Trader’s Narrative

Since the last time I looked at the trend of the market, the S&P 500 has put in a higher bottom at 1235. This is the first thing we need for a change in trend. The next thing we need is a higher high.

Right now, it seems the market is working on that. If it can close decisively above 1280 and put in a higher high as well, the probability of a trend change will be very high. In the mean time the market is simply coiling within a tight range.

The Nasdaq 100 index, however, is much weaker having been unable to put in a higher low. The NDX seems to be still struggling with the 1525 resistance level.

Today Bernanke’s testimony on Capitol Hill stoked a rally as the market interpreted him to be more dovish than previously. Specifically, he said:

We must take account of the possible future effects of previous policy actions — that is, of policy effects still in the pipeline.

This was taken to mean that Bernanke is not in a hurry to push rates to extremes in an effort to control inflation but instead is willing to take a more relaxed approach to allow the effects of previous increases work themselves through the economy.

The market may think this is bullish, but according to James Stack of InvesTech, history shows evidence to the contrary:

…in the past 80 years, there has been over a 71 percent probability that stock prices will be lower six months after the final rate hike.

In any case, the market had a fantastic trending up day. In fact, it was so bullish that again, we saw more than 10 times the volume in stocks closing up than down. I wouldn’t be surprised if it was also one of those fabled Lowry’s 90-90 days too. This sort of market action is very rare because such skewed positive days don’t usually cluster this close together (we had two other ones in the past month). But eventhough they are rare, they are unmistakably bullish.

The volatility, as measure by the VIX index, got crushed again today falling intraday almost 18% ! To be honest, I’m getting tired of this. Uncharacteristically, it has been happening a lot lately. Historically it has been bullish but the reason I don’t really like it right here is because it shows a market that is too ready to abandon its skepticism. And as you know, skepticism, like virginity, should not be abandoned too readily.

We see this same phenomena in the Hulbert Stock Newsletter Sentiment Index (HSNSI). According to Hulbert, at the end of June, when the S&P 500 was at 1270, the HSNSI stood at 12.6%. Then days later on July 12th when the S&P 500 was lower at 1258, the sentiment reading was higher at 31.4%. And the Hulbert NASDAQ Newsletter Sentiment Index went from a -25% at the end of June to 0% on July 12th, eventhough the Nasdaq fell more than 40 points. Tsk, tsk. That’s not what lasting rallies are built on.

Here’s the daily Nasdaq 100 chart :

According to the classic definition: lower lows and lower highs; we are still in a clear downtrend. We’ve just put in our third lower low in fact. And unless the previous high is taken out and a higher high put in, we can’t really claim that the trend has changed. For that to happen, we would have to see the index climb all the way to close above 1600.

Is it possible? Sure. But if the market does go up from here, you can bet that it won’t be powered by the old has beens of yesteryear: Yahoo!, eBay, Microsoft, Dell, etc.

Instead, look for tomorrows leaders to be unknown, mid-caps, in unpopular sectors and possessing the ever important, strong relative strength.

I’ve been doing some thinking about the market, trying to peer into the fog and while tinkering with some charts, came up with this :

The candlesticks are the weekly Nasdaq 100 and the thin line the % of NDX stocks above their 50 daily moving average. Usually, when we have gotten an ‘oversold’ reading on the percentage of stocks above their moving average, we have seen a significant rally. Take a look at July 2004, for example.

But this has not always been the case. In January 2005 things were similarly oversold and after a tepid attempt at recovery, both metrics cascaded down again. It wasn’t until mid April 2005 that the market put in an intermediate bottom and began to rally.

So are we seeing the same situation repeat itself? Will the second bottom be the real one? Of course I don’t pretend to have a definitive answer. All I can offer are some ideas: yes, possibly but the general market - other than tech - is not as weak and can actually fall much further before hitting oversold levels. Also, if we are at a critical junction and seeing the switch from cyclical bull to bear, the things which we counted on before can simply stop working going forward. Oversold readings in bear markets are not at all the same as oversold readings in a bull market. Finally, you have to be wary of a market when an oversold condition doesn’t lead to some kind of rally.

Here is the same chart for the Canadian index: