Trader’s Narrative

About 4 months ago I wrote about the Canadian stock markets with a dual message: the Canadian retail investor was panicking and cashing in their mutual fund. According to contrarian analysis, this is a good thing because the less knowledgeable and weaker market participants are usually wrong - especially when they react like a herd.

But I also wrote “Caution, Caution, Caution”, saying that even so, I was worried that the market looked heavy. My reasoning was based on the percentage of stocks above their moving average.

My thinking was that although the sentiment would probably put a floor on the market, things could get a bit dicey. Did they ever!

In this case, it pays to be lucky! I was right in being cautious but wrong in thinking that the market would soon rebound from any weakness. After falling, the index has been wrapped up in a tight trading range for the past two months. To be honest, it shocked me to see it so weak in the aftermath of the July sell off.

I wanted to layout my thinking to illustrate that relying on any one indicator, however sound or logical it may be, is dangerous. Timing the stock market is an extremely difficult thing to do and if you’re going to get lucky, it pays to have many tools in your toolbox.

I’ve been doing some thinking about the market, trying to peer into the fog and while tinkering with some charts, came up with this :

The candlesticks are the weekly Nasdaq 100 and the thin line the % of NDX stocks above their 50 daily moving average. Usually, when we have gotten an ‘oversold’ reading on the percentage of stocks above their moving average, we have seen a significant rally. Take a look at July 2004, for example.

But this has not always been the case. In January 2005 things were similarly oversold and after a tepid attempt at recovery, both metrics cascaded down again. It wasn’t until mid April 2005 that the market put in an intermediate bottom and began to rally.

So are we seeing the same situation repeat itself? Will the second bottom be the real one? Of course I don’t pretend to have a definitive answer. All I can offer are some ideas: yes, possibly but the general market - other than tech - is not as weak and can actually fall much further before hitting oversold levels. Also, if we are at a critical junction and seeing the switch from cyclical bull to bear, the things which we counted on before can simply stop working going forward. Oversold readings in bear markets are not at all the same as oversold readings in a bull market. Finally, you have to be wary of a market when an oversold condition doesn’t lead to some kind of rally.

Here is the same chart for the Canadian index:

The Toronto Composite Index has been whacked with the double whammy of a general market drop and a commodity pull-back (oil and gold). The result has taken the index down from almost 12,500, in mid-April, to around 11,800.

Previously, I wrote about my unique take on % of stocks above their moving averages, and below you can see it applied to the TSX index:

As you can see, the ratio is fast approaching levels which have marked significant market bottoms. I don’t think we’re necessarily there yet, but the situation does deserve to be closely watched.