Trader’s Narrative

Last week we looked at the head and shoulder chart formation which was evident on almost all major stock market equity indexes.

It looked perfect. The symmetry of the rallies making the shoulders and head, the volume, everything about it was picture perfect. Perhaps too perfect. I warned about failed head and shoulder patterns which cause prices to bolt the other way.

Right now, it looks like it was a false pattern. It trapped many giddy bears in the 8200 level and then put them through the meat grinder, taking the Dow Jones Industrial up 6% in 3 days flat. As the shorts cried uncle and closed out their positions (either because they hit their predetermined stop losses or because of margin calls), the rally started by the bulls gained even more momentum. While many will explain it by saying it was because of Intel’s (INTC) earnings release, tape readers know the real reason.

Not only are we back above the neckline of the head and shoulders pattern, we are once again above the long term moving average (simple 200 day). When something is obvious to everyone, then you shouldn’t treat it as an edge.

Here’s a short video from MarketClub from Adam Hewison on the recent action in the the Dow Jones Industrial index and what he expects going forward:

The quick bounce wasn’t out of left field since we looked at very short term indicators which told us that the market had quickly gotten very oversold.

An interesting factoid: after today’s strong close, 75.6% of the Standard & Poor’s 500 component stocks are trading above their 200 day moving average. That is the best breadth from this measure since June 2007. It is significant that it has been recovering relentlessly after falling to less than 5% for six months (almost continuously).

Also, Monday’s and today’s strength was actually almost back to back 90%/90% days. Today 93% of the volume on the Nasdaq and 96% of the volume on the NYSE was advancing. Then again, we’ve seen so many of these extremely positive breadth days throughout the bear market that they’ve practically lost all of their ability to command attention.

While this may have the feel of a classic bear trap, I’m not sure we’re going to just ramp up from here. Instead of either a cascade down or a rocket ride higher, we might just be climbing back into the previously established range bound trading. In other words, the lazy meandering action that is endemic of summer trading.

This week the markets were propelled ahead by the positive earnings of major tech companies like Intel (INTC) and Google (GOOG). Here is the sentiment summary:

Sentiment Surveys
Investor’s Intelligence results are basically unchanged so no need to delve into them. The AAII survey this week shows a reemergence of bearishness with 49% of respondents in that camp (only 30% are bullish). This is rather odd because the market has continued to go higher but part of the mysterious gloominess of the retail investor may be that the survey was completed on Thursday, before Friday’s powerful rally.

In any case, as a contrarian and a current long, I always welcome pessimism, especially when it is accompanied by higher prices.

Market Breadth
With the rise in market prices, the percentage of stocks above moving averages has also increased. The shortest time frame I use is the 10 day moving average and it now shows about 82%, very close to levels which have pushed back rallies in the past. This is where we found this indicator last October when most indexes created their swing highs.

Chart from indexindicators.com

But is is a very short term metric which doesn’t preclude the market from rising higher in longer time frames. More importantly, the percentage of S&P 500 stocks above their 50 day and 200 day moving averages are 71% and 40%, respectively. The most important is the longer metric which is still very low.

It reached eye popping lows of 15% in January and again in March 2008. We haven’t seen numbers that low since the darkest days of the last bear market. This was one of the reasons I was unapologetically bullish. As I’ve brought to your attention repeatedly, such extremely low breadth numbers have always marked the start of a new bull run.

But right now, we’re a tiny bit over extended and I wouldn’t be surprised to see the market yet again pause and/or be rebuffed at the 1400 level which has turned it back 3 previous times. The difference now is that there are more and more stocks participating in the rally, as can be seen by the number of stocks above their 200 day averages.

CBOE Put Call Ratio
After spiking higher than 1.30 the CBOE equity only put call ratio backed off this week in a hurry, falling below 0.59 - this is the lowest number since early February 2008. And yet another short term argument for the tape to run into resistance.