Q’s Signal End to Rally?

We continue to believe that the stock market has likely entered a new bear market and have positioned our portfolios to outperform if further market declines are in store. However, with short-term technical indicators signaling oversold conditions when the S&P 500 dropped to 1100 in early August, we decided to wait for a bounce to slightly modify our more aggressive portfolios. This strategy has been a wise one as the S&P 500 has risen 8.5% in a couple of weeks, and we decided to act yesterday. In our aggressive policies, we rotated a few more chips from cyclical sectors to defensive sectors.

Why did we act yesterday? Well, there are a few reasons but the main reason in my mind was the QQQ chart. The QQQ, which is an ETF that tracks the Nasdaq 100 Index, has been a leader for the overall market since the bull market bottom in 2009. With 14% of the index invested in Apple it is easy to understand why. In looking at the QQQ chart, I notice the price level has rallied back to the 50-day moving average (the blue line in the chart below). This moving average provided resistance to price advance yesterday and again today as the market rallied right back to that level again only to sell off heavily after reaching it. Additionally, the momentum of price as measured by the RSI hit the 2011 downtrend marked by the red line in the bottom panel. This indicator tells me that the bounce may be ending.

There are other reasons to suggest this bounce has run its course including separate technical indicators signaling that the market is now short-term overbought, but other analysts feel there may be more upside. Ned Davis is looking for 1250 on the rally (and possibly more) and John Kosar at Asbury Research is looking for 1275 based on a triangle break to the upside. They are probably right, as they have been at this much longer than I, but cashing in on the 8.5% bounce feels great…for now.

Relative Strength

Relative Strength is the study of the price movement of a security relative to the price movement of another security. In more simplistic terms, it is a line graph that shows which security is outperforming. If the line is rising, the numerator is outperforming. If the line is falling, the denominator is outperforming. Analysts frequently use this simple concept to ensure they are invested in the right areas (i.e., the areas that are outperforming) relatively. Therefore, it becomes a great tool to assist with asset allocation and equity sector rotation, but there are other useful applications.

Below is a chart of two securities: the MSCI Emerging Markets ETF (EEM) in red and the S&P 500 Dividend Adjusted Index (SP-DA) in green. The line in orange at the bottom of the chart is the relative strength line of EEM/SP-DA. When EEM is outperforming the orange line rises, and when EEM is underperforming the orange line falls. The start date for this chart is 1/23/2009 (to help illustrate my point), and it shows strong outperformance of EEM versus the S&P 500 through yesterday. But the chart can also be used to identify divergences, or differences between the S&P 500 and the relative strength line.

There are a few divergences that I can point out on this chart, which will hopefully highlight the leading characteristics of Emerging Market stocks. At the very far left of the chart, the S&P 500 fell into March 2009 while the orange line was rising. The market bottomed shortly after this positive divergence as the emerging market stocks led US stocks higher. Another positive divergence occurred in June/July 2009 as the relative strength line started moving higher while the S&P 500 made its bottom in July. There are also negative divergences, like when the relative strength line started to head lower before the S&P 500 top in April, and most recently the relative strength line has moved lower from the October peak as the S&P 500 continues higher. Does this negative divergence foretell of another correction in the S&P 500?

Bullish Engulfing Pattern

With the disappointing IBM and Texas Instrument earnings announcements last night, the S&P 500 opened sharply lower this morning. It seems that the market is now very concerned with companies that miss revenue targets and we could be setting a theme for this quarter’s earnings. However, as we returned to the office after a gorge fest at the local Chinese restaurant, the S&P 500 had completely erased all losses and rallied throughout the remainder of the session. Why? I don’t know, maybe rumors on the Fed stopping interest payments on excess reserves or leaks of Apple’s great earnings. Whatever the reason the market action today created a nice bullish trading pattern called the engulfing pattern (which in no way relates to our lunch habits).

The Bullish Engulfing Pattern is basically a period of market movement (one day in this case) that opens below the previous market movement (yesterday) low, and closes above the previous market movement high. And although technically speaking yesterday should have been a down day this still seems to be a good signal for the bulls especially after the sharp sell-off on Friday. The chart below shows the S&P 500 over the last three months. At the very far right of the chart you can see the last green line has completely covered the green line to its left. Or it seems to ‘engulf’ Monday’s price movement. This signals that the bulls have taken control of the price action and might be the end of the short-term decline.

