Studying market behavior during the current rally provides a glimpse into how key indexes are setting up for the second half of 2009.
Emotions are a drug that intoxicates asset prices. The dosage varies over time. On Tuesday, the market was less pessimistic as the S&P 500 rallied.
Although the index closed ever-closer to its previous intraday high of 930.17 on May 8, there were a pretty decent number of stocks that were unchanged from the previous week. So there's still a lot of indecision remaining.
In times like these, bullish moves tend to be very aggressive but don't amount to much over the longer term.
Until that 930 level is breached on heavy volume and sentiment is strong enough to show a clear change in leadership, we're still in rather speculative times. And until indicators show more positive signs, a new secular bull market could be more than a year away.
In the more immediate future (the next one-to-three months), the S&P 500 seems to be setting up for a double-digit percentage fall. (See specific details in the "Where Are We Now?" section of this column below.)
Any really concrete new leadership in this cycle should come from more growth-oriented names, so watch the Nasdaq 100. When that really jumps significantly and holds its gains, a recovery with legs will be more in the cards.
Breaking Down The Latest Rally
In the meantime, remember, emotions are the "animal spirits" identified by economist John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest and Money."
Keynes himself was a trader (mostly commodities) who built much of his wealth from buying equities in 1933. A new book "Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism" by George A. Akerlof and Robert J. Shiller reviews the emotional ties between economic trends and asset prices.
Akerlof and Shiller show how emotions/politics infect economic trends by convoluting fundamentals in a feedback loop that precipitates booms and busts.
Judging Asset Price Trends
Technical analysis (TA) guides our insight on asset price trends. Eventually, fundamentals determine market direction. Consequently, TA is not a stand-alone tool for building investment strategies. But TA enabled us to identify a likely rally from 757 on March 13 into the 850-950 price range for the S&P 500 ($SPX, Figure 1).
Figure 1 employed a 12-month S&P 500 price-trend channel and the $NYAD or net advancing minus declining issues on the New York Stock Exchange (NYSE) in support of this view. Figure 2 compared the relative performance of the Nasdaq 100 to the S&P 500 ($NDX returns divided by $SPX returns) to spot the potential for a bottom in the market's decline since its October 2007 high near 1576.
Figure 1 is technical. Figure 2 also employs fundamentals. The $NDX:$SPX ratio is a proxy for increased risk appetite evidenced by more and more investors buying the earnings growth of the firms within the $NDX since the prior lows seen in November 2008.
Investors are correct about $NDX fundamentals, which we touched upon in the May 2009 InPerspectives. This tech sector dominates this index. It should best the S&P's earnings growth as we export our way out of recession during the next recovery. Unlike the S&P, there are no financials in the $NDX, which weigh on fundamentals. On March 5, a rising ratio signaled that a bottom was near.
(Little did we know that when we published Figure 2 in our March perspectives piece that the S&P would bottom the next day at 667.)
Figures 3 and 4 have been updated from our March 13 article. Back then, we found that the increased percent of stocks above their 200-day moving price averages ($NYA200R) since the November 2008 and March 6, 2009 lows was evidence that deflation fear was waning.
The $NYHILO records the 10-day average of stocks trading on the NYSE that are hitting new 52-week high prices minus those setting new 52-week lows. The $NYHILO has been updated in Figure 4. Like $NYA200R, this indicator normally trades above 50 percent (%) in bulls and below 50 in bears.
On March 13, we indicated that the $NYHILO had remained above its November readings as the market recorded a series of new lows in late February and March 2009. Our view then was that market breadth indicators supported a bounce in equities until $NYHILO nears 40. In April, they briefly exceeded 70 and are now at 44 and 35.
In bear markets, readings above 40 breed technical climates where rallies often exhaust themselves. Trend exhaustion is typically followed by weeks to months of price consolidation or a sharp 5% to 15% decline. The short-term trend signal went negative on May 21 when the S&P 500 closed below its 20-day moving average (893) with a close at 888.33.
Retesting New Levels
A retest of the March low is likely if the S&P's intermediate-term trend also turns negative. It is currently neutral. More often than not, TA helps you to access risk and reward.
