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When Breadth Is This Bad, It Usually Gets Worse at Trader’s Narrative

This week brought about a notable technical deterioration in the stock market. It isn’t just the indexes that look ugly, there is a change in tone when we look ‘under the hood’ at market breadth, advancers vs. decliners, new highs vs. new lows, etc. As well, we are continuing to see further deterioration in the S&P 500’s cumulative advance decline line as well as the traditional NYSE AD line.

I’ve shown this chart many times as it is a good barometer of the intermediate health of the stock market. It is the percentage of S&P 500 components that are trading above their 150 moving average over time. By May 19th, it was falling out of the persistent state of bullishness that had sustained the cyclical bull market’s momentum for almost a year.

Click to see larger chart in a new tab:
percent SPX above 150 moving average Jul 2010

Since then it has continuously declined, falling today another 3% points to 18% - the lowest point in more than 15 months. The same is true for the percent of S&P 500 components above their 200 day moving average (27%). But the bad news isn’t necessarily over. Usually when breadth gets this weak, it gets worse before it gets better.

If you think about what the above chart actually means, it isn’t too difficult to understand why. As stocks fall further and further below their trend, it gets more and more difficult for them to shake off a correction and get back to ‘normal’. This is because there is more and more overhead resistance that they have to contend with.

When individual stock prices do rise, then there is an ample supply of previous longs who are unhappy and will gladly take the chance to get out even if they can. This provides a dampening effect on any rallies. And the more deterioration we see, the larger this dampening effect will be.

The only way to get through this is to come out the other end when all the weak hands have been forced to sell and by pushing prices much lower, a lasting floor is finally reached. This is what happened in late 2002 and again in late 2008. We aren’t there yet. As you can see from the chart, this is a process, not an event and can take a while to complete. While it does, stock prices work their way lower.

Since we are deeply oversold in the short term, you shouldn’t be surprised to see a rebound, either brought about by the bulls or by short covering from the bears (or a combination of both). But it will be short lived because of the overhang of supply from higher prices and the change of tone in the market.

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3 Responses to “When Breadth Is This Bad, It Usually Gets Worse”  

  1. 1 AB

    Certainly smells of bad breadth wafting about, but how do we interpret the $VIX experiencing such a sharp reversal the last two days?

    And one can’t help but scratch their head when they see that the domestic indices were down the last two days but the emerging markets ETF (EEM) was up.

  2. 2 AB

    Smiddy, very much enjoyed reading your input.

    I wouldn’t read too much into the last 15 minutes of Friday, first because volume was very light the entire day and that prices were more prone to strong move, and second, markets are still short-term very oversold and we should get at least a pullback to the 10-day moving average before supply pours back in, or at least a move back to the 5-day if bears are so aggressive; prices ALWAYS move back to the 5-day at minimum.

    Referring to the $VIX, I was talking about how it sold off the last two days, going from 37 to around 30. That is not exactly a move suggesting a lot of fear for the week coming.

    About EEM, I was referring to relative outperformance as a sign about actual strength; all markets are still in a downtrend, and during such corrective modes, I tend to think there’s a lot of rotation going on. I know that all the sector charts look like crap.

    But, I’d like to know what you think, if you were to run a ratio between the S&P 500 and the Dow Jones Commodity Index - my chart is showing that there’s the beginnings of a change toward outperformance within the commodities - which might explain why EEM has done better the last two days.

    Shanghai has major support around the 2200-2250 level, and it’s going to be all about whether this level holds. Also, a lot of global bearishness sentiment is related to how much the Baltic Dry Index has fallen so much the last month; but I would think, China WANTS the index to fall, so that they can pay lower prices for shipping. China does not want to pay up for anything - think about all the haggling going on with iron ore prices and BHP/RTP over the last year.

  3. 3 AB

    so much for that 15 minute selloff into the close on friday

    too many traders waste too much time analyzing static

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