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rising wedge




Annual Review: May 2009 Highlights

I'm reviewing this past trading year by looking back at each month and highlighting the most significant comments and analysis from this blog. This is the review for the month of May, if you missed the previous ones, here they are: January, February, March, and April.

My goal is to reflect on the accuracy and quality of my thinking as well as to summarize the year that was so that I'm ready for the new challenges that a new year will bring. As a trader, it is vital to go over the past so we can learn from the successes and failures. Hopefully you're doing the same thing and incorporating it into your own routine.

As you'll recall, the rally from the March lows was well under way by now. In fact, the sheer tenacity and intensity of the spring rally had confounded almost everyone.

The question everyone was wondering in May was, is this for real? and how long can it keep going?

So, here are the highlights from the month of May 2009:

  • Coppock Guide About To Give Bullish Signal
    This slow moving long term indicator was finally about to give the all clear signal for a bull market. The Coppock Curve for the Nasdaq had already given a signal in April and if it managed to not fall significantly, we would have a signal for the S&P 500 index. I was monitoring this indicator since January and finally was ready to "welcome our new bull market overlords."
    The Coppock Guide is very accurate but it has given us false signals in the past (most recently in 2002). While I was still apprehensive in May to accept it as a guarantee of a bull market, the signal has worked out extremely well.
  • Brazil’s BOVESPA Shows Impressive Relative Strength
    While everyone's attention was obviously captivated by the unstoppable US market, the emerging markets were even hotter.
    Brazil's relative strength was white hot and after I pointed it out in early May, it just kept going. For the year it is up 85% (so far) and since I mentioned it +37.5% (so far) - individual components like Banco Bradesco (BBD) went up even more (+65%).
  • Comparing Wedge Formations: Then & Now
    Returning to the comparison of the two March bottoms (2003 and 2009), this time I looked at the similarity in the wedge formations. I argued that this pattern was bad news, not just because it was a wedge but also because it was forming just under the 200 day moving average.
    The S&P 500 index didn't collapse but it had difficulty climbing at the same torrid pace as it had. It was two and a half months of range bound trading until the index managed to clear the 950 resistance level.
  • Sentiment Overview: Week Of May 15th, 2009
    By mid month, sentiment gauges like the AAII and the Investors Intelligence survey had almost the same number of bears as bulls. As well, the put call ratio in both the CBOE and the ISE were giving an unmistakable sign of too much optimism.
  • Weight Of Financial Sector Relative To S&P 500 Index
    A great timing tool for sectors is to watch how they wax and wane in popularity by measuring their weight in a wider index. When they balloon, as technology did in 2000 it is a very good sign of a top. In March we saw the opposite as the financial sector shrank to a multi-decade low (as I showed in the accompanying chart): "the March lows were a major low where the sector was as unloved as it has been for the past 20 years". From the very bottom on March 6th 2009 the Philadelphia Banking index (BKX) zoomed up 160%.
  • Is This Bear Market Rally Over?
    Since the bullish percent index for the Nasdaq was approaching levels which usually corresponded with tops, I wondered it the top was in. But the key distinction was whether this was a powerful thrust like the kind we saw in 2003 or just a run of the mill counter rally. My hunch was that the index would push into 'oversold' and stay there. And that's pretty much what happened. Thank you Mr. Coppock!
  • A Walk Through World Stock Markets
    Taking a closer look at the international developed and emerging markets, it became rather obvious that the strength we were seeing in the US equity markets was not isolated. There was clearly a concerted and powerful change in trend throughout the global financial system.
  • Tobin’s Q Ratio Valuation Gives Bullish Market Signal
    Yet another slow moving (glacial in comparison to Coppock's Guide) indicator that was signaling a significant low in equity markets. The Q ratio compares the replacement value of assets in the economy with their current price.
    Although it hadn't fallen to previously historic low levels, at an estimated 0.43 it was very close to multi-decade lows. Since then, we've snapped back of course. Come to think of it, I'll do an update soon.
  • "Bailout Nation" By Barry Ritholtz: Book Review
    You can easily fill a whole bookshelf with books on the financial crisis (without even trying). What sets Ritholtz's book apart is that it is great fun to read both for its ample use of graphs, cartoons and charts as well as his writing style. I enjoyed the book because it touched on almost every single facet of the causes of the crisis (and a few I hadn't thought of). Ritholtz wove them together to explain how so much could go wrong and using history as a template, suggested what we could expect to come next.

