Trader’s Narrative

Here is a chart plotting every single major rally in the Dow Jones Industrial index since 1900:

Source: Chart of the Day

While the Dow has surpassed its highs from last month, this has not been confirmed by other major indexes. In any case, there have been 27 significant rallies in the past 109 years of market history - not counting the current one. That’s about one for every 4 years. Paul Desmond of Lowry Research pointed out this four year cycle as one of his reasons for believing this to be a real bull market.

About three quarters of the rallies resulted in a gain of 30%-150%, lasting 200-800 trading days (9.5 months to 3.2 years). These are the data points highlighted in the blue shaded box above. The current rally is just shy of making it as it is too short in duration.

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While we all like to think of ourselves as rational beings, making decisions based on sound judgment, the truth of the matter is much more unsettling. We are, for the most part, rather peculiar creatures, prone to irrational and emotional biases. What makes this even more disturbing is that the edifice of our economic and financial system is built on the foundation of a rational, utility maximizing individual.

The most recent sentiment overview shows an amazing turn of events. Even as the stock market has gone on to rise almost 60% from its dark depth 8 months ago, a moderate correction was enough to plunge the majority of retail investors into a new state of capitulation.

Even more curious, instead of investing more as the stock market recovered, which is the norm, the US retail investor has completely given up on equities. Here is an updated chart which I originally shared two months ago (Equity Mutual Fund Outflows):

If anything, the exodus of US retail investors (mutual fund owners) has intensified. The data for the full month of September shows redemptions of almost $13 billion - the most since February, just before the spring rally started. And to make it even more bizarre, the frenzy of bond buying is getting even more frenetic with net purchases of $55 billion (in September).

The data for the latest data (3 weeks in October shown in darker colors) promises a continuation of the same trend, if not a new record. So far, October had net equity redemptions of $11.5 billion.

Almost the same can be seen from insiders trading activity. These more ‘in the know’ individuals have continued to sell shares of their company’s stock almost as fast as they could. While there are many reasons for an insider to sell (diversification, divorce, etc.) the fact that we aren’t seeing an uptick in purchases is telling.

So why is there so much pessimism around this latest stock market rally?

Loss Aversion
A concept from behavioural finance offers a possible explanation for the bizarre fund flows pattern, bearish investor sentiment and insider selling. “Loss aversion” is a concept from prospect theory which explains that people prefer to avoid losing, rather than take a proportional risk to receive a gain.

Think of it this way. Given an event which triggers either a loss or a gain of the same amount, for some strange reason, we prefer to avoid a loss, rather than receive a gain. In other words, we prefer to keep what we have (not lose some or all of it), rather than add to what we already have. For most people, losing is much more painful than gaining is pleasurable.
Continue reading ‘What If Wall St. Threw A Party, And Nobody Came?’

Last week we reviewed the latest position of Lowry Research on the stock market: Turbulence Ahead, Uptrend Intact. One of the major reasons that Lowry’s continues to believe in the health of the market and a continuation of the uptrend is the lack of selling pressure.

Lowry measures this through their proprietary metric called (what else?) Selling Pressure. It remains low and falling, helping to support the thesis of a healthy market rally. According to Paul Desmond: “Every major market top in Lowry’s 76-year history has been preceded by a sustained rise in selling pressure. With selling pressure recording a new 12-month low within the past two weeks, no such rise is now evident.”

This has got to be frustrating for the bears. But it is also unbelievable to the large number of participants in the market who continue to look at the current price levels as a mirage. The US retail investor is not venturing out into equities, even after watching the stock market climb a wall of worry inch by inch.

This has been and continues to be the most hated stock market rally that I’ve ever witnessed. In any case, it is comforting to confirm Lowry’s proprietary measure of selling pressure with a similar measure from InvesTech.

Click chart to see larger version:

Source: InvesTech

Jim Stack, the writer of InvesTech has a handy checklist for new bull market conditions. One of them is this metric. And along with the rest of the list, it has been flashing a bright green buy signal for a few months.

As well, the month of November has been historically one of the best months for the S&P 500 since 1950. I’m not sure that another 20% rally by year end will convince the retail investors to risk their money in the stock market again. But we may just see that.

While I think the S&P 500 has more room to the downside, the bounce today wasn’t unexpected. If you listen to the mainstream media, the explanation is the the positive GDP numbers, which at 3.4% blew away expectations.

While it will take a few days for the whole report to be dissected, it is more likely that it was an excused used to run up prices, rather than the actual rationale. Especially since many have pointed out reasons at the beginning of the third quarter why the recession may be over. I attribute the bounce today to the extremely oversold breadth - in the very short term.

One of the best measures for this is the percent of S&P 500 stocks above their short term (10 day) moving average. This metric sharply fell to just 6% yesterday. At the start of the week it was 20.4% and on Tuesday it was 14.4% and then it fell below the important 10% level which marks extreme short term oversold levels. This is the level that was mentioned in the recent Lowry report: Turbulence Ahead.

The oversold level was clearly visible across many important sectors. Many of which had equal or worse breadth than the general market proxy. The transports were especially hard hit for example. As were the gold stocks, which as I’ve repeatedly mentioned, tend to follow the general market.

Another measure of short term breadth is the ratio of daily new highs to new lows on the Nasdaq:

As the chart shows, the last time new lows increased this much and new highs dissipated this much was back in early July, which launched the second leg of the spring rally. As Lowry’s report mentioned it is quite possible to experience a short term set back within a primary uptrend. Things to watch for are how the market responds to this oversold condition. If the market weakens significantly in spite of poor breadth, then it will need to trade lower to find a strong bid. If on the other hand, the S&P 500 can rally immediately off such a short term extreme, then we know that the uptrend is intact.

An important part of this is the medium term outlook. The percent of S&P 500 stocks above their 50 day moving average has managed to put in higher lows each time as the chart below shows:

Since October 2008, medium term breadth for the S&P 500 index has been stair stepping higher. It needs to remain above 30% to maintain the uptrend, which it seems to have done already.

And the very long term breadth measure - the percentage of S&P 500 components above their 200 day moving average - remains at peak levels. With today’s strong showing, it moved once again above 90% where it has been since August 2009. This is reminiscent of the rally we saw in late 2003. I’ve detailed this here: Comparing Market Breadth To 2003’s Bull Market.

Let’s check in with the latest Lowry Research proprietary indicators. As persevering readers will recall, Lowry arrived late to the (bullish) party with their intermediate buy signal in August. Since then, they’ve continued to monitor their indicators and diagnose the uptrend as healthy: Rally Continues Strong. No indicator, whether proprietary or otherwise is perfect and no one has a crystal ball.

HAving said that, personally, I respect the oldest technical analysis firm on Wall Street not just for their heritage but also because they refuse to be swayed by emotion and always root their approach in a methodical study of the market.

Here are some notes from the latest interview with Tracy Knudson of Lowry Research (you can listen to the whole podcast at the bottom):

• S&P 500 bouncing off its 50 day moving average
• near term, we could get a move down to that MA
• around 1045-1050 which is a converging support area
• the trendline from March and July lows also meets in that area
• this area will act like magnet to draw market lower
• volume is sending a clear message: weakness on upside and more strength on downside
• S&P 500 tried several times to clear the 1100 level
• it has approached that level on contracting volume
• but volume expands on downside days
• this telling us demand weakening and selling more intense
• so the market is gearing up for a correction
• last short term pullback occurred in late Sept to early October
• that began with a downside reversal day
• this is when the market made new high then wasn’t able to sustain it and made a new low

Continue reading ‘Lowry Research: Turbulence Ahead, Uptrend Intact’