Trader’s Narrative

Well, that didn’t take long. The S&P 500 is only down less than 5% from last month’s peak and already we’re seeing signs that this shallow correction has reached important levels.

Take for example the percentage of stocks closing above their 10 day moving average. This simple breadth measure is surprisingly accurate at finding inflection points, both in the short and intermediate term. According to a study from Lowry Research which I shared with my readers a few years ago, it has an almost perfect track record: Latest Research Report From Lowry Research (2007).

The key level to watch is 10% - which we breached on Friday. Here is a chart of this breadth measure for the components of the S&P 500 index:

This wasn’t limited to just the most popular stock market index. Other indexes provided a similar outlook. Take for example the Nasdaq 100 index where 9% of the stocks closed above their 10 day moving average. Lowry’s operating company only version of this breadth measure was 8.13%, which is the lowest since March 2009.

We can add to this the McClellan Oscillator which is another measure of market breadth. If we strip out the ETFs, CEFs, and other ‘junk’ from the NYSE and just consider real corporations, this operating company only index’s (Ratio Adjusted) McClellan Oscillator is as oversold as it was in March 2009.

But other metrics like the short term average of the daily Nasdaq advance decline numbers are still quite high. So is the percentage of S&P 500 components which closed above their 50 day moving average. In an important bottom, this number can fall to 20% (and lower) but so far the lowest it has reached is a lofty 53.6%.

A note of caution before you jump to conclusions. Interpreting this type of data can be rather tricky. That’s because these measures of internal market breadth act differently during different market conditions. In strong bull markets they can levitate for prolonged periods of time at atypically high levels. While in bear markets they oscillate with much more volatility.

The best way to look at this market juncture is to see it as a litmus test of the spring rally. Just as we went over when we updated Lowry Research’s latest views on their intermediate buy signal, this correction was expected. The best way to take advantage of it is to see how the market reacts to it and specifically how the market internals deteriorate in the face of a decline in stock index prices.

A shallow correction followed by a sharp rebound with very limited damage to the underlying breadth of the market would be a tell that this is a real cyclical bull market and not just a prolonged bear market rally.

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At the beginning of the year, fueled by a cocktail of optimism and the famed Santa Claus rally, the market reached for the sky. I pointed out the decade high in the McClellan Oscillator and suggeted that the extremes in this breadth indicator meant that the gravity defying rally was about to lose momentum.

Vin referred to this post recently and requested an update, along with a chart of the S&P 500 index for comparison. Here is the most recent chart of the McClellan Oscillator (ratio adjusted) for the Nasdaq:

And a comparison of the chart with the S&P 500 index (SPX):

I’ve marked the few times in recent history when the McClellan Oscillator has reached an extreme high and how that corresponded with a swing high in the S&P 500 index. Along with the hint that we are again at a peak, is an indication from the McClellan Oscillator of the increased volatility we’re going through in today’s stock market. Exciting to live through and lucrative to trade but leaves your teeth rattled.

In the end, whether this is just another bear market rally or the end of the bear market remains to be seen. But even if it is the latter, don’t expect the market to just rocket higher from here. A realistic scenario would have the market embark on a slow, healing process where we take two steps forward and one step back.

The last time we saw the McClellan Oscillator at an extreme was in the first week of the new year. Back then, for both the NYSE and Nasdaq, it reflected a very overbought market - so much so that it was a decade high (see long term charts in previous link). We now know that the signal it provided in early January was correct as the S&P 500 index quickly reversed and fell from 940.

Now the McClellan Oscillator has swung to the other extreme and is plumbing depths rarely seen. This indicator, is of course, a measure of internal market health. It is a measure that uses advancing and declining issues in a market to find overbought and oversold oscillations.

Here’s a chart of the McClellan Oscillator (Ratio Adjusted) for the NYSE:

Since there is so much non-common stock securities trading on the NYSE these days, I always look at the Nasdaq data to make sure that they aren’t distorting the picture:

According to this indicator, we are close to a ‘wash out’ scenario in the market. And it couldn’t come at a better time for the bulls because the market is sitting right now at support. The McClellan Oscillator’s extreme low level may help the market to hang on by its very fingernails by buttressing it exactly when it needs the support most.

We are starting to see some shifts in sentiment that reflect the sort of pessimism that usually accompany market bottoms. While the Dow Jones is below the November lows, I’m not convinced because it is not capitalization weighted and it represents a very small sample size of 30 companies. I’m giving much more weight to the capitalization weighted S&P 500 index which has yet to convincingly break support.

Another possible scenario is for the market to pierce the November lows, trapping new bears and crushing them as it bounces up. Always remember that the market is no one’s friend, and it doesn’t owe you anything. In fact, more often than not, it is there to distribute the most amount of financial pain, to the most number of participants.

Today’s market decline isn’t that surprising when you consider that we walked into the new year with a lot of complacency as shown by option traders’ sentiment. As well, we have the McClellan Oscillators at decade extremes for both the Nasdaq and the NYSE.

Here is another view of the market which points to the same general theme of a market that is feeling toppy in the short term:

This is the percentage of S&P 500 stocks which are trading above their simple 50 day moving average. I use this to measure the state of the market in general. Things have swung yet again to the extreme which we saw at the October 2007 highs. And yet again in May 2008 before the S&P 500 took another tumble.

Within the time frame of the chart, the only time the market didn’t top out when this technical indicator hit extremes was in October 2006. At that time the S&P 500 continued its slow relentless upward pace until late February 2007. But as it kept climbing, there were less and less constituent stocks powering the index higher.

A much more short term view is that of the percentage of S&P 500 stocks above their 10 day moving average:

Right now this is also at an extreme, having swung from zero in October and November 2008 - which by the way has been amazing buy opportunities in the past according to Lowry Research.

But both of these charts provide only a short term view of the market. The percentage of S&P 500 stocks above their 200 day moving average continues to be very low at 3.20%. As it has been since October 2008. Until this number rises, we shouldn’t expect a real rally to be underway.

From recent option sentiment readings we have reason to believe that after a fantastic “Santa Claus rally” the market is entering thin air territory - at least in the short term. To that we can add an important technical indicator: the McClellan Oscillator.

If you’re unfamiliar with it, it is simply a measure of underlying breadth and is calculated by taking the difference of advancing and declining issues and then using this net breadth to calculate 39 day and 19 day exponential moving averages. The oscillator is then calculated by subtracting the former by the latter.

You can calculate this oscillator for any market and for each it will display different characteristics but usually, +100 is considered overbought and -100 oversold.

Here is the McClellan Oscillator for the NYSE:

I would take this chart with a grain of salt because over the years, a larger and larger portion of the issues traded on the NYSE is attributed to non-common stock securities like bonds, CEFs, municipal bond funds, preferreds, etc. But even so, the McClellan Oscillator is off the charts!

And this is the McClellan Oscillator for the Nasdaq:

It is important to note that this technical indicator compliments the view that option traders provide because they are both short to medium term in nature. It wouldn’t make much sense using a long term indicator, like say, the Coppock Curve to confirm a short term indicator - or vice versa.