Also, note that the blue line on the chart is the 50 Day Moving Average. That seems to be the next resistance zone as prices could not move above that moving average in early May, mid-June and last week. It also coincides with the downtrend line Carl mentioned last week. These longer term trends are where we focus our attention but the day to day activity in the market is interesting to note because the market may be giving us hints.

Market Volume a Concern

Looking at stock market volume statistics over the last few weeks has not given me much confidence in a resumption of the bull market. In a healthy bull market we would like to see strong volume on up days and/or weak volume on down days. This general pattern is regarded by technicians to be a confirmation for bull markets, and the opposite pattern to be a confirmation for bear markets. Of course this is not always the case, and more analysis should be considered before calling bear markets, but it’s not a good sign.

Below is a chart of the S&P 500 SPDR ETF, ticker SPY (I have used the SPY as a general proxy for the trend in volume although there might be slight differences to actual exchange volume). The top section of the chart is the SPY price movement and the bottom of the chart is the SPY volume. When the market is down the volume bar is red, and when the market is up the volume bar is green. During the up-trend in March and April you will notice red volume bars spiking higher than the green bars indicating that volume was much stronger on down days then it was on up days. This volume pattern would seem to question the bull market as more investors were eager to sell on down days than buy on up days. Or put another way, volume did not confirm the trend.

After the April 23rd high, you can see that the red volume bars at the bottom still stick out higher than the green bars, with significant peaks during the May 6th “flash crash.” At this point volume is now confirming the short-term trend as volume increases on down days and decreases on up days. This is only one look at the market but I would like to see the volume pattern change, and provide some rocket fuel for what may be the last leg of this cyclical bull. Until then I would remain skeptical of the rallies.

Technical Damage Contained So Far

Prior to the recent sell-off, we’d repeatedly referenced how strong the underlying technical condition of the market was. We regularly monitor a variety of these different price-based measures, and prior to yesterday, we didn’t see any of the classic divergences that have preceded significant market declines in the past.

While yesterday’s rout was certainly nerve-wracking, it appears that technical damage was relatively contained on most measures. At one point, the S&P 500 broke below its longer-term 200-day moving average. However, it managed to finish above that level by the end of the day. Other measures like advance/decline lines and new 52-week lows were moderately worse on the day, but don't appear to be flashing alarming warning signals at this point.

There were a couple of measures that suggest that there may have been too much fear in the market yesterday – total volume on the NYSE reached 11.4 billion shares, very close to the levels hit in the fall of 2008, just after the collapse of Lehman Brothers, and about a year into a bear market that had already seen a 20%+ decline in stocks! In addition, the VIX Index, which measures the volatility of options prices and is widely viewed as a “fear” indicator, rose to 41, which was the highest level since last May, almost exactly a year ago.

In short, while there may be more volatility ahead as the Greek crisis continues to capture headlines, we believe yesterday’s sell-off may have been overdone, and are staying the course for now.

Chart: NYSE Total Composite Volume

Technical Take: Keep an Eye on New Lows

Technical analysis is one of the main building blocks of our forecasting process, along with fundamental macro analysis and valuation. It involves the study of many different market-based indicators, including momentum, sentiment, breadth, volume, divergences, etc. We believe that different market environments require different levels of emphasis on each part of our process, and I think it’s fair to say that today’s liquidity-driven market requires that we devote more attention than normal to the technical condition of the financial markets.

During the current stock market rally, one of the strongest technical measures has been market breadth, which gauges the number of advancing versus declining stocks. Typically, in a healthy bull market advancing stocks significantly outnumber declining stocks, and in bear markets the reverse occurs. One market breadth measure that we’ll be keeping a particularly close eye on is the number of new 52 week lows in the marketplace. The indicator is fairly straightforward – as the name implies, it’s simply the sum of the number of individual stocks that have fallen to a new 52-week low.

Below is a chart that plots the Bloomberg New 52 Week Lows on U.S. Exchanges Index (blue line) against the S&P 500 Index (red line). It shows that as the market began to rebound in March, new lows fell dramatically and have stayed very subdued ever since. Lately, however, new lows have been slowly rising, and even closed above some key moving averages. At the moment it’s too early to tell if new lows are in the early stages of an important trend change, or if this is another false breakout like we’ve already seen several times this year. Either way, we’ll be watching new lows closely for signs that the current bull market is running out of steam.