Trader’s Narrative

Well, is it?

That’s what a lot of people are wondering (which has the built in assumption that this is a bear market rally and not the real thing). To get some perspective on this, I decided to look at a long term view of the Nasdaq Composite Bullish Percent Index.

If you’re unfamiliar with this type of index, it is created by looking at what percentage of the components of an index (in this case the Nasdaq Composite) are exhibiting a certain bullish pattern according to point and figure charting. To see how I use this as an indicator, check out: How to Time the Market with Bullish Percent Charts.

Here’s the long term chart of the Nasdaq Composite compared to its Bullish Percent Index:

By the way, I used the Nasdaq Composite because it is very broad with about 3000 components and it excludes a lot of the junk found in the NYSE (CEFs, convertible debentures, ETFs, preferred stocks, rights, warrants, etc.) which can skew the index, especially because of their sensitivity to interest rates.

The chart shows the tech bear market and the latest one which started in late 2007. Almost every single bear market rally top was flagged by the Bullish Percent Index (BPI) - indicated by the red down arrows. It also did a good job of finding exhaustion points during the good times - with one important exception.

The red box shows the span of time that the BPI went above 60% and stayed there. During this time, the normal relationship we otherwise see between the two charts broke down. The only argument I could think of to explain this, is that this time period was the start of a new (albeit short lived) bull market. All kinds of indicators, breadth readings and overbought metrics went into the red zone and stayed there as the stock market powered ahead - seemingly oblivious to them.

The other difference between this most recent bear market and the last is that the counter rallies we’ve seen this time around have been much less powerful than before. As you can see marked by the orange down arrows, they don’t even reach 50% BPI.

The latest BPI reached slightly higher than 62% - that the highest since early 2007 and before than, early 2004. Obviously, this latest run up is different from the previous ones. Going back to 1996 (not shown on the chart) it was rare for the Nasdaq Composite Bullish Percent Index to reach or exceed 50%. So this level is clearly significant.

So what we have to consider is, if this is just a run of the mill bear market rally, then it is over. But if it the real thing, similar to what we saw in 2003 (the red box) then the market will confound everyone and keep going higher.

According to the long term market direction guide known as the Coppock Curve, the Nasdaq is already on a buy signal (from last month). But since it tends to whipsaw much more than the Standard & Poor’s 500 Index (SPX), I’m waiting until it gives a signal. There are only 8 more trading days left in the month and if the S&P 500 can stay above 874 (3.74% lower from Tuesday’s close) then the Coppock Curve curls up.

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Who could have imagined that with crude oil at +$110, the transports would be one of the highest relative strength sectors out there?

Well, if the stock market was strictly logical we would have figured it all out centuries ago. This is exactly what makes trading so fascinating.

Bullish Percent
The recent swing low was in early January, when the bullish percent for the sector reached a measly 5%. Five percent!

Do you know the last time they were that low? Try July 2002.

But since you’ve read my post about timing the market with bullish percent charts, you know all about that and of course, took obscene advantage of it. Of course.

But there’s more going on here. Take a look at this chart:

The top chart shows the relative strength of the transports (to the S&P 500). Notice the higher lows and the higher highs. Then check out the completed head and shoulder formation with a nice quick retest of the neckline.

Believe it or not, it has already made it to the October 2007 highs. In contrast the Dow Jones Industrial average is still well below that area on its chart.

Dow Theory
According to Dow Theory, major signals are given when the two major sectors (sometimes along with the third: utilities) confirm each other.

While the recent action is not bullish per se, at least according to strict Dow Theory, it sets up what is called a “non-confirmation” - in this case, for a decline. That is, because the Dow Transports didn’t confirm the lows that the Dow Jones Industrial Average reached but instead headed up.

What would be truly bearish, according to Dow Theory, is if both the Dow Jones and the Transports print prices lower than their January levels.

So right now what we have is simply the potential for a buy signal, if the Dow Jones continues to rally and rises above its February highs.

My previous position on gold has been wrong. At least so far. I didn’t think it would punch through the resistance at $725 but there it is, firmly established above that level now. So take the following with a truckload of salt:

An almost perfect double top is forming on the chart. We have an uptrend where price has appreciated for a few months and then the two peaks which are about the same height. The support line is just below the current price. If it is violated a picture perfect pattern may unfold.

Something remarkably similar is going on with crude oil:

In the summer I turned bearish on the oil sector as there was a buying panic underway. Oil stocks continued to rise into July but then stumbled badly. Their low was in mid-August, along with all the other sectors out there, as I was pounding the table to go long.

Bullish percent indices are very useful in timing the market. Right now the bullish percent index for the energy sector is at 38% which is low but not too low. And for the gold sector the bullish percent is just below 50%, smack dab in the middle of nowhere.

Other than the financial sector, which is extremely oversold, the only other major sector in the market approaching such levels right now is the transports.

After participating in the Dow Theory buy signal in late April, the transports powered to an all time high last month (5487). But even as this sector was climbing into thin air territory, its bullish percent index was falling.

This sort of divergence is usually a bad omen as it means that less and less stocks in the sector are participating and fewer and fewer are responsible for pushing the index higher.

Anyway, historically, when the bullish percent index for this sector reaches 30% it is a good time to hunt for longs and eschew the short side.

You can see details of how this signal worked out last summer.

Bullish percent (BP) charts are calculated differently than other price charts you may be familiar with. For starters, they aren’t really price charts. Second, they’re only applied to an index or group of stocks not individual stocks. And at their heart, they rely on point and figure charting. Tom Dorsey couldn’t have predicted their success or wide application when he first popularized the New York Stock Exchange bullish percent index.

A bullish percent charge is calculated by first taking each component stock and charting it using the point and figure system. Then those that have a point and figure buy signal are added together and this number is divided by the total number of stocks in the index or group. Theoretically, a BP chart can span from 0% to 100% where no stock in the index has a PnF buy signal and where they all do. But usually it tends to oscillate between 70% and 30%.

Dorsey never intended his creation to be used the way I use it, but I’ve found that it is quite a useful way of looking at sectors when trying to identify tops and bottoms. Of course, I don’t exclusively rely on this as a signal but it is a great way to confirm other technical analysis. Take a look at this example from last summer:

Mid-August saw the lowest reading in the bullish percent index of the transports since March 2003! Doom and gloom was thick, peak oil was being bandied about matter-of-factly everywhere and oil was pushing $80 a barrel. You would be a fool to suggest going long. But that’s exactly what the bullish percent was saying.

And here’s the result:

The extreme low (20%) marks the exact intermediate bottom of the Transportation Index. There is a weak retest in early September 2006 but the previous low holds. From there, the index powers ahead with higher highs and higher lows. If we assume that you were taking your exit signal from the bullish percent index, you would probably exit when it reached the other extreme (high of 85%). That would give you a 12% move in about 3 months. And that’s assuming you went with the index and not individual stocks which would have moved with a larger beta.

So what about right now? Are there any sectors or indices that look like the transports did last summer? I’ve scanned them but alas, none are low enough to show an extreme washout. But keep an eye out on the bullish percent and you may find a very compelling signal soon.