Trader’s Narrative

According to the talking heads the US stock market declined because of worries related to the “stress test” and due to the bad news from Bank of America (BAC). While these are valid events, they aren’t the main cause of the market’s weakness because they aren’t really news. Had it not been for these ‘news’ the market would have fallen on some other event or in spite of any significant news at all.

At the start of the month I started pointing out that the market had com too far too fast and we were about to see another cycle high: Stock Market Rally Hitting the Wall. Since then the confirming news from sentiment, technical analysis and market internals have piled on.

Consider that we are now seeing an astronomically high level of market breadth as almost every single security out there has suddenly come to life:

I use the Nasdaq advance decline numbers because the NYSE data is notoriously polluted with non-common stock securities such as ETFs, CEFs, LPs, bonds, etc. The only time in recent history we saw so many stocks participate in a short term rally was in early January 2009. To be fair, there have been times when the stock market continues to go up in spite of breadth becoming over-extended. But these are rare and usually occur at the early stages of a powerful new bull market.

Another measure of breadth, the percentage of the number of securities within the S&P 500 Index that are trading above their 50 day moving average has reached an extreme:

On Friday, it just about reached 90% and with today’s market weakness, backed down. Anything time 80% or more are above their 50 day moving average, stock prices in general either slow down their pace or simply top and fall.

We’ve also seen an very rare occurrence in the same indicator’s short term perspective. The percentage of S&P 500 (SPX) constituents that have closed above their 10 day moving average has clustered above 80% for most of March and April 2009.

Finally, another measure of the market’s internal health, the Nasdaq McClellan Summation Index hit 241 today. This level corresponds to difficult going for any rally in the past. The only exception was during the 2003 (new) bull market when we saw breadth overextend beyond this with no ill effects to stock prices.

Sentiment
As long time readers will know from the weekly sentiment overview, option traders which had been behaving in a rather uncharacteristic way throughout the bear market have now shown their hands quite clearly. They are unmistakeably bullish with a penchant for call options vs. put options (and I’m referring specifically to trades which result in a new long position in either calls or puts).

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Since the market is making fresh new lows, lets see if the market breadth is showing any signs of a potential exhaustion point.

Here is a chart of the daily Nasdaq advance decline numbers, averaged out with a simple 11 day moving average:

The last time I mentioned the Nasdaq advance decline chart was late last year when it was extremely overbought and the S&P 500 trading at around the 900 level.

Here’s another way of looking at pretty much the same data, the Nasdaq McClellan Summation Index:

At first glance, it looks like its just a cleaner version of the first. For the purpose of this exercise, it confirms that while the market breadth got washed out completely late last year, what we are seeing now is not at all similar to previous times.

Compared to the current one, the 1998 global financial contagion looks like a sneeze. But when the market made a double bottom in September and October 1998, both it and the breadth measures lifted off to higher ground. By the time the first dip to -750 (on the Summation Index) happened, the S&P 500 Index was not only off its lows, it was higher than its previous swing high.

Instead, if you look carefully at the current McClellan Summation Index, you’ll notice that since mid-October 2007, this measure of internal market health hasn’t even been able to break the zero line. And going back to 2003, almost each and every subsequent high was lower than the previous one.

This is what makes this current market so damn frustrating to navigate. My hunch is that we are once again nearing a bounce. Whether it sticks as a long term support or not, I have no idea. But I base that expectation on two reasons, the technical data, like the market internal data outlined above as well as the inflation adjusted returns and on sentiment. We are finally seeing some definite signs of exhaustion in sentiment, which I’ll go over in more detail in tomorrow’s sentiment overview.

Believe it or not… welcome to the new bull market. Calculating from the depths of the November spike down (741.02) the S&P 500 has now rallied 20%+. Which means that technically, we are now in a very young bull market. The bear market lasted around 408 days and cut the index by more than half (52%).

Whether it survives to become a powerful bull or dies stillborn as merely an especially strong counter rally, is another question. One that at the moment no one can truly answer. But we’re seeing more and more signs that things look ok:

• historical 10 year returns
• Ford valuation model
• previous bears coming on board: Fleckenstein, Leuthold, Ritholtz, Kass
• etc.

Here’s another: the McClellan Summation Index has now curled up to form a bottom. And from a level last seen in 1998:

We may get confirmation of this nascent bull market in a few months time from other sources like the Coppock curve. But until then, only the brave (or foolhardy) should apply.

The picture shows one of the famous “Osborne” bulls that dot the landscape in Spain. They were originally used as massive billboards to advertise a sherry made in Jerez (a region in Spain) by the name of Veterano. After a law prohibiting the advertising of alcohol the government tried to take them down but there was an outcry from people who had by then come to see them as a cultural icon. A compromise was reached were the red lettering of “Veterano” was covered with black paint.

Interesting factoid: many of the statues have a couch or mattress directly under them as the folklore goes that couples that um… couple, under the sign will receive the fertility of a bull and conceive a child.

On June 25th, I featured the Nasdaq McClellan Summation Index as it stood at -100 and wondered out loud if the coiling and tiny breakdown we were seeing then meant that we would see the same kind of breakdown in the market as last summer.

The verdict is in and yes, that was rather prophetic. Here’s what happened:

Although the index did fall precipitously, it is just shy of previous historical extremes (green box) that marked intermediate bottoms. But remember that the market, like history, rhymes, it never repeats perfectly.

Here’s the NYSE Summation Index:

The NYSE equivalent is in a much more extreme situation. It is pretty much where previous market corrections have run their course.

Both these breadth indicators are telling us what we can easily discern from the indices themselves: that the market has seen a tremendous amount of damage within a short period of time. And is now either at or very close to, an inflection point.