Jan - February - March - April - June - July - Aug - Sept - October - November - December

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We've looked at the market through various complex lenses recently: market breadth, momentum, sentiment, etc. but let's return to a simpler analysis and consider just the tape.

Ascending Wedge
Whether we look at the S&P 500 in the short term or medium term, there is a clear rising wedge pattern that is about to complete. The tops (marked by red arrows) correspond to each instance that daily price has deviated from its long term trend by at least 19% (What Happens This Far Above the 200 Day Moving Average?). And the lower trend line joins the lows in July and late October.

The expected conclusion to this pattern is a break down. However, keep in mind that it is possible for it to resolve either by petering out (continuing sideways) or with higher prices.
S&P 500 rising wedge flag formation Dec 2009

We last saw this pattern in the S&P 500 index just a few months ago: Comparing Wedge Formations, Then & Now. The market didn't break down from that wedge formation but actually continued to meander and for the next two and a half months the S&P 500 basically went nowhere.

Flag Pole Consolidation
The other technical pattern we can see in the short term is a flag consolidation (blue lines in the chart). For several weeks now, prices have been treading water at the 1100 level. Since expansion follows contraction in the markets, the longer this contraction in price continues, the more forceful will be the trend out of it.

Usually a flag formed after a strong up move, like the one from the November/December lows, is a sign of further gains to come. But the more dominant ascending wedge pattern suggests lower prices. A break below 1075 would signal the completion of the wedge.

Price Momentum Oscillator
Stepping back and looking at the market in the long term, the proprietary PMO (Price Momentum Oscillator) indicator from Decision Point has recently given a rare positive signal:

S&P 500 long term chart PMO indicator
Source: Decision Point

Since 1987 there have only been a handful of similar signals from this indicator so it is difficult to argue based on the sample size. But whether you decide to listen to the PMO or not, keep in mind that like the Coppock Curve, which gave the all clear back in May 2009, this is a very long term indicator.

That means it does not preclude the possibility of a stumble or significant correction. Although I set out to just look at the tape, I mention this indicator because it offers us a long term perspective and provides a balance to our more pessimistic, current technical outlook.

Speculative Fumes
There is really no doubt when we look at the fundamentals of this market that we are running on fumes. But we have been for so long that it has become irrelevant. Nevertheless, the disparity of returns between 'junk' and high quality equities is simply remarkable.

Ford Equity Research looked at +4000 individual stocks and categorized them into quality quintiles based on their balance sheets, debt levels, earnings history and stability. Those in the lowest quintile, that is the poorest quality, have risen an average of 152% from the March lows while the highest quality stocks have gained only 66%.

When we compare this irrational scenario to past market periods, things look even more disconcerting. Since we do not have detailed 'quality' data going back beyond 1970's Ford simulated that by comparing large caps to small caps - an imperfect but defensible proxy. They found that:

...the 20 percent of stocks with smallest market capitalizations have on average outperformed the largest 20 percent by 72 percentage points — only slightly less than the 85-point disparity between the lowest- and highest-quality issues.

By contrast, in the first nine months of all bull markets since 1926, the average outperformance of the small-cap sector was just 21 percentage points, or less than one-third as much as the disparity over the last nine months...

This is the concept that I explored when I looked at the divergence between large and small capitalization stocks. To conclude, seen this way, the current market conforms to a bear market rally rather than a secular bull market.

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technical analysis of stock trends edwards magee.jpgIn April we played an easy guessing game to point out the strange similarities that the stock market is exhibiting almost to the day, six years apart.

