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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.
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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