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Stock Market Update - May 2009

by Frank Barbera, CMT | may 12, 2009

Over the years, the adage about “selling May and going away” has actually been very good advice, as stocks have generated the vast majority of their performance in the time period between late November and early May. This year this advice is shaping up to be at the very least a good suggestion, as equity markets have now rallied on a scale not seen since the early 1930’s, when judged on the amount of percentage gain squeezed into a given period of time. Over the last 100 years many rallies have lasted longer, many rallies have ended up generating larger overall gains, but few rallies have been this large, moving in this kind of uninterrupted fashion. As is typical with Wall Street and its grand spin machine, the word on the street is that a new bull market is in force. Forget about all the bad stuff that just happened, and get back in the market because stock prices are going much higher. At least that’s the sentiment you get when reading a lot of what Wall Street is putting forth.

While we do not dispute the idea that eventually stock prices could turn the proverbial corner and that the return of inflation could easily translate into a new asset bubble in equity prices, at least for now, any talk of a new bull market in stock prices is likely wildly ahead of itself. Think “Bear Market rally,” and for that matter, possibly bear market rally complete. To be sure the stock market technicals are so tightly wound, something is bound to shake loose in violent fashion at any moment. I am reminded of the old World War II movies where a bunch of guys are huddled in a submarine pushing the very limit of the pressure seals, watching the bolts explode in the middle of a depth charge attack. In the stock market, the technical pressure is building rapidly and the bolts will soon be flying. As a result, the advice today is: get ready to duck.

But before getting into any short-term analysis, let’s step back for a moment and look at the Big Picture trend. In the chart below we see the S&P 500 plotted on a monthly basis with the 20 month moving average in bold. Hey—wanna beat the performance pants off the stock market every time? Keep an eye on the direction of the 20-month moving average. When the moving average is moving sharply lower, like it is right now, don’t get caught up in any bull market fantasies. Notice that during the last bear market there were a number of sharp rallies just like this one that came and went, while over the same time stock prices just continued to drift off.

The old saying on Wall Street is “never try to catch a falling knife,” and moving averages can help an individual avoid the flying daggers. Once the moving average begins to flatten out, or slow its rate of descent, then maybe a bottom has formed. What so many in the cable news media neglect to point out is the concept of stock prices building a base. That’s right, in order for a powerful trend to go from strongly down to strongly up, this doesn’t happen quickly and overnight; it takes months, and during that time prices need to base. Usually, a base looks like a large sideways pattern where prices see-saw back and forth for months on end. Back in 2002-2003 it took more than nine months before the market had completed a base and was ready to stage a lasting recovery move. In the current situation the 20 month moving average is still falling like a knife through butter, virtually guaranteeing that the rally in equities is part of a large bear market rally and not a sustainable trend reversal.

Breadth

Other gauges which track the major trend are also still pointing strongly down. Take the CBOE Options A/D Ratio. This gauge tells us about the net plurality of gains and losses in the options market and has done an excellent job tracking the stock market over the years. At the moment, the CBOE Options A/D Ratio remains way below its declining 200 day (or 39 week) moving average. What’s more, the 200 day moving average is still falling at a very sharp pace, not at all like what was seen back in 2002-2003 when the moving average had begun to slow its rate of descent. When prices upside penetrate a flattening moving average, that is a good sign. When prices snap back to a steeply declining moving average, that’s a sign that a failing rally has likely just been seen, with prices likely to reverse lower before doing anything else in a major way.

Above: Weekly S&P 500 with CBOE Options A/D Ratio and 200 day Moving Average

In addition to strong down trend in place on this gauge, the 9 week RSI on the CBOE Ratio is now all the way back up to fully overbought condition. Buying into one of these readings didn’t work out well even in the bull market of 2003-2007, and could be a whole lot more dangerous if the 2008 Bear Market is still in force.

Above: CBOE Options A/D Ratio with 9 week RSI

Above: S&P 500 Weekly Bars with CBOE Options A/D Ratio Detrend Oscillator

In addition, another technique we use is to Detrend the CBOE Options A/D Ratio using its 39 week moving average to produce the oscillator seen in the chart above. Again, we see the oscillator gives very good signals at major market extremes, but has now moved up a great deal from its 12/5/08 low at –243.73 to a current reading of +42.72 as of May 8th. A big question for the next few weeks will be, can the oscillator stay above zero, or is this move above zero just a quick head-fake? Often, bear market rallies will move the oscillator back up to zero and then fail, reversing back down into negative territory within short order. That is the outcome we believe is likely in the weeks just ahead.

