Trader’s Narrative

You’ve probably already noticed this since the pattern completed in late July and early August. In case you haven’t, the Philadelphia Banking index (BKX) has carved out a fairly decent reverse head and shoulder formation:

Of course, the technical pattern in the above chart mirrors the one visible in other sectors as well as the general S&P 500 index itself. No surprise there since most stocks take their cue from the major index, rising and falling like the tide.

The one fly in the ointment is the left shoulder (see red exclamation mark on chart). Although the left shoulder is fully formed, I’d prefer to see a more symmetrical one to the right shoulder. That would have only been possible if the year end rally would have taken the Banking index a bit higher to reach the neckline. So it isn’t a picture perfect inverse head and shoulder pattern.

Back in June I mentioned that the financial sector was losing relative strength and the baton had been passed to the Semiconductor Index (SOX). Since then the banks have continued to lag the S&P 500 and the tech sector has been the engine of the stock market.

We’ve got considerable resistance ahead at the 50 level (on the BKX). But the measured move target is 74 - which takes us to the next significant support/resistance level. Needless to say, the reverse head and shoulder formation is the quintessential reversal pattern in technical analysis.

The semiconductor index (SOX) is a high beta sector which can be a leading indicator of the health of the market. It found a floor in late November of last year, much earlier than the S&P 500 index. From there it continued to power ahead with consistently better relative strength:

But in August, while the general market powered ahead, the semiconductors started to lag. That by itself wouldn’t be a major negative for the market. After all, there are naturally short periods of time when the SOX gives up leadership. What stood out at that time was that the trend line starting from November’s bottom and stretching for months and months had been broken.

I wasn’t the only one who noticed. Dave, a reader, contacted me then:

I just realized yesterday that my canary-in-the-coal mines, my lead husky SOX is out-of-sync with SMH, XSD, PSI, IGW, & USD, vis-a-vis their June highs.

Again, by itself, that wouldn’t ring any alarm bells. But considering everything else that we’ve covered which paints a picture of a market dangerously overextended, this just adds to the many other reasons to be positioned for a correction.

The spring rally began in early March with the financial sector taking leadership and rising from a death spiral. The Philadelphia Banking Index (BKX) rallied with such a ferocity that in about two months time it had more than doubled.

In fact, by early May 2009, the financial sector had gone up by an astronomical 135%! Meanwhile, the wider market index, the S&P 500, had only managed a 35% increase. On its own, that was very impressive rally but it pales in comparison to the banks.

The banking sector is now 13.35% of the S&P 500 - it reached a low of 8.57% on March 6th (to see more historical data and graphs check out: Historical Weight of Financial Sector.)

But while the S&P 500 went on slightly higher in June, the financial sector as measured by the Philadelphia Banking Index (BKX) started to lag. This was the first time in many months that it didn’t move in lockstep with the general market.

So if the Banking Index (BKX) has given up leadership, which sector is driving the market higher?

Currently the Semiconductors (SOX) is going strong with Information Technology being the largest sector of the S&P 500 at 18.3%. As well, Transportation and Energy sectors continue to have relative strength. The question is, is this a normal sector rotation or does the weakness in the important financial sector mean that the market has lost an important leadership sector and will weaken as a result?

While the general market, tracked by large indices like the S&P 500 (SPX), fell to lower levels than late last year, there are pockets of strength in some sectors. One sector that is showing surprising strength is the seminconductors:

Not only has it put in a higher low, it is close to breaking out in its relative strength chart (compared to the S&P 500) - not to be confused with RSI. As well, the 50 day moving average is flat, with prices well above it. The only downside is that the longer term, 200 day moving average, is still barreling down at a good clip and about to smack it around the 255-260 price level. Also, according to the internal measures of the sector, it is just too extended.

Here’s a closer look at the breadth within the Philadelphia Semiconductor Index (SOX):

Notice the cluster of data points where 90% of stocks in the sector have closed above their 10 day moving average. Not only is this very rare, it is unsustainable. Especially as the general market is similarly over extended and catching its breath. While things look much better here, as prices levitate out of the abyss and extend up and away, it isn’t a good idea from a risk/reward view to start buying here. This is where the smart money starts to unload the positions they built during the darkest hours.

There are a few other sectors in a similar technical position. For example, take a look at the AMEX Broker Dealer Index (XBD). From an optimists perspective, all of this points to a gradual rebuilding of the market - not a new bull market! But when the generals that lead the charge are tired, it is time for a pause. From a pessimists perspective, the bear market rally has exhausted itself and the brutal reality of a continuing bear market is about to reassert itself.

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I was looking at some charts and noticed that the 1982 super bull market bottom was actually a classic “bear trap”:

This is where price breaks down below the support line (green), making a new low (red arrow) but then reverses quickly above the support (now resistance) and then continues higher. That little blip you’re looking at was the last throes of the bear market that tore through portfolios all through the 1970’s and early 1980’s. It was the last chance that investors had to buy shares at those depressed prices because from then on, from a long term view, the market marched relentlessly higher.

Those that shorted into the new break-down, had to (sooner or later) cover at much higher prices, and by doing so, propel prices higher. As well, those on the sideline were seduced by the new bull market to put their money to work on the long side. And a trend was started.

What we see in the short term as a “bull trap” can also be viewed as an engulfing candlestick formation on a weekly or monthly perspective. Opining about the McClellan Oscillator, this is what I wrote towards the end of February:

Another possible scenario is for the market to pierce the November lows, trapping new bears and crushing them as it bounces up. Always remember that the market is no one’s friend, and it doesn’t owe you anything. In fact, more often than not, it is there to distribute the most amount of financial pain, to the most number of participants.

The market never repeats itself, but it can sometimes rhyme. What I described above was pretty prescient (if I do say so myself!). Take a look at the familiar chart of the recent S&P 500 Index (SPX):

Of course, if we draw the support line differently, by having it coincide with the January 2009 low, then we see that the November 2008 low was a failed “trap”. And obviously this pattern could also find a similar end. No one really knows the endurance of this recent rally. As I pointed out, one of the characteristics of this bear market has been a remarkable lack of any real counter rallies.

But in some pockets of the market like the tech sector and the semiconductors especially, there is a speculative mini-mania. As well, some of the other internal market health measures have become stretched as a result of this rally - just at previous resistance levels. This is the real test of the nascent rally then. There is no question that we have seen a considerable degree of the bear market and put it behind us - at least as far as any historical measure can tell us. The real question is how protracted the healing and recovery will be.