Seventh Inning Stretch

Tue, Oct 20, 2009 - 12:00am

With the major league baseball series now in the championship playoffs, and the World Series dead ahead, this week seemed like a good time for a stock market article with a baseball theme. Of course, baseball games can often last close to three hours, so fans of the sport have to be relatively patient in watching a game, as there is a reasonable investment in time. Just the other day, the Yankee/Angel game went into extra innings extending to 13 innings. What a marathon that was! No wonder the baseball league set up the tradition of the seventh inning stretch, where everyone in the ball park stands up and sings “Take Me Out to the Ball Game.” It is that late stage pause, where the audience has a break to come up for air, stretch out the arms and legs, before getting right back into the game. So it is in the stock market, where after a long advance, the market will normally consolidate and ‘catch its breath,’ just prior to the final rally leading into a more significant market top. Right now I believe that while the rally of the last few weeks has been terrific, it is now largely complete with a consolidation phase dead ahead.

The consolidation phase is the market's way of issuing a ‘seventh inning stretch.’ In my view, the chances are very high that the upcoming pause will last anywhere from three to five weeks, most likely encompassing most of the month of November. In fact if I had to guess, I would venture a strong guess that for the next four to five weeks the S&P straddles 1100 with a range of 20 to 25 points either side. Call it 1075 by 1125 with a 50 point spread centered around 1100. High to low, I doubt that market swings more than 4.5% at any time. Now, the reason for this is called ‘carry over’ upside momentum. In my work I look at a lot of different gauges, and at the moment most of them are at very high levels suggesting that the stock market is very overbought and therefore due for a rest. Yet it is in the degree of “overboughtness” that is very high which tells us that we are not yet at a final rally high. Markets do not peak on maximum overbought values, nor do they peak on maximum price momentum. While the market is not exactly on the ‘max’ values right now, in general, we are still in close proximity to what were very recently ultra high values, and that tells us that overall, a significant medium term top, possibly a very major top, is still a few more weeks down the road.

Let’s start this week's overview with a look at medium term MACD. For those unfamiliar with MACD, the acronym stands for Moving Average Convergence-Divergence, which with a name like that probably does little to demystify anything. Simply put, MACD is the difference or price spread that exists between two moving averages. Normally, exponential calculations are used because exponential moving averages tend to weight the most recent data to a higher degree and therefore tend to be the most responsive. The traditional inputs for MACD are a 12 day moving average and a 26 day moving average. The strength or weakness in MACD at any given time is a measure of the distance the 12 day moving average is either above or below the 26 day moving average. The more the 12 day is above the 26 day average, the higher value MACD will achieve. Unlike other momentum gauges, such as RSI, MACD is non bounded, meaning it has no set scale. This is the beauty of MACD as the larger the bulge above zero, the more upside momentum exists. In my work, I like both the traditional MACD and my own version, in which I roughly double the inputs. As a result, to get a more medium term view and less of a short term view, I use 24, 48, and then 12 as a signal line. In the chart below, we see that as recently as late September, medium term MACD was still making new recovery highs. Most recently, the gauge has come off those highs ever so slightly, but has once again turned up during the last few sessions. At present values the gauge is still very high by any measure, with the last such high values seen all the way back in early 2003 when the last bull market began its kick off. Unfortunately, I do not believe that a bull market is in effect at the present time, at least, not the classic bull market which is based on positive fundamentals. At the moment, economic fundamentals could not be much worse, and what’s more my forward looking forecast is for another very difficult recessionary year in 2010. Thus, this rally falls more likely into the category of large bear market rally, not unlike some the rallies seen in the Japanese stock market during the last 15 years.

In this context, the key element to watch for in the weeks ahead will be to watch MACD coming down off these highs as prices meander in a narrowly confined price range. Later on, we should then see one final burst of buying that lifts the major indices to higher highs, with medium term MACD potentially at levels only one half or less of the recent peak readings. At that point major trouble could follow.

Above: the CBOE Options Advance-Decline Line.

Yet another gauge that is still acting very well is the CBOE Options Advance-Decline Line. In this case, the indicator was still making new highs right through the end of last week. That is robust behavior and underscores the idea that the market is probably still a few weeks from a more serious peak. Yet a close cousin of this gauge, the CBOE Options A/D Line Detrend Oscillator, which is shown in the next chart, paints an even more accurate assessment. In this case, we are simply detrending the Weekly Options A/D Line with the 39 week, 200 day moving average. This process yields the oscillator plotted in the chart below where we can see that once again, the spread above and below zero has recently been near absolute record positive values. With values this high there is little chance that the market has completed the 9th inning, or that the game is about to end. Instead, readings like this tend to either come very early in the game or around the seventh inning stretch. Because the fundamentals are so poor, I believe that the current outcome is that of the seventh inning stretch. The high readings indicate a market that will be, or already has reached a point where it is ready to begin a consolidation. This does not preclude a series of minor new highs in the days ahead, up to as high as 1120 on the S&P. Yet, on balance I believe with high conviction that 1075 to 1120 will contain the S&P for some weeks to come. The final innings, the eighth and ninth innings of this game will then likely unfold in either late November or December, and will be identified by a final surge to higher highs, at which point this Detrend Oscillator will be sporting pronounced bearish divergence. At that point a downside reversal in the averages to the tune of 3 to 4% could start to yield major trend sell signals, which would be a prelude to the Return of the Bear.

Above: CBOE Detrend Oscillator

In my work I also track investor sentiment, which also has a strong tendency to peak well ahead of a markets actual final price high. In this case I again see evidence of the seventh inning, with gauges like Consensus Inc spiking up into the low 70% zone. This is an early warning shot across the bow, that a more important top could develop a few weeks down the line. For now, however, the sun is still out, and the game has at least a few more innings left.

That's All for now,

About the Author

Chief Investment Officer, Editor
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