Trader’s Narrative

Last week I presented a historical study of what happens when the S&P 500 is this far away from its 200 day moving average. If you missed it, click the link to check it out in full.

According to the study, when the stock market has trended enough to set off this indicator, it has trouble continuing its heady ways in the months that follow. The average 6 month return is -5%.

If you look at the data carefully, it becomes apparent that certain date ranges contain a lot of repeated instances where the S&P 500 index is 20% or more above its long term moving average. We’ve just traversed one of these periods from September 16th to the 22nd. Between those dates there were 5 consecutive days were the S&P 500 was at this threshold (or very very close).

The last time this occurred was at the end of July 1997. But the best example was of tenacity in this indicator was in late 1982, just as the great generational super bull market was launched. Although the expected consequence of such an overbought condition is for the market to hit a wall, or at least to pause, during the start of the great bull market, this was not the case. While it continuously flashed red, the stock market continued to climb higher and higher, acting very out of character.

So the question is whether what we are seeing is a repeat of that atypical market action. In other words, do bull market rules apply?

Although there is no way for me or anyone else to prove it definitively one way or another, I highly doubt that what we are witnessing is the dawn of another rare secular bull market based on one variable: valuation.

I mentioned a lot of ratios, statistics and data before but putting all those numbers aside, here is a simple chart which sums up the strange voyage we have taken, from fully priced perfection to panic induced forced liquidation and back again:

That doesn’t look like a great launch pad for the next generational bull market. Heck, even bonds are priced for perfection. At best, we are going through a cyclical bull market - otherwise known as a bear market rally.

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.

With the news of massive infrastructure works and the rescue of Detroit by the US government, the stock market continues to rally. Today’s rally put the S&P 500 index just barely above the previous swing high. We now have a higher low and it looks like the market is working on putting in a higher high to cement a change in trend.

But when I looked at the moving average of the daily advance decline numbers, I was shocked to see just how overbought the market is. Take a look at the data for the NASDAQ:

By the way, there is nothing magical about the number 11, I just chose it because it is short term enough to remove the lag inherent in any moving average. Here is the NYSE data for the same market internals, which show that we are now at levels last seen back in the summer of 2003 and 2004:

While this does mean that we are extremely overbought at the moment, it doesn’t automatically follow that this is bad news for the bulls. While I was entertaining these thoughts, Jason Goepfert wrote at SentimenTrader.com that:

There have been 13 times when the 10-day average of the ratio has been 63% or greater, and today’s reading was 79% or higher. A month later, the S&P 500 was positive all 13 times, averaging +4.8%. Three months later, it was still 13-for-13, but the average return climbed to +8.6%.

Lowry Research continues to be skeptical that we have seen the bottom. But more and more “experts” pile on. Just recently, Fleckenstein announced that he would be shutting down his short hedge fund and begin working on a long only fund.

The one caveat that Lowry dangled in their analysis is that the market needs to show follow through. In previous rallies it just couldn’t put together a decent push higher. But with sentiment becoming more pessimistic as the indices continue to climb, we may just have the right sort of environment for that.

I don’t know how some get the impression that I’m a perma-bull. I’m human, so by nature I’m biased. However, what I try to do always is to allow the tools and indicators to speak for themselves.

For example, on Wednesday (February 27th, 2008) I wrote a cautionary note that based on overbought breadth of both the Dow Jones Industrial and the S&P 500, the mini-rally wouldn’t keep up the pace.

My hunch was that we’d schlep around until it worked off and then head higher. But in any case, overbought is overbought. When you have both the indices showing 80% of their components trading above their 10 day moving average, you have to rein in the longs and bunker down.

Dive, Dive, Dive!
But instead of meandering, the market worked off its overbought breadth by nosediving. For those keeping count, the last time the S&P 500 was down hereabouts was in early February but the breadth numbers were washed out. We had only 20% of stocks in the S&P 500 trading above their 50 day moving average. Now we have 31%. We had a measly 17.5% above their 200 moving average. Now we have 21%.

My point is that the market has rolled over (again) without first getting really overbought in anything over than the shortest time frame possible - the aforementioned 10 day moving average. I don’t like that.

CBOE Put Call Ratio
Something else which bugs me is that on Thursday when the market fell a fraction of today’s move, the CBOE equity only put call ratio spiked to 1.0 (or for the obsessive compulsives: 0.966).

But today, when red filled trading stations the CBOE ended up falling! It closed at 0.836 if you can believe it. So according to this gauge, the option traders aren’t afraid - even in the face of a 2.5%+ decline

This is odd, and disconcerting. Yet, it is part and parcel of the mystery that is the market. These counter intuitive days when the put call ratio walks with the index are rare but they do occur. Sometimes they paint a bullish picture and other times not.

ISE Options Data
The ISEE index shows a more congruent picture with a dramatic decline in the number of calls relative to puts. Friday saw the ISEE index fall to 75 from 97.

That’s about as low as it got in mid February 2008 when the S&P 500 was trading slightly above Friday’s close. In contrast to the CBOE put call ratio, the ISE Index is saying that option sentiment is anything but apathetic.

Market Internals
How did we go from expecting a 90-90 up day to put a nice bow on the rally to getting a 90-90 down day? That’s what I’d like to know.

Maybe it was the short term overbought that I mentioned on Wednesday or maybe something else. In any case, we’ve been jarred from the slow and steady recovery from the January spike low with horrible market breadth.

Depending on which market data provider you use, we got anywhere between 2340 to 2400 declining issues on the Nasdaq and 2700+ on the NYSE. This has only been exceeded during this year on January 17th, when the market made its swing low.

Taking a quick glance at the graph of declining issues, I noticed that usually a low was carved out two to three trading sessions after such a spike high. Curious that it didn’t match such a wash out decline in breadth:

Hurts So Good
To leave on a positive note, the same short term indicator that that flashed a caution on Wednesday is now saying the opposite.

Of the 500 components of the Standards & Poor’s Index, only 13% are now above their 10 day moving average. This is low “enough” but if it happens to fall to less than 10%, without causing a concomitant fall in the indices, then the bulls are in for real a treat.

That’s because whenever we’ve had a similar deep oversold condition, even on such a short term time horizon, the market has rebounded strongly - see Lowry’s research.