low has already been reached prior to it or whether the shallow retracement occurs after a maximum has been reached.

Caution
Let me explain. If we keep walking forward with the example I last mentioned, in early 2004 we had our first correction of the new bull market. But the NHNL indicator dropped to almost 70. The next correction was in May 2004 with the market dropping a little bit lower than the March 2004 lows. NHNL fell again but this time to almost reach 20. Then again in a few months, the market fell again (August 2004) and this time the NHNL got a real extreme low reading (below 10).

My point is that the first time the NHNL fell, it wasn’t really extreme. And since it was after it had already been at the extreme high, it was telling us that this wasn’t a real market bottom. Only after reaching a real extreme (below 10) did the market finally find its footing again.

Smooth Sailing
So shallow retracements of NHNL while the market is dropping are not to be trusted. But if they occur after it has already reached an extreme they signal a continuation of the bull move already underway.

Let me explain by continuing the 2004 story. In October 2004, the market again dipped. This time however the NHNL indicator only dipped below 50 - a shallow retracement. But since this was immediately after a very extreme retracement (below 10) in August 2004, it was a signal that the bull move was still going strong.

So what does this indicator tell us about the current market?

For starters, the correction in March 2007 corresponded to a shallow NHNL retracement (40). And since it ocurred after it had already been high for some time this meant that the decline wasn’t finished. But of course, it was - atleast as far as we’re concerned. This was the first time since I have data for the NHNL indicator that such a shallow pullback following a time at the maximums was the real deal (significant bottom).

And the latest correction which we had hardly registered on this indicator. In early June 2007 it slipped just below 80. So are we seeing just a correction within a strong bull market?

All the NHNL indicator can really tell us is that the latest correction was very muted. Even more so than the March 2007 one. But as long as we are in a strong bull market, that isn’t a problem. Short and shallow retracements are par for the course. The best way to be more certain that we are seeing that sort of scenario is to reach new highs.

Click to Enlarge Graph
Notice how the shallow pullbacks (orange arrows) that follow immediately after a climax low are good buying opportunities (October 2004, May 2005 and August 2006) but those that happen some time after treading maximums are not (August 2005 and March & April 2006)