Since then the similarity is even more striking as the S&P 500 index is in a clearly defined wedge formation. That's why I decided to pull out my trusty "Technical Analysis of Stock Trends" by Edwards & Magee - the classical and definitive work on technical analysis - to see what they say about this formation. Here's an excerpt from the pages they dedicate to the topic:

The Wedge is a chart formation in which the price fluctuations are confined within converging straight (or practically straight) lines, but differing from a Triangle in that both boundary lines either slope up or slope down. In a Rising Wedge, both boundary lines converge, the lower must, of course, project at a steeper angle than the upper.

It can develop either as a sort of Topping-Out Pattern on a previously existing uptrend, or start to form right at the Bottom of a preceding downtrend. It normally takes more than three weeks to complete... Prices almost always fluctuate within the Wedge's confines for at least two thirds of hte distance from the base (beginning of convergence) to the apex; in many cases, they rise clear to the apex, and in some, they actually go a short distance beyond, pushing on out at the Top in a last-gasp before collapsing.

As a final note, we might add that the Rising Wedge is a quite characteristic pattern for Bear Market Rallies. It is so typical, in fact, that frequent appearance of Wedges at a time when, after an extensive decline, there is some question as to whether a new Bull Trend in in the making, may be taken as evidence that the Primary Trend is still down.

We can clearly see the definition of a rising wedge formation being realized on the chart. I don't think there is any equivocation (if you disagree, let me know what you think the formation is):

wedge formation March 2009 rally

And it looks very similar to what we saw exactly 6 years ago. With a few exceptions. Not shown on the chart is what happened immediately after May 2003. The S&P 500 continued to go higher, then lurched lower to retest the 920 level. This action broke the lower trend line and made many believe that a text-book wedge formation was playing out. I was one of them, by the way. Of course, it didn't. Just as abruptly, the market again turned up and never looked back.

wedge formation March 2003 rally

To explore why, I want to concentrate not on the similarities between the two scenarios but the differences. For starters, the 2003 wedge formed above a previous low (October 2002). Related to that, the long term moving average (200 day simple) was not only flat and turning up slightly, it was below the pinnacle of the wedge. Finally, 960 was an area of resistance for the index and when it was clear, there was nothing but "blue sky" after a lengthy base.

Right now I'm more focused on those differences and as I pointed out before when we looked at the market through Weinstein's stage analysis, we need to do more back and filling before this bear is really over. I would be very surprised if the market didn't look back from here. Shocked more like it since it would be the second time in 6 years it had fooled me in the same way!

To prevent that, I'm relying on an indicator which I didn't know about back then: the Coppock Curve. Of course, even if the Coppock guide gives us a rare and valid bullish signal by month's end it wouldn't negate this scenario from playing out:

...the market falls once more but not beyond the swing lows it has already marked. This allows for the sideways action or basing which ameliorates the steep slope of the 200 day moving average and eventually sets up for a final push which takes price, along with the 50 day moving average, above the long term average.

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Take a look at these two charts. They are both of the S&P 500 Index (SPX), they both span roughly the exact same time period, from the start of the year to mid April. But only one of them shows the current market. Which one is it?

And what time period is the other one showing?

spx twin charts which is which chart 1

Hey, no cheating!

Take a careful look at both and notice the uncanny similarities. They both top in early January and then trend down until the inflection point in early March. And then there's a more or less orderly march upwards:

spx twin charts which is which chart 2

Have you made up your mind? Give up?

The bottom one is showing the current market. That was the easy one. What about the other?

The first chart is from 2003, showing the bear market in its last throes. Of course, as you know, from then on, the S&P 500 continued to climb higher and higher. Similar to today's market, the technical pattern appeared to be a rising wedge. But this only threw off the bears even more as they waited and waited for the eventual pullback that never really came (well, until after 6 years that is ;) ).

Honestly I have no idea what significance this has, if any, for the market right now but I've never seen this much synchronicity between two exact time periods. What do you think?

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