Trader’s Narrative

This is a guest post by Wayne Whaley (CTA):

I’m not sure whether this market reminds me more of my grandfather’s beagle puppies or the current Secretary of State’s husband, but either way he (the market) doesn’t seem to be inclined to hang around the house for long. It looked like this market might show signs of mean reversion in the second half of October, but then yesterday, it caught wind of the third quarter GDP report and wondered off again, allowing the S&P 500 to post it’s 8th straight up month since the bottom was established in March 2009.

So what’s ahead? A couple of considerations from a seasonal vantage point:

First, since 1950, the average annual return on the S&P 500 index is 8.05%. Over half of that annual return (4.25%) has arrived in the three months November to January.

Second, some respected market technicians have argued that since we didn’t get our usual autumnal sell off, that it may come later in the year. I do agree that the market tends to try to confuse as many of us as possible, but it is very possible the 5% sell off in late October was all we needed to rattle a few cages and I am still inclined to believe that the market’s ability to prevail against traditional seasonal headwinds is a sign of forward strength.

Last month, I posted an article “When September Flexes Its Muscle“, that showed that if the market can manage to post a gain in the seasonally weak September month, the market was has a very high probability of finishing the last quarter positive with an average gain of 4.84%.

Below is a table, with an update of those results for the final two months of the quarter, when both September and October are positive.

Since 1950, the November & December time frame, following up September & October , was 13-2, with a median +6.69% return. If you can allow yourself to consider 1968 to be an unchanged data point (-0.18%), then 2007 was the only noticeable loser in the 15 data points. Under the theory, when the market goes against the seasonal trend - go with the market, the 2007 data point provided strong clues as to what was to come in 2008.

There is a meaningful pullback coming. And staying long for the well known, traditionally strong, year end rally almost seems too logical. But I think that given it has been eight in a row with the holidays to go (rhyme intended), we are well advised to stay with the trend at least through January of 2010 or until the tape shares some information with us to the contrary.

Those of you who follow my commentary know that I am also influenced by the three strong breadth thrust “The Mother of All Momentum Thrust Years” we had this year, the last coming in September. However, if the year end rally doesn’t materialize (ala 2007), one would be well advised to take some defensive measures.

Good luck to us all.

No, really. How high can this market keep going?

That’s the question a lot of people are asking. It isn’t surprising that once the S&P 500’s perfect head and shoulder pattern failed, prices rocketed higher - almost non-stop. We’ve had 12 consecutive trading days closing higher. That kind of streak is not only extremely rare, it is an unmistakable sign of surging momentum.

Now, many are pointing to a head and shoulder bottoming formation (on a larger time frame) and expecting prices to keep rising. Actually, I commented at the beginning of June 2009 that we may see a flag formation and then a break to the upside: Comparing Flag Formations: Then & Now.

Amazingly enough, we seem to be replaying the same price action that we had when we came out of the last bear market. The similarities are uncanny as I’ve mentioned more than once. So what’s next?

Below is a short video that briefly summarizes what the market has done and then finishes by looking ahead to what we may see next week and next month.

Click to watch video:

With the benefit of hindsight, lets take a look at my bullish calls in March 2009. I’m sure that persevering readers will remember a few of them. For example, the suggestion that we were about to witness a ‘bear trap’ - similar to what we launched the super-bull market from August 1982.

I also showed a chart of the rolling 10 year returns for the Standard & Poor’s 500 index. So at any point, that chart shows what you would have gained over 10 years (ex-dividend) had you invested at that time.

For me the most interesting, from a technical analysis point of view, was a deceptively simple indicator: how far prices are from their simple 200 day moving average. In Another Reason We’ve Seen the Market Low I suggested that prices deviate from their long term trend, sometimes extremely but that eventually, they revert back and the cycle begins again. Here is the updated chart:

On March 9th 2009, the S&P 500 was stretched to the downside to an extreme degree that we had not seen in a long, long time. Although we can look at the difference between prices and the long term average as points, this isn’t helpful over time. So instead we normalize and express it as a percentage. So in early March, prices were below their long term trend by more than 36%!!

We’ve since recovered and are trading almost 12% above the 200 day moving average. Of course, the spring rally had already begun by the time I wrote about this market dynamic on March 31st 2009. To be exact, by that time, the S&P 500 index had already rallied 18%. But even then it wasn’t too late to jump aboard.

Looking ahead 60 days from the extreme posted in March 9th of -36.53% distance from the 200 day moving average, the Standard & Poor’s 500 index rallied a total of 39.65%. So the record since 1960 is:

• 7.95%
• 10.03%
• 12.93%
• 10.72%
• 6.14%
• 9.54%
• 8.3%
• 20.9%
• 39.65%

For an average 60 day return of 14%. The latest recovery is by far the largest in our time period lookup. No doubt due to the fact that we had two dates close together when prices were pushed lower in a panic: November 20th 2008 (-39.79%) and March 9th 2009 (-36.53%). The other precedent of this was in 2002 just as that bear market was breathing its last: July 23rd 2002 (-26.98%) and October 7th, 2002 (-23.84%).

Often it seems our analysis of the markets are like children looking at ants through a magnifying glass. So once in a while it is always useful to take a step back and get a long term perspective. The chart below shows the inflation adjusted Dow Jones Industrial Average since 1925.

There are a lot of lessons to glean:

• While the corrections in 1929 and 1964 were of equal magnitude, the latter took much longer to play out.
• The 1960’s top (previous resistance) acted as support and repelled prices to initiate the spring rally in March 2009.
• The Dow trades at less than twice where it closed at the 1929 top.
• After more than 40 years the Dow is only trading a trifle 30% above its 1964 peak (inflation adjusted).
• Finally, the Dow managed to rise 31% since the spring rally in March 2009 - that is amazingly a pinch more than the gain from the top in the 1960’s.
• The Dow has traded in a very wide and rising trading range - so if you are really really pessimistic, you could say we are headed to 4000 (eventually)

Source: Chart of the Day

To get a full picture, compare this to the (very long term) inflation adjusted chart of the S&P 500 index.

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?