Figure 5 highlights the neutral nature of the S&P's intermediate-term (three to 18 months) trend signal. A buy or sell signal results if four indicators confirm each other.
For now, the intermediate trend is neutral. One of our intermediate-term indicators employs the crossover of two S&P 500 price averages. They are the exponential weekly price averages (EMA). The 13-week EMA (now around 861) crossed below its 34-week corollary (now 916) in mid-December 2007.
For some investors, this alone is a sell signal. Notice that the Moving Average Convergence/Divergence (MACD) also confirms the weekly price indicator with a reading below zero (0). What fails to confirm are the relative strength (RSI) and the commodity channel indicators (CCI), which remain above 50 and 0. CCI alone is quite overbought. It supports our short-term trend sell signal.
Over the past few weeks, the put-to-call ratio's ($CPC) 13-day EMA hit bullish extremes where sell-offs usually ensue.
On May 8, the S&P reached its highest price since bottoming at 667 on March 6. It was up a whopping 39.4%. Since then, it has declined 5%.
On May 20, a violent outside-reversal day took place, which was very bearish (Figure 7). It was an outside day because the high price was above the prior day's high and the May 20 low price was below the prior day's low. It was a reversal day because the $SPX opened strong, but reversed course and closed weak on the day. Notice too that since April 22, the volume of stocks trading (histogram at bottom of Figure 7) on declining days (red) has been higher than the volume on rally days (gray). This is quite bearish and supports our short-term sell signal. It also leads me to believe that the correction will be more than 10%, to at least an S&P price of 837.
Figure 8 was first featured in our March 9 article when we wrote:
The point of the week is this -- the equity and high-yield bond markets will bottom along with a continued waning of severe deflation fears. The first waning has begun. When it wanes, markets will rally. When it ebbs, they will decline.
The market's worst declines during this bear market have been driven by fears of debt default and consumer price index deflation. Asset classes are acting much like they did during the 1930s, but our journey back to the future may not be for long.
Since this writing, Treasury (TSY) inflation-indexed notes, high-yield bonds, crude oil ($WTIC) and 30-year TSY bond prices have continued to indicate a waning of severe deflation fears. Our Arrow Insights (AI) 75/50 Portfolio has profited from these trends by investing in these exchange-traded funds and exchange-traded notes: the iShares Treasury Inflation-Protected Securities (NYSE:TIP); the iShares iBoxx High-Yield Corporate Bond Index (NYSE:HYG); the PowerShares DB Crude Oil Double Short ETN (NYSE: DTO) and the UltraShort 20-Plus Year Treasury ProShares (NYSE: TBT).
Where We Are Now?
Technical analysis has not yet confirmed that the rally of the past 10 weeks is the start of a new bull market. It is a bear market rally until long-term trend indicators say so. These indicators are not shown here because no value is added until the intermediate-term signal turns positive.
A new secular bull market is most likely one-to-three years off. One or two more cyclical bulls like the one that might have ended on May 8 are customary in a secular bear market. TA empirically defines primary and countertrends.
The recent rally is a countertrend rally for many reasons.
For one, the advance was on weak volume and there is more. The stocks with the weakest balance sheets, highest short-interest and limited liquidity rose the most. The financial sector alone accounted for over one-third of the S&P's advance.
Most importantly, the $NDX:$SPX and $NDX:XLP (consumer staples) ratios have been in declines since mid-April, which is typical in bear market rallies because investors are focused on making a quick buck! In April, speculators began to overwhelm investors buying the earnings growth embedded within the $NDX.
More recently, they changed course and have returned to defense (like XLP). In new bulls, investors aggressively turn to new sectors for leadership on high trading volume. The junk that has been leading stocks since March and the comfort of XLP do not qualify.
Most indexes have touched their falling 200-day moving averages for the first time since May 2008 and are now in declines. Momentum indicators are extremely overbought. Bears are in the minority. Investors who were waiting to get even in 2009 are now selling.
So for now, TA indicates that the S&P rally will stall or decline at least 10%-15% to 790-840 within the next one-to-three months.