Trader’s Narrative

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.

Breadth is an important element of technical analysis that usually gets ignored for pure price action. But every once in a while, it is helpful to pop the hood and take a look at what is driving the price action in the indexes.

A simple way to measure breadth is to look at new 52 week highs relative to new 52 week lows. A healthy bull market will have a persistent bias towards new highs as most shares on exchanges trades to make new highs.

The indicator below is the New Highs New Lows Index for the Nasdaq. And it is based on a basic formula: new 52 week highs divided by the sum of the new highs and the new lows. It varies from zero to 100. When it is zero, it means that we have absolutely no new 52 week highs (with every single stock trading at a new 52 week low). This is a very rare and exceptionally oversold market. The reverse would be 100 with all shares at 52 week new highs.

Naturally, it is a very good timing indicator which I’ve used before to find inflection points in the market: Can the New High New Low Indicator do it again?

Since it can be rather volatile, I’ve used a 10 day simple moving average to smooth it out and provide a more meaningful chart:

We’ve moved very quickly from the extreme lows in March (where the 10 day moving average was 0.48%!) to 88% in recent trading.

Historically, when the 3000 or so constituents of the Nasdaq Composite start trading at 90% new highs, the market has a tough time moving up. We either enter into a range to work out the overbought or fell lower. Often times significantly lower.

The only exception to this in recent history was the powerful new bull market in 2003. New 52 week highs, relative to 52 week lows, as measured by this indicator continued to levitate at the extreme edge, reaching almost 100% for about 12 months as the stock market powered ahead.

The other interesting portion of the chart is the divergence shown in 2000 as the market was topping. Even as priced reached for the heavens, there was a complete collapse in the number of stocks reaching 52 week highs. You can see a similar divergence happened in mid 2007 as the S&P 500 once again climbed over 1500.

So the question continues to be: is this another bear market rally or like early 2003, the start of something much more?

The only way to know is to watch for price action in the face of overbought indicators like this one. If the S&P 500 continues to trade higher, shrugging off this and other indicators pointing to an overbought condition, then it is clear that what we are seeing is not just a regular bear market rally.

Once again, the indices are toying with the November 2008 lows and have everyone on tenterhooks about the resolution of this support line: will it hold again? will be broken and cause a cascade down? will it break only to trap the bears?

Yesterday I presented my reasoning why the support wouldn’t hold. Today let’s play devil’s advocate and see why the bulls may just hang on by their fingernails for dear life.

As a reader (Russ) pointed out in the comments section, the very fact that there are now a larger percentage of S&P 500 stocks trading above their 50 day moving may be a positive sign, showing that the components that make up the index are stronger than might seem.

That would imply that the single number that represents the S&P 500 index is hiding the fact that smaller capitalization stocks are doing better than the larger capitalization stocks. Both the mid-cap and small-cap indices are trading well above their November 2008 lows.

As well, take a look at the recent chart showing the number of stocks trading at new lows:

The green arrow points to the spike in new lows that corresponded to the November 2008 low. You’ll also notice that in October 2008 there was a higher number of new lows - that was in early October when the S&P 500 spiked down to 839.80 only to recover and close almost unchanged for the day.

This chart is showing that while the ’stock market’ is once again near its lows, the market of stocks is still holding up surprisingly well.

We can see something similar during the last throes of the last bear market in late 2002:

Once again, the green arrow points to the spike in the number of new lows, corresponding to the low in the S&P 500 index in early October 2002. In July 2008 we saw slightly higher new lows but the market also closed slightly higher. But then, in March 2003, the number of new lows was dramatically lower as the S&P 500 index dove to retest those same lows:

Sentiment Shift
So keeping an open mind, this may very well mean the bulls get a break (finally). At the same time, technical analysis is one layer. The other that I rely on heavily is sentiment. And although in the past few weeks contrarians have little to cheer about, the most recent data from the AAII weekly survey shows a drastic change in the outlook of retail investors.

Whether it is the nerve wracking dance on the edge of the rain slick precipice or the relentless bad news that pounds us all through the mainstream media, the AAII bullishness collapsed from 33% to just 22%. Needless to say this is exactly the sort of extreme sentiment that I’ve been waiting for.

What an inauspicious anniversary. It is a year since the Dow closed at its all time high - it is now trading down about 35% from that level. While I don’t think we are going to go straight up if things do stabilize, there is enough shrill panic out there to make me think that we should be close to a floor. If we aren’t, then all bets are off and I suggest we all flee to the hills. This isn’t based on mere “gut feeling” but on metrics and indicators that have been faithful guides historically.

So here are some observations:

Global Meltdown
There is enough pain for every single market out there. Forget banning short selling, Iceland outright suspended trading altogether. Indonesia halted trading after a 10% plunge. Russia has seen an utter collapse of their market. Same thing with China’s equity bubble. England has taken equity stakes in financial institutions while other European countries struggle to find a solution. There is a blanket of fear and panic covering the world to a degree that we haven’t seen in a very long time.

Credit Squeeze Easing
The first hints that we could finally be seeing a loosening up of the tight credit markets are here. The spread between the rate for the 2 year interest rate swaps and Treasury yields seems to have formed a double top at 167 on September 29th and October 2nd 2008. At its top, the spread was the widest since data has been collected (going back to 1988). This is a signal of easing for the LIBOR rate but the bad news is that LIBOR and TED spread haven’t responded by falling yet. But this may be the first inkling that they are about to.

Sheer Disgust & Panic
Finally, we can say that there is extremely negative sentiment out there. Both from everyday investors and traders, to newsletter editors. The option metrics are still not “cooperating” by showing extreme put buying. Which is something that I’ve mentioned before. It is still very puzzling to me. But the other traditional measures of sentiment show that the vast majority have thrown in the towel and believe that we will see further declines. From a contrarian point of view, this is a good thing. I’ll go into more detail in tomorrow’s sentiment overview.

How Bad Is It?
Things are so bad that, of the 500 stocks in the S&P 500 Index, only 6 closed trading yesterday above their 50 day moving average. And only 4.2% are trading above their long term, 200 day moving average. For the Dow, all 30 stocks are trading below both of the moving averages.
Continue reading ‘If We Aren’t Near A Bottom, Find A Cave & Buy Guns’

Let’s see if the new high-new low indicator can do it again.

About a month ago (November 21st to be exact) I noticed that the new high-new low indicator was flagging an inflection point in the market.

As a quick refresher, the new highs-new lows indicator is calculated by taking the new highs in an index or market and dividing by the sum of the new highs and the new lows.

Anyway, here’s what I wrote then:

On November 21st the S&P 500 index closed at 1416.77 (green arrow) — within two days, the market action took the index down to 1407.22 (on November 26th). And that was it.

From there on it started to climb. Except for a slight pause, it went all the way to 1520.

Not a bad call at all, if I do say so myself

So let’s see what the same indicator is saying now:

Yesterday’s close took the indicator for both Nasdaq and the NYSE down to less than 5%. Those are abysmally low numbers which means we are very oversold and close to an inflection point.