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.

Today the venerable Dow Jones Industrial index is undergoing changes to its component stocks: Altria Group, formerly Philip Morris (MO) and Honeywell (HON) are being replaced with Chevron (CVX) and Bank of America (BAC).

Actively Passive
Which explains why I always chuckle when people get into debates about “passive” (aka index) funds vs. “active” funds. As today’s change should evidence, all funds, including indexes are active.

Somebody has to decide: a] what to put into an index b] rebalance it using some formula and c] make changes to the components, from time to time.

In an active fund, those calls are made by the manager who charges a hefty fee and in the case of an index fund like the Dow Jones the decision is made by the editors of The Wall Street Journal. Same difference.

The only real distinction is the portfolio turnover and the MER. While changes to the Dow happen every few years, an actively managed portfolio can have positions traded into and out up to several times a day.

Better Out Than In
Another interesting twist to this debate is that historically, stocks deleted from the Dow Jones end up outperforming the ones that replace them. That goes for not just the Dow but all major indices.

For example, Chevron was in the Dow before until it was deleted on November 1st, 1999 in a swap that involved 3 other boring stocks getting dumped for sexier stocks: Home Depot (HD), Intel (INTC), Microsoft (MSFT) and SBC Communications - now AT&T (T). The editors of the WSJ weren’t immune to the lure of the internet bubble.

The four new stocks went on to produce an average loss of 40% while the deleted and unloved stodgy ones produced an average gain of 27%. So the Dow would have been much better off had there been no changes at all!

The most (in)famous change to the Dow is the elimination of IBM from the index in 1939. While it was eventually added again, according to Norman Fosback, the Dow would now be twice what it is today had there been no change.

Still like indexing? still think it is passive?

Technical Analysis
Rather than a typical technical analysis of the Dow using its own chart, I thought I’d share something a bit more advanced and perhaps more insightful.

The chart below is a ratio of two breadth indicators: the percentage of Dow components above their 50 day moving average, divided by the percentage of Dow components above their 200 day moving average. If it sounds familiar, you’ve probably read this: “Timing the Market with % Above MA Ratios”

Whenever the ratio spikes, the Dow is extremely oversold. The current ratio has spiked because the denominator is 13.33% - the lowest it has been in five years.

Anything in the 2.0+ range is beyond extreme. We’ve only exceeded this level in recent times when the market was making the 2002-2003 bear market bottom.

Fundamental Analysis
According to Morningstar’s fundamental analysis, the Dow is undervalued by 17%. They arrived at this valuation by doing an analysis of each component. They also expect the index to rise 50% in the next 3 years.

According to Jeffrey Ptak, “The Dow hasn’t looked this cheap to us since September 2002 when the index stood at 7,592″. Sound familiar?

The research note was released before today’s changes to the Dow but Morningstar added a note saying that Chevron and Bank of America will actually make the Dow even more undervalued, reducing both trailing and projected price earnings ratio and increasing the dividend yield.

I’m not big on fundamental analysis but when it dovetails so neatly with technical analysis, I can’t help but take notice. Oh and for another take on the general market fundamentals, take a look at the IBES model.

Remember to add your own thinking and due diligence.