Trader’s Narrative

While the market has been acting tired this month and the tape looks like it want to head lower, we have some signs that, at least in the very short term, the equity markets are oversold.

For example, take a look at the percentage of stocks above their 10 day moving average. Earlier this week this fell to just 11% which is just a hair’s width shy of the ‘magical’ 10% level:

The medium term breadth measure, percentage of S&P 500 stocks above their 50 day moving average, is not showing any indication of being oversold. As of yesterday about 60% of the 500 component stocks closed above their 50 day moving average.

Since mid April this percentage has been hovering around 90% - signaling an extremely overbought market. But the indexes have been able to move higher in spite of this.

This provides for a potential tell for the health of the market. If we are able to put in a strong bounce (in the short term) here in response to the oversold condition, then there is a higher chance that the market can continue to snake its way higher as it has since March 2009. But if we fall hard in spite of it, then we are looking at a weak market that may retest the previous swing lows.

The Dow Jones Transportation sector is acting really wonky. At first glance, it might seem to be getting tarred with the same brush as the general market. The wonky part is that it has completely decoupled from the crude oil market.

For example, on October 29th, 2008, West Texas crude oil futures went into free fall, closing the day almost down 10%. On the same day, the Dow Jones Transports went down 5.2%. Huh?

Other than the plausible explanation that people are selling everything, is that the market is starting to discount an economic slowdown which will damage the transport sector more than a decrease in fuel costs.

But in any case, the transport sector has goetten clobbered out of proportion. Take a look at the bullish percent index for the sector to see what I mean:

The index closed last week at 5% - meaning that only 5% of the components of the Dow Jones Transportation index are trading with a point and figure buy signal. Five percent.

To find a time when the number was this low we’d have to go back to the beginning of the year and then the summer of 2002. The advantage is that such an extreme oversold is occurring right at support (~4100 on the Transports index) where it has found support two other times - summer of 2006 and early 2008.

I don’t know if the market is signaling an economic shift with the way this sector is melting down, but I am willing to wager that it won’t be straight down. We’re about to see a bounce or snap back rally.

On returning from hiatus last week, I promised to give you the broad strokes of the market: then and now. There are a lot of different technical measures I could point to but in trying to keep things simple and provide a context, I found myself returning to one of my favourite market internal measures: the percentage of stocks above their moving average.

The first chart shows the portion of stocks within the S&P 500 Index (SPX) that traded above their respective 50 day moving average. This internal market statistic has gyrated from extremes several times within the past two years. On several occasions it has hit extreme lows, which not by chance, coincide with intermediate swing lows in the market.

But while the market hit extreme oversold areas, the rally that followed was the important litmus test. And if we look closely, we see that each successive oversold level was followed by a weaker and weaker rally. The bears appear to be grinding the bulls down.

Take the first instance in early March of 2007. Only 25% of S&P 500 stocks were above their 50 day moving average when the market stopped going down. The resulting rally took that number to 85% by the end of the next month.

Over at the price chart, by the end of April, the S&P 500 had recovered all the ground it had lost. Then it continued to rally, gaining an equal amount on top of the recovery. This is normal for a healthy bull market:

Now compare this to the next time the market became oversold in late July and mid-August 2007. The percentage of stocks trading above their 50 day moving average temporarily spiked below 10%. A rare feat. And as it usually has historically, this caused a rally.

But the bulls were able to recover the lost ground and a smattering more - before being pushed back in October (green arrow above). This time, the rally didn’t continue.

You can go through the next 3 examples yourself and see how prices recovered less and less with each instance of extreme oversold readings.

Notice especially how in January 2008, although there were again less than 10% of stocks above their medium term moving average, the ensuing rally was so weak that it didn’t even go above the previous swing low. And so, the market had a lower low and a lower high (red dashed line).

Extreme oversold conditions are a great opportunity for the bulls to fight back. The “value” buyer steps in and creates a floor. The momentum trader then steps in and creates a virtuous buying cycle for others.

An oversold extreme is not automatically reason enough to buy. This depends on the tone of the market. Which is only truly revealed when you observe how the market behaves after it gets oversold.

So here we are, heading into the weakest month of the year, with lukewarm sentiment and a market that seems to be looking for any excuse to meander lower.

Wednesday’s market performance took us down to a seldom seen place: only 10% of S&P 500 Index components closed above their 10 day moving average.

Chart from indexindicators.com

That is oversold but according to Lowry’s research, when the market reaches below 10% for this indicator, we have a setup for a powerful snap back rally that most of the time transforms into a full blown bull market rally.

The good news is that the S&P 500 Index (SPX) is approximately 60 points above its March levels here while it has pushed the percentage of stocks above their short term average to these low numbers. The bad news is that technically, we didn’t go below 10% but actually reached 10.2% and recovered.

Remember the Top?
Today is the 8th year anniversary of the tech bubble. Yaaa…aay! Don’t feel like celebrating? I don’t blame you.

Believe it or not it has been eight years since Nasdaq temporarily peeked over 5000. Back then I had a friend who almost threw a “Nasdaq 5000 Party”. How’s that for a contrarian indicator?

Here we are after eight years sitting more than 50% below the high. Alright, put away the party hats.

10/10 Breadth
I’ve been watching the percentage of stocks above their 10 day moving average to see if it can breach 10%. Although this is a short term indicator, it has had a great track record of finding major inflection points. You can read about Lowry’s in depth research on this indicator here.

The above chart is as of Friday’s close. With today’s horrible market action, I wouldn’t be surprised if the percentage goes below 5%. For the NYSE, the number was 9.12% at last week’s close and most likely lower after today.

UPDATE:
On Monday there were only 3% of S&P 500 components closing above their short term moving average (10 day). The last time we had this many stocks oversold was in the beginning of March 2007. If you pull up a chart of that time, you can see it was a significant low.

This should be good news for the bulls but after a deluge of extreme oversold readings that didn’t amount to anything, it is tough to get excited about one more.

V or W or…?
We are now approaching the lows of the mid January spike. The very same that gave us a short respite. In a manner of speaking, the bulls are being pushed inch by inch closer to the edge of the precipice. What I’d like to see is sheer panic… desperate, uncontrollable, illogical despair. Unless I’m not looking at the right spot, I don’t see that.

Some thought we would have a “V” bottom. Some watched for a “W” or double bottom formation. While some still are convinced that we are going lower, much lower.

Bear Market
One of the characteristics of a bear market is that oversold readings that would normally ignite a ferocious rally simply don’t. They putter about or cascade into even more extreme oversold readings. I’ve been, admittedly, tenacious in holding on to the bull thesis - not as some might suggest, because I’m a “permabull”, but because until proven otherwise, you go with what has worked.

And until now, buying extreme oversold levels has worked. Over and over and over again. So at some point it stops working. If (big IF) you’re using discipline in your investing or trading, you come out with a few scratches and nicks. What I refuse to do is to flip a coin or go with my “gut”. That is just dumb. On any day, I’d rather have my indicators, technical analysis, contrarian sentiment, etc.

So although I continue to find multiple indicators which are pointing to oversold, I wonder if they really mean much. After all, price trumps all and as price continues to slide lower, it is not being accompanied by a proportional increase in bearish sentiment nor of extreme indicators.

I’ll do a quick recap of the indicators and you can judge for yourself.