October Market Breadth
Post Source: Short Side of Long
There has been quite a lot of market action in stocks as of late, so it is time for another Market Breadth Summary. Most market participants would look at the chart of S&P 500 and conclude that some kind of trouble only started several days ago as selling intensified and the volatility index jumped. However, the internal market breadth for the US equities has been deteriorating since at least June of this year. Let us look at a few charts.
Chart 1: Market conditions are changing as bears take control from bulls
Source: Short Side of Long
Before I start, there is an important point I would like to make. According to the price behaviour and various indicators I track, market conditions are changing as bulls lose control to the bears. In other words, probability is quite high that the central bank sponsored rally, which has lasted for the better part of two years, has probably come to an end and the prevailing trend right now is bearish.
Why is this important? Because a lot of market participants fail to trade with the trend. Since I’m not that smart nor experienced, I will quote Jesse Livermore on this subject:
I was utterly free from speculative prejudices. The bear side doesnt appeal any more than the bull side, or vice versa. My one steadfast prejudice is against being wrong. When I am long of stocks it is because my reading of conditions has made me bullish. But you find many people, reputed to be intelligent, who are bullish because they have stocks. I do not allow my possessions, or my prepossessions either to do any thinking for me. That is why I repeat that I never argue with the tape. Obviously the thing to do was to be bullish in a bull market and bearish in a bear market.
Chart 2: Percentage of stocks trading above 20 day moving average…
Source: Index Indicators (edited by Short Side of Long)
With that in mind, let us now focus on the various internals and breadth readings. The recent sell off has pushed the S&P 500 broad index into a short term oversold condition. The percentage of stocks within the index that are trading above short term moving averages like 20 day and 50 day stands at 17% and 24% respectively (refer to charts above and below).
These are rather minimal numbers that usually indicate that some kind of a rebound could occur. But it is worth saying as a side note that just because the index is oversold, does not mean selling could not continue for awhile longer and become even more oversold. During an uptrend, we saw markets become overbought and yet they kept making higher highs for months on end. While I am not predicting this, there is no reason as to why something similar could not occur on the downside.
Chart 3: …as well as 50 day moving average has dropped into oversold!
Source: Short Side of Long
If and when markets do decide to turn around for a rebound, the nature and strength of the rally should be judged with a microscope. Chart 3 clearly shows that the current price action signals technical damage in form of a breakdown from a recent two year uptrend. And while the index is oversold in the short term, keep in mind that the percentage of stocks trading above 200 day moving average is not yet oversold (longer term and more meaningful perspective).
Chart 4: New highs vs new lows ratio is most oversold since mid 2011!
Source: Short Side of Long
With quite a number of stocks breaking down, it shouldn’t be a surprise that the NYSE new highs vs new lows ratio is now very close to oversold conditions as well (refer to Chart 4). We haven’t seen a condition like this occur since middle of 2011, when majority of the market participants panicked during the US Debt Ceiling saga. Whether we are in a bull market or a bear market, oversold conditions in this indicator usually produce some kind of a rebound or a relief rally. Therefore, a further fall towards 20% or lower in the HL Ratio could produce a rebound soon enough.
Chart 5: Advance decline line and down volume is becoming oversold!
Source: Short Side of Long
Furthermore, both the advance decline line and down volume averaged over 21 days (or one trading month) is now turning towards extremely oversold level as well. We have seen this type of a condition in May 2010 during the flash crash, in August 2011 during the US Debt Ceiling saga and in May 2012 during the last leg of the Eurozone Crisis, before Draghi’s “whatever it takes” speech. For more then two years, breadth in the US has not become extremely oversold, at least based on this indicator. But today we find ourselves with a condition where selling has turned a bit extreme, in particular with the down volume.
Chart 6: One third of the S&P is trading in short term oversold territory
Source: Index Indicators (edited by Short Side of Long)
So what is next for the stock market? I understand that most traders would claim that S&P 500 might find some support at its previous trough from early August at around 1900 level. So therefore, one might assume that a rebound could occur soon enough as the price sits at this important support.
However, instead of talking about how the market is oversold from the short term, I think the more important point to make here is the breadth deterioration between the August trough at 1900 and the current internals as S&P trades at 1900.
In August about 20% of S&P stocks became oversold with RSI below 30 and about 10% of S&P stocks traded at 6 month new lows. Fast forward to today and while S&P 500 finds itself at the same level of about 1900, we now have 30% of S&P stocks with RSI below 30 and 32% of stocks making new 6 month lows. So what does this mean?
Chart 7: One third of the S&P 500 is breaking down to 6 month new lows
Source: Index Indicators (edited by Short Side of Long)
For me, it is plain and simple: a growing number of stocks are breaking down towards lower lows (definition of a downtrend), while the index itself gives the appearance of still respecting support. My view is that the market is trying to trick majority into buying this oversold dip, as if it is the same as every other dip since November 2012. However, with Federal Reserve changing its policy, the up-and-coming rebound from oversold cod notions discussed in this article could end up being a bull trap. Therefore, instead of buying a potential rebound, I would actually consider selling the coming rally.