Other stock market gauges are even more overbought. Take the NASDAQ for example, where the very long term McClellan Summation Index now resides at some of the most overbought values ever seen. At these lofty levels it is hard to imagine the NASDAQ not ceding back a lot of the recent gains, as the Summation Index is bound to unwind. While there have been occasions when high Summation Index values were a ‘sign of strength’ there have also been occasions where high Summation Index values were the kiss of death, and those included readings seen in October 1997, June 1990, May 1983, September 1980 and June 1972. Following those readings, the punch in the nose was painful and bloody. Another important point: these high Summation values are being seen just as the NASDAQ moves back to the area of resistance at the 200 day moving average, which I would add, is still trending strongly down. This combination strongly suggests that at the very least a sharp correction is overdue.

Above: long term view of NASDAQ Market and the Summation Index, now at high end of the range.

Above: Close Up view Summation Index and NASDAQ with 200 day average.

Sentiment

While many bulls seem to believe that the stock market can simply continue to rise indefinitely, that mindset is getting more and more infectious as caution has been thrown to the wind. With this uninterrupted advance has come a sea change in market sentiment, with big changes in advisory opinion. In our work, we track a number of major sentiment polls including Investors Intelligence, AAII, Consensus Inc, and MarketVane. Putting them all into one evenly weighted model, we arrive at the chart of our Sentiment Composite Index which is now about to reach neutral territory near zero. Coming off record negative values, the odds are high that this gauge will stall near or just below zero and then reverse lower and retest the lows. Elsewhere, our work in the area of options Puts and Calls is also showing a huge swing toward optimism. All of those ‘green shoots’ in the economy must be blowing through the air and infecting the nasal passages of major options traders as the current set of readings from options traders represent the kind of optimistic, one-sided view of the world only seen seven or eight times in the last few years. This is strong evidence that a counter trend decline, a correction, should be dead ahead.

Above: GST Sentiment Composite Index moving up rapidly off deeply oversold lows.

Above: CBOE Options Put/Call Oscillator. Low readings as seen at the current time indicate high levels of optimism, while high readings (at the upper end of the range) indicate panic and fear. We have swung 180 degrees on this gauge in record time.

In addition to the volume of options trading, we also like to watch the VIX Index to see what the crowd believes could be ahead in the world of volatility. Right now, the GST VIX Oscillator for the S&P is back down to sell signal levels, while at the same time the NASDAQ VXN Oscillator is plumbing the depths of optimism rarely seen. Again, this suggests that a mean reverting “punch” is about to be thrown.

Volume

Finally, we also like to watch the cumulative trend in volume and money flow. A favorite arena for this is the NASDAQ market, where volume has done a good job leading price. So far the bounce in volume is a whole lot less impressive than the bounce in price. This is a serious Red Flag flying from the masthead which is supported by the fact that long term moving average of NASDAQ Money Flow are also still declining strongly.

Back in 2002-2003 we saw the following series of events coming at the end of the bear market and just before a new bull market advance. Prices surged off the low with volume surging in tandem. Point I was the initial peak. Prices then corrected back around 50% of the entire advance with volume doing the same. From there forward prices then broke out to new higher highs and were confirmed by a break out in volume. At the very least, even in a perfectly improving world, the same type of basing structure would need to develop in today’s market, which would likely be no farther along in this pattern than the high at Point I.

As a result I remain of the view that a sizeable pull back in equity prices is the most likely outcome for the markets in the weeks ahead. While there is a possibility that prices could continue to move higher from here, if that happens we won’t view it as a positive development, but instead a market that is getting farther and farther ahead of itself and thereby setting itself up for another big decline. For fans of a new bull market, the best thing the stock market can do from here is to pull back and correct, allowing the market the potential to (a) stabilize, (b) build a base, and (c) then possibly regroup and rally later on.

That’s all for now,

Frank Barbera
The Gold Stock Technician

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Frank Barbera
The Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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