Trader’s Narrative

With today’s close the S&P 500 index arrived at a new high for the year. So far, it has risen 22.8% - not bad at all compared to the average historical return. And the year isn’t even over yet. If we look at the performance from the very bottom of the lows in March, it is even more remarkable at 63%.

But even as the stock market continues to power ahead, and longevity of this rally continues to strain all credulity, we can’t ignore that the market breadth is down right horrible. Usually, the measure of advancing vs. declining stocks rises and falls like a tide, keeping a rhythm with the indexes.

Right now however, the 20 day average of Nasdaq’s daily advancing and declining issues is acting the way it would at intermediate lows - even though we’ve well into an uptrend:

This means that fewer and fewer stocks are pushing the averages higher. When we start to see less participation from the wider spectrum of stocks trading on the exchange, we don’t have a healthy rally. My hunch is that most of gains can be laid at the feet of the large caps either because of their international sales exposure or because of the dollar carry trade (sell the dollar and buy anything risky). Check out the Russell 2000 - it has yet to confirm a new year to date high as the S&P 500 index. The same can be said for the equal weight S&P 500 index.

Another cause for concern is just how quickly the index has been able to rise on the back of fewer and fewer rallying stocks. For a bull market to be considered healthy, it has to have staying power. This is an endurance run after all, not a sprint. I measure the speed of a rally by comparing the closing daily price to the long term trend as measured by the 200 day moving average.

While the 200 day moving average has been rising, it hasn’t been able to climb as fast or faster than the price it tracks. So the distance between them as a ratio has increased. With today’s strong close, the S&p 500 index is now 19.3% higher than its long term trend line. That’s slightly more than the last time this same metric made me raise the caution flag: Stocks Have Little Room to the Upside.

That was 11 points lower than we are now. Running the numbers with a 20% and 21% ceiling, we get 1117 points and 1127 points respectively. So imagining that we leapfrog 8 to 18 points from here, we will have hit an invisible wall. Check out the previous link above to see a chart.

So odds are that we either correct here (again) to give the long term moving average a bit of time to catch up. Or prices meander to and fro, not really going anywhere and boring both bears and bulls. There is very little probability, from a historical study of the market, that we will see a rush higher.

Back at the beginning of August, we looked a study of momentum thrusts which showed that historically, when the 10 day ratio of NYSE advance decline was pushed to an extreme the market tended to enter a protracted rally.

There were only 10 instances in the past 4 decades, with 2 of them occurring this year. Since some time has passed, I wanted to update the table and look at where breadth stands now:

From March 23 2009, the market rallied about 12% in 3 months and almost 30% in 6 months. And forward 3 months from July 23rd, the market rose 18.6%. That’s in line with the previous returns historically (or slightly better).

When Wayne shared this historical study with me, my initial concern was that this is relying on NYSE breadth data. As I’ve stressed several times before, NYSE market internals are now skewed by the increasing number of non-operating company securities trading on the big board. While the NYSE is the most well known stock exchange around the world, increasingly ETFs, municipal bond funds and other CEFs and even bonds have started to take a larger and larger share of trading.

But, if you look closely at the Nasdaq data, it corroborates the last two momentum thrusts that are shown above. In late March and late July you can see two distinctive spikes:

So far, so good. Or more accurately, in line with historical norms. Lately though, the breadth has been horrible. We haven’t seen market internals this bad since the beginning of the year - just before the spring rally was launched.

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.

This is a guest post by Wayne Whaley (CTA):

I have written over the last few months on the importance of the historic momentum thrust that we have experienced this year and how they could possibly push the market higher than most would anticipate.

Today, Sept 16th, 58% off the lows of 666 on the S&P, I am rolling my eyes, looking to the heavens in disbelief and sharing with you that today we had the third “Ten Day 2:1 Advance Decline” reading in the last 6 months. The previous two were on March 23rd and July 23rd. I haven’t had a great deal of time to study it yet, but it appears unprecedented with really very little to compare too. But I would caution against interpreting this as a sign of an overbought market. As I have shown in the past, single 2:1 advance decline thrust signals are very bullish. Two in a short period of time, even more so, and I am assuming until I find evidence to the contrary that a third is bullish as well. Since I have no tri-signal data, let’s take a look at the three other occasions where there were double signals in a short period of time.

The table below shows the three previous double signal dates, followed by the percentage change in the S&P 500 and the returns 3, 6 and 12 months later.

