Trader’s Narrative

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 this bear market has unique hallmarks, there is something rather familiar about it. We’ve already covered many of the uncanny similarities between the last cyclical bull market and today’s market action.

For example, they both bottomed in March and the two charts look like they were separated at birth. The there’s the ensuing flag formation which played out in the same familiar way this year, as it had 6 years ago. And finally, there is the extreme breadth thrusts which are showing an intense, broad based rally pushing the stock market higher.

Maybe I’m seeing a pattern where there isn’t one but these similarities are too numerous and too picture perfect to simply dismiss. If you disagree, by all means let me know where I’m going off the right path.

But that’s not all. Let’s add yet another to the pile. Here is a chart of the 50 day moving average of the daily Nasdaq advance decline statistics:

If you look carefully, you can see that the bear market ended, at least according to this breadth metric, in July 2002. We then had a beautiful ABC pattern. This is Elliott Wave parlance for a three part wave pattern where the first part (A) takes us against the prevailing trend, then we have a corrective wave (B) and then a final move to complete the countertrend move. There is much more to Elliott Wave of course than this simple pattern.

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Getting back to the Nasdaq breadth, we see a very similar pattern end the bear market in late 2008 as it did in 2002. First, there was a very strong up move (A) and then a shallow retracement (B) and then a continuation move (C) in the original direction. Not only is the ABC pattern almost identical, it takes place almost during the same time of the year!

A ‘head and shoulder’ formation is one of the most famous technical formations in price charts, probably because it is one of the most common formations. The name comes from the way that the chart formation looks like the sillouette of a person’s upper torso.

The head and shoulder formation consists of a rally (the head) separated by two smaller rallies (the shoulders), preceding and following it. As with all technical formations, the fractal nature allows for it to occur on a variety of time lines, from minute charts to weekly and monthly charts.

The slope of the neckline can also vary, being horizontal, downward or upward sloping. In all cases, the effect is the same. Upon completion, the expectation is for lower prices:

Volume is also an integral part of this pattern. Typically volume is heaviest during the left shoulder, or first tentative rally. Then during the more successful rally that follows (head), volume recedes. And the final, smaller rally has equal or lower volume. As you can see from the chart of the S&P 500, the head and formation that has printed recently follows these volume conventions exactly.

If the Head and Shoulder formation completes, then the target would be 820 for the S&P 500 Index (SPX). I got that by taking 885 as the neckline and 950 as the top of the ‘head’ and then projecting the difference downward. Depending on how you drew the line you may have gotten a slightly different number but I’m sure it would cluster around the same level.

Although instantly recognizable to the trained human eye, this chart formation is extremely challenging to quantify. But there have been more than a few who have taken a crack at it. Over the years I’ve read a handful of research reports that show the results are surprisingly positive. Even those who are skeptical of the efficacy of technical analysis in general, have accepted that a head and shoulder formation is very reliable.

Interestingly, this technical pattern is printing not only in the important Standard & Poors 500 but in the Russell 2000 (small caps) and the Dow Jones Industrial. But not in the Nasdaq Composite as the tech sector’s high relative strength has powered this index to higher highs. On the other hand, you could argue for a double top pattern in the Nasdaq which is equally bearish.

The important thing right now is to watch for the completion of the head and shoulders pattern. If it breaks the neckline, then the projection stands. However, such a formation is not guaranteed to complete. If we have a head and shoulder failure - that is prices break the neckline but do not go lower, then usually what follows is an explosive rally as many people who expected lower prices are caught on the wrong side and have to cut their losses.

A recent mention of cumulative TICK on Trader Feed blog caught my attention and I looked at this indicator today. Now I know, Dr. Steenbarger’s chart of cumulative TICK is using the NYSE TICK data and it is very short term in contrast to my analysis.

But he does briefly mention that “…the Cumulative NYSE TICK has stayed well above May levels.” And then goes on to extrapolate:

Continued strength in Cumulative TICK would suggest to me that we’re experiencing a correction in a bull market, not the start of a renewed bear.

I’m not so sure we can draw that conclusion. For reasons that I’ve outlined many times before, I prefer to use the internal breadth data from the Nasdaq. So here is a look at a few years worth of cumulative TICK for the Nasdaq:

If a higher high is a sign of a correction within a bull market, then by that account according to cumulative Nasdaq TICK we’ve never even entered a bear market!

Now I know this is the Nasdaq data but the NYSE chart doesn’t look all that different. Which reminds me of the uselessness of cumulative breadth numbers (advance decline) as any type of indicator - NYSE Breadth Is Strong: Why It Doesn’t Matter.

Instead of looking at TICK data cumulatively, I prefer to smooth it using a simple short term moving average:

Although it has come down from the extreme in April 2009, it isn’t anywhere close to the range that has historically coincided with market lows (or lasting market bottoms).

A very old indicator that measures the magnitude of speculation on Wall St. is the volume ratio between the NYSE and the OTC market. This ratio hearkens from the early days when Nasdaq was the over the counter market where smaller and riskier securities traded.

This was before the time of Microsoft (MSFT) and Intel (INTC) - bellwethers of both the stock market and the US economy. Today it would be more apt to substitute the Pink Sheets OTC BB market instead.

Even so, for some reason the volume ratio still holds and has flagged important market tops. Including the start of the bear market in October 2007.

There is no absolute level however in this ratio that can give us oversold and overbought readings. As with all analysis of volume, we have to contend with not only a seasonal pattern, but also a continuous increase of trading over time. Since we are looking at a ratio, most of the upward creep in volume should be canceled out.

Right now, the volume ratio is extremely high and points to a lot of froth in the market. We’ve seen other signs of this in the sentiment data as well.

To play devil’s advocate, the ratio could be higher because of the Nasdaq’s leadership (it has rallied much more than the NYSE since March 2009).