Trader’s Narrative

At the risk of wearing out the welcome of this technical indicator…

Towards the end of June, something quite rare happened. Something that hadn’t happened in the stock market for more than 5 years!

… zero Dow Jones Industrial component stocks traded above their 50 day moving average.

The last time we saw this was in January and February 2003. Sure, there were many times that the percentage of Dow components trading above their intermediate moving average approached very low levels. And each of those times usually corresponded with an important inflection point in the index.

But zero? That makes you stand up and take notice.

Looking at this very long term chart, one can’t help but automatically assume that the percentage of Dow Jones components trading above their 50 day moving average and the end of the bear market coincided with each other perfectly.

However, zooming into the chart we see that things are not that simple:

In fact, once the percentage of Dow Jones stocks above their 50 day moving average reached zero, the Dow Jones index continued to fall. In fact, if you close your eyes and imagine, it must have been terribly frightening to have such a reliable indicator hit the most extreme levels and to have no foreseeable effect on prices!

Equities fell, almost non-stop for what must have seemed like an eternity but was only another month. The definitive bottom was reached in mid March 2003 but by then, as you can see on the chart above, the percentage of Dow Jones components trading above their 50 day moving average had already recovered.

Now, let’s fast forward to today’s market and zoom into the charts:

On June 20th 2008, there were zero Dow Jones components trading above their 50 day moving average. But the market continued to fall, just as it had after the same signal in 2003.

Of course, the only difference is that with the 2003 charts, we have the advantage of hindsight and know exactly when to call the definitive market bottom. With the more current charts, we are handicapped by the ‘hard right edge’.

Only time will settle the question of whether we have already seen the definitive market bottom already but it is rather uncanny to see such similarities, wouldn’t you say?

So after warning you that we were headed into some shaky grounds on Monday morning (premarket) when the S&P 500 stood above 1540. And after the market fell to around 1510, saying that we had still some more room to the downside… Let’s see if I can continue this streak.

Lowry’s 90/90
No question today’s market action was severe. No doubt it was a Lowry’s “90/90″ day - where 90% of the points and 90% of the volume are on the downside. From the 3417 issues on the NYSE, 3144 of them closed down. That’s 92% to be exact. Meanwhile, volume on the NYSE was 95% to the downside.

Can you say e-x-t-r-e-m-e?

This is the sort of panicked, thorough selling that market inflection points are made of.

New Highs New Lows
This week I mentioned a few indicators that I was watching. The Nasdaq’s New Highs/New Lows indicator told me that we had more room to fall as it was still above 10. Today’s devastating decline took this indicator to just below, at 9.39. At these levels we can start to seriously look for a bottom.

Today, the New High/New Low Ratio also fell to extreme oversold levels. According to these two indicators, the number of 52-week lows (compared to highs) presents a compelling argument to go long.

Leaving aside market internals, a simple glance at the chart of the S&P 500 gives us a hint that the market may find its footing here. The February 2007 top which previously acted as resistance but can now become support:

Usually I leave volume off my charts but check out the volume today! Notice how in previous market inflection points, the surge in volume coupled with a wide range dark candle tends to signal a change in trend?

Most common indicators swung to extremes: The volatility index (VIX) spiked above 23 and met my request to go a tad higher. And the put/call ratio also spiked to a bullish extreme.

But the indicator of market health that I give a lot of weight to still hasn’t reached the kind of wash-out extreme that I’d like to see:

I’d prefer to see a real washout that would be a reading of 20-something. Similar charts for other percentage of stocks above 50 day moving average for indices like the Nasdaq 100 are also low but not low enough yet.

We could still bounce from here, especially as a gap up open tomorrow morning. That’s why right after 3pm I bought a bit of Ultra S%P 500 Proshares (SSO). The last hour of trading is known as “contra-hour” for good reason

What I’m most interested in seeing is how sentiment reacts to this recent decline in the markets. If we have real fear (increase in bearish sentiment), then we are probably all clear for another leg up in the bull market. But if people are complacent and do not flinch, things could get ugly.