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Stock Market’s Afterburners End, But Ride Not Over at Trader’s Narrative

The market continues to thrash about within a relatively tight range even as breadth, technical and sentiment gauges register an oversold condition. The S&P 500 index is back to where it was on May 25th when the chart printed a beautiful hammer candlestick.

I’ve shared the chart below with you before (A Subtle Shift in the Balance of Power) because of its significance in establishing a context for the general trend.

When we see the majority of stocks, represented here by the percentage of S&P 500 components, consistently trading above their long term moving average, then the stock market undergoes a thrust momentum rally.

Click to see larger version in a new tab:
percent S&P500 above 150 MA Jun 2010
S&P500 index thrust slope Jun 2010

This was certainly the case for the 13 month rally that started in March 2009. It was so swift and intense that before most made up their minds up about whether it was just another bear market rally or a cylical bull market, it had left the station.

According to Lowry Research, since 1940 the average 13 month rally at the end of a bear market has provided a return of 36%. In contrast, this cyclical bull run pushed the market up by 71% - almost double the average. You can see the steep slope in the above chart (the green line scaffolds) and how it compares to the previous cyclical bull market from early 2003 to early 2004.

When the percentage of stocks above their long term moving average falls off the top edge, it signals that the afterburners that have powered the thrust higher are finished. That isn’t necessarily the end of the bull market however. It just means that the slope of the trend has changed (see blue line scaffolds).

Also notice that we are now at 34.4% - the last time we saw a similar decline from heights of 80-90% was in August 2004. Back then the S&P 500 index flopped around the 1060-1070 area for a few days before resuming its uptrend.

Which takes us back to the opinion of Lowry Research that the current decline is a normal correction which will be followed by higher prices. That view is shared by several distinct indicators we’ve discussed recently. Among them, Wayne’s Confusion Index and the Coppock Curve’s elevated level.

So what we may be seeing is much more subtle change than most people imagine; a shift to a shallower trend rather than the ultimate end of the cyclical bull market or the start of another bear market.

drach herzfeld high return low risk book coverAnother important prognosticator with similar views is Robert Drach, editor of the weekly Drach Weekly Market Report. Drach has also co-authored a very underrated book with Herzfeld (the specialist on closed-end funds) titled: High-Return, Low-Risk Investment: Using Stock Selection and Market Timing This long time market timer uses a handful of indicators that follow economic data, monetary policy, sentiment and stock market technicals.

Since 1995 Drach has been sharing his portfolio online to demonstrate his methodology. So far, his market timing portfolio has returned +149% versus +112% for the S&P 500 index. You can follow his daily commentary on the Nightly Business Report’s website.

Drach is currently bullish, expecting stock market prices to recover because of the weight of the evidence before him. His conviction is drive by the indicators he relies on, including one that looks at how many “high quality” stocks are trading below their prices from 20 days ago. He has found that when three quarter or more of stocks trade below where they were 4 weeks ago, the stock market tends to make an important low. Currently, 96% of the S&P 500 index components are trading lower for the past 4 weeks.

This is similar to the familiar, percentage of S&P 500 stocks trading above their 50 day moving average (but just inverted). Right now there are only 46 S&P 500 stocks that are trading above their 50 day moving average. In other words, 90.8% of them are below this moving average.

But again, it is important to note that Drach is not relying solely on this breadth measure to arrive at that conclusion. As I mentioned, he is basing it on many other factors, including the current sentiment.

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5 Responses to “Stock Market’s Afterburners End, But Ride Not Over”  

  1. 1 dave ross

    Sorry I think you are wrong.

    Its rolling over and going down.

    Guess we will all know soon enough

  2. 2 Jon

    I followed Drach quite closely for about 5 years. His ideas are interesting, but there are two problems with his methodology:
    1. He always buys into a decline, without knowing how deep the decline will be. Instead, one can wait for bottoming signs, instead of oversold signs. This is important for deep bear markets which, though infrequent, can rob you of years of “normal” market profits.
    2. He depends upon fundamental data in choosing his investment vehicles. As we all know, companies play with their published data. There are a few dramatic examples of deep deep losses resulting thereby, the most obvious example being his choice of Doral Financial as a stock to invest in. Also, he will just hold a stock until it comes back, even if it takes years.

    Drach usually buys good companies after sell-offs-”buy the dips.” I’m not sure this is a good methodology for a deflationary recession. It might have been good during the bond bull market of 1980-2000[2007].

  3. 3 PEJ

    Thanks Jon for your valuable input. I obviously would agree with you and wouldn’t really buy that dip yet.

  4. 4 Babak

    Pej, I’m glad to see readers use their own judgment. By the way, Lowry’s proprietary supply/demand picture has worsened with the selling pressure index rising to the February lows but the buying power index is still strong as it has fallen much less. You can get the same picture by looking at the Cumulative AD lines.

  5. 5 PEJ

    Thanks Babak, this is indeed an interesting post. That said, the market is short term oversold anyway, so one cannot ignore the possibility of another relief rally.
    The main problems that I see are both on the fundamentals: markets are very much overvalued given the state of the economy and the market internals as well: given that everybody was more than fully invested and that the euphoria was higher than back at the top of 2007, who is a position to play “buy the dip” yet again?
    Interesting question: how many bears where actually short just 6 weeks ago?

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