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The simple bond indicator wasn’t responsible actually. Eventhough the rate of change in the bond market is both logical and fairly accurate, I still give more weight to breadth analysis.
In the first week of June 2007 we saw a curious anomaly. The NYSE advance decline numbers suddenly went haywire and spiked into extreme oversold levels. Many at the time interpreted this as they had all previous times: time to buy! But following an indicator without really understanding it can be dangerous.
In fact, the NYSE breadth extreme was due to the sharp move in the bond market which forced all the interest rate sensitive issues on the exchange to sell off dramatically. Because I keep an eye on the Nasdaq breadth numbers as well, I picked up on the divergence in the two breadth levels and wrote about how the NYSE’s advance decline numbers can be deceptive.
So I was very careful to not jump in and go long. For the most part I stayed on the sidelines and picked at a few selective sectors here and there.
Here is a chart showing the S&P 500 Index during two separate instances involving extremes in market breadth. In the first, both the NYSE and Nasdaq’s market internals spiked to an oversold level. Almost immediately afterwards the market recovered and went higher. But in the recent situation, the divergence lead to a month long meandering. Also notice how the short lived recovery in mid June failed to take out the previous swing high:
The other time we had a similar situation was in May 2004 when the NYSE and Nasdaq breadth numbers diverged. After that instance, the market went sideways and then down until August 2004. But it looks like we won’t have a repeat of that. This market is much too strong.
With the breakout we witnessed in the major indices I’m much more comfortable buying here. What gives me confidence is not only the muted sentiment but also the unflinching conviction of commercials.
I’v also noticed that eventhough we’ve enjoyed a quick ramp up in a short time, the market seems to still have a lot of kick left in it. For example, the Dow which has been leading the charge just breached 14,000 and yet only 70% of its components are above their 50 day moving average. Compare that with May 2007 when it was more like 95% above their 50 day moving average.
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