Double Ten Day 2:1 Advance Decline Signals in less than six months:

Note that these three previous double readings occurred in different decades and notice that although the second reading came well after the initial advance was launched, the S&P 500 gained an average of an additional 26.37% over the next year, with nary a less than 24.28% gain. The S&P 500 index is currently up 9.5% since the second thrust that occurred on July 23rd, 2009.

This market is similar to all three of these markets in some ways. But appears to correlate the closest with 1975, which similar to this rally followed a 48.4% sell-off in equities that lasted 20 months; was often postulated to precede the next great depression and was accompanied by massive federal stimulus.

For much of the last 6 months, analyst have compared the recent rally to the bear market rally that took place between November 13th 1929 and April 17th, 1930 - rising 48% over five months. One can not totally rule that possibility out, but a major difference was the fact that in 1929, the preceding sell-off in stocks occurred in only two months, while the current rally followed a 15 month long bear market. It seems that in just in the last few weeks such comparisons have dissipated.

I understand that it works against human instinct to buy the market this high off the lows, but I assure young readers that investors in 1975 and 1982 had the same dilemma. If you have been waiting and are tempted to reenter, I suggest dollar cost average into it.

I see a lot written on indicators that are at historic levels with many interpreting this market as overbought. But if you look back through history, anytime there is a 50% or more move in the major indexes, the oscillators, sentiment indicators, etc, that are bounded from x to y are going to be tested repeatedly. Divergence analysis between range bound indicators and a potentially rangeless market tend to mislead at such times.

Yesterday, the S&P 500 continued to make new highs for the year, almost reaching the round number 1050. But even as this major index continued to climb, several measures of internal market breadth haven’t kept up the same pace.

For example, here is the Nasdaq Summation Index chart showing that it is well below its high in May 2009:

The last time I mentioned a similar divergence was in June 2007 when the Nasdaq McClellan Summation Index was coiling as the S&P 500 was acting strong. Of course, armed with hindsight the S&P 500 didn’t soldier on much higher. While the breadth measure showed a weaker and weaker market internal, the index finally succumbed to a severe bear market.

Having said that, I’m not sure that this is necessarily a huge red flag for the market. Well, let me backtrack a bit. I think it could potentially be slightly negative but only in the short term. In the long term, there are other forces at play which seem incredibly bullish.

We’ve already covered the stupefyingly powerful rally: zero new lows and the intense positive breadth thrusts. For a clue about why there may be a very powerful underlying force driving the market, take a look at the ratio of new highs vs. new lows on the Nasdaq:

The last time we saw the stock market behave with the same single minded intensity was in the summer of 2003. And that set the stage for a cyclical bull market, of course.

Persevering readers would remember just a while ago when I was Comparing Market Breadth to 2003 and in trying to answer the main question on everyone’s mind (is this just a bear market rally or the real thing?), said:

… what this analysis tells us is that the recent rally was one where a small subset of the S&P 500 rallied, pushing the averages higher. To see a change in market tone, we need to see almost all shares trade above their long term moving average. We can not start a healthy bull market with a few extremely strong shares pulling the rest along for the rise.

I think we arguably have that now. In fact, if we look at the breadth chart which was featured in that past post, we see 95.6% of S&P 500 components above their 150 moving average. That’s higher than the brightest interval in the 2003 bull market launch.

And turning to the more short term breadth measure, there are 92.6% of the S&P 500 trading above their 50 day moving average. To see equivalent positive breadth, we would have to go back to the early days of the 2003 bull market.

The next trick the market has to perform to convince me that this is indeed a genuine cyclical bull market is to maintain positive breadth at this level (or close to it). And to do this, even if we have some profit taking in the S&P 500 itself. That is exactly what we saw throughout 2003 and into 2004.

So far, today’s market is showing promise in this regard as well. The shallow correction in July of this year was met with an equally shallow breadth damage: the percentage of S&P 500 components trading above their 150 moving average didn’t fall below 60% before recovering smartly.

Conclusion
Over all, this market has defied the vast majority of traders and investors in rising as far and as fast as it has. The recent divergences we are seeing are negative but the nature of divergences are that if they do not have a consequence in the short term, they can continue for much longer than most predict.

Much more important in my view is the powerful breadth which is propelling the index higher. Rather than just a handful of stocks taking the averages higher, we are seeing an almost unanimous participation. And that not only bodes well for the continuation of this rally, it speaks of a change in underlying tone.