Trader’s Narrative

Depending on the framework you use to understand the market, at times it is possible for the market to be “confused” or even “wrong”. Of course, according to some, the market is the perfect amalgam of all relevant information so that isn’t possible.

But then again, any student of the financial markets can easily call up many examples where the market exhibited what can perhaps be best described as collective temporary insanity.

As I look across this market, checking the advance decline breadth, the highs and lows, the VIX, put call ratios, and all the other technical indicators, I can’t shake the feeling that it is a bit confused. Or perhaps, it just can’t make up its mind and is trying to hedge its bets as best as possible.

Just look at the past few trading days! Up, down, up, down, up, down… ending up at pretty much the same place we started.

I’ve been accused of having a penchant for the bullish side so I’m trying to be more than careful in scrutinizing the weight of the evidence, on both sides. And for the most part, there is really no compelling reason to be in either camp right now.

Maybe (gasp) the retail investors are right and cash is the best spot right now.

The market certainly feels heavy, but while intuitively I think it wants to go down, I don’t see any strong reasons to push it down with my own measly contributions.

Here is a snapshot of the sort of thing I mean. This chart shows the percentage of S&P 500 stocks trading above their 10 day moving average. Notice how in mid July, as the market was pulled sharply lower, this very reliable indicator (check out the research report from Lowry’s), did not perform its usual magic:

Is it too much of an obvious to say that this market is being driven by the financials? They were responsible for the mid July spike down in the behemoth S&P 500 Index. Pull up a chart of the 90 day Treasury Bill and you can see the epicenter of the quake that shook the markets.

I’ll go more in depth in tomorrow’s weekly sentiment overview and we’ll see if we can make any sense out of this crazy tape.

Here’s yet another metric showing that the market may be approaching overbought conditions:

For those unfamiliar with this indicator, it is the percentage of stocks within the S&P 500 Index (SPX) which are trading above their simple 50 day moving average. So for example, if we had 100 trading above and 400 trading below, that would give us 20%.

This is a very good measure of the market internals and it has been a useful yardstick to measure oversold and overbought conditions. It was one of the indicators which got me bullish in January. Admittedly, that was way too early.

The concept can be equally applied to any moving average. Obviously the shorter the moving average, the shorter the time horizon of the metric. With the exception of the 10 day moving average which has proven to have incredibly prophetic characteristics even into the long term. In mid March the percentage of stocks trading above their 10 day moving average declined to an unbelievable 3%!

Getting back to current market conditions, we are now slowly approaching the other extreme: overbought. We aren’t there yet. Usually the market tops out when this percentage gets between 80% and 90%. When the market topped out in October 2007, this indicator reached 85%. But right now we are only at 74%.

So its just something to watch out for. Especially when compounded by other sentiment and technical indicators which similarly argue for a pause or retreat.

We’ve recovered around 10% from the darkest days of the market slide in January. Tragically for the bears, the world didn’t end. At least not yet.

While it all looked gloomy and depressing, it is important to remember that this is the stuff that stock market bottoms are made of: panic and fear, predominant bearish sentiment and major technical indicators hitting extremes… all accompanied by bad news.

But the market doesn’t go up (or down) in a straight line. Now we are overbought in the short term. The percentage of S&P 500 components trading above their short term 10 day moving average is slightly above 90%.

Just as an extreme low reading indicates a great buying opportunity, a high reading is an indication of caution. For more information read Lowry’s research.

Here’s a recent chart with the red line indicating the +1 standard deviation and the red line the -1 standard deviation:

Having said that, this matters in the short term. We could easily work off this level of overbought by treading sideways for a week or so. Or we could move down slightly.

A high reading from this indicator doesn’t mean it is automatically time to sell or sell short. Especially if you have a long term time horizon.

A good example of that is what happened in mid September 2007 when the percentage of S&P 500 stocks trading above their 10 day moving average peeked above 90%. The S&P 500 itself meandered for a few days and then went higher (and reached its swing top in October 2007).

The good news is that while this short term breadth indicator is overbought, the percentage of stocks above their 50 day moving average is only 40% and those above their long term 200 day moving average only 25%.

The really scary thing would be if any of these were 75% or higher. But we are still too close to the precipice ( the fall apparently avoided) for that.

Let’s see if the new high-new low indicator can do it again.

About a month ago (November 21st to be exact) I noticed that the new high-new low indicator was flagging an inflection point in the market.

As a quick refresher, the new highs-new lows indicator is calculated by taking the new highs in an index or market and dividing by the sum of the new highs and the new lows.

Anyway, here’s what I wrote then:

On November 21st the S&P 500 index closed at 1416.77 (green arrow) — within two days, the market action took the index down to 1407.22 (on November 26th). And that was it.

From there on it started to climb. Except for a slight pause, it went all the way to 1520.

Not a bad call at all, if I do say so myself

So let’s see what the same indicator is saying now:

Yesterday’s close took the indicator for both Nasdaq and the NYSE down to less than 5%. Those are abysmally low numbers which means we are very oversold and close to an inflection point.

On light volume, the market closed strongly down today ahead of the US Thanksgiving holiday. The action brought about an acceleration in the number of new lows (52 week) relative to the number of new highs.

The ratio of new highs to new lows is one of my favourite technical indicators because it has an uncanny predictive power. Like the majority of breadth indicators, it is much more accurate in finding bottoms than peaks.

The last time I mentioned this indicator, I highlighted its cousin the new highs/new lows indicator which is a slightly different way to look at the same data to make it normalized on a 0-100 scale.

At the beginning of August it had flashed a critical level which presaged the summer to fall recovery. Right now it is even lower than the minimum it reached in mid-August 2007.

Here is a chart showing the ratio of Nasdaq new 52 week highs to new lows since 2000. Notice how the spike lows match every significant market bottom:

Of course, the reason why this indicator has such predictive qualities is that it highlights when the market is near a “wash out” stage where all the weak hands have sold and there is a total disequilibrium in sentiment.

I don’t think we’re at an inflection point just yet but we are darned close. So keep your powder dry and sleep with one eye open.