Bull or Bear Market? July Sets Up to Be the Ultimate Test

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 |  Includes: DIA, QQQ, SPY
by: Financial Sense

By Chris Puplava

Prior to the early May peak in the markets, most investors and financial pundits were convinced we were still in a bull market and would see higher prices into the end of the year. Bullish sentiment was elevated, fear levels were low, and the economy appeared to be chugging along just fine. Two months later and after an 8.2% decline in the S&P 500 (NYSEARCA:SPY) the words 'bear market' resurfaced and fear and anxiety levels spiked.

Over the last two weeks, the S&P 500 stabilized and held the important 200 day moving average (200 DMA) and also reclaimed its 50DMA in the process, though it is still below the early May peak of 1370.58. So the question many are asking is, is the bull market peak in or did we just go through a healthy pullback in an on-going bull market? While no one has a crystal ball and can predict what the stock market will do over the course of the next year, there are many traits of a topping market that one can identify that illustrate a market that is losing steam and transitioning into a bear market. The strength and pervasiveness of this next rally will show the true character of this present bull market. If the rally is weak then we will begin to see traits of a topping process. Iif the current rally is strong then the bears will have to wait to come out of their lairs.

No Bear Market Warnings Signs Prior to May Peak

The stock market is more akin to a large oil tanker than a speedboat; it usually does not turn on a dime, particularly in transitioning from a bull market to a bear market. Thus, it is not that difficult to see the market begin to top just as the turning of an oil tanker takes considerable time and is hard to miss. The reason why the topping process is slow and visible for those looking beneath the surface is that the stock market is a collection of hundreds and thousands of individual stocks. It is only when enough individual stocks roll over into their own private bear markets that the more publicly viewed indexes and exchanges roll over as well.

Another analogy is the changing weather seasons. A bull market transitioning into a bear market is similar to the change from fall to winter. Looking at the trees you can first begin to see them lose color (akin to the market losing momentum), and then the leaves begin to fall. First there are a few here and there and then later you see leaves falling consistently to the point where there are no leaves left on the tree. Similarly, as mentioned above, the topping process starts first with individual stocks that refuse to participate in the rally and roll over. At first there are a few stocks making new 52-week lows and then after time, their ranks begin to swell such that the number of new 52-week lows trumps the number of new 52-week highs. And then enough stocks are declining to pull the entire index or exchange down as a bear market gets underway.

In regard to looking at 52-week highs and lows, there was not enough deterioration heading into the May 2011 peak to suggest that a top was in for the markets. Typically there is a handoff that is visible between the bulls and bears as a market transitions from a bull to bear market and vice versa. For example, looking at 52-week high and low data for the NASDAQ (NASDAQ:QQQ) and the NYSE for the 2000 and 2007 tops, clearly shows this handoff. It occurs when the peaks in new 52-week lows during corrections are greater than the peaks in new 52-week highs during the prior rallies.

Shown below is the peak of the NASDAQ in 2000, along with new 52-week highs and lows on the bottom. Looking at 1999 through early 2000, you can see that the peaks in new 52-week highs (green line) are higher than the peaks in new 52-week lows (red line). This changed by mid-2000 as the peaks in new 52-week lows were higher than the peaks in 52-week highs as more and more stocks failed to participate in the rally. From mid-2000 through 2002 the peaks in new 52-week lows continued to exceed the peaks in new 52-week highs, which is the hallmark of a bear market.

Click to enlarge:

nasdaq
Source: Bloomberg
(Click here for larger image)

While this handoff from the bulls to the bears in the NASDAQ occurred in 2000, the handoff occurred two years prior in the NYSE (as it was not as dominated by technology stocks as the NASDAQ was). Then the Asian Currency and Long Term Capital Management (LTCM) crises took their psychological toll in 1998, in which new 52-week lows began to exceed new 52-week highs.

Click to enlarge:

nyse composite
Source: Bloomberg
(Click here for larger image)

This same handoff was present in the last bull market peak in 2007. In 2003, there was a huge surge in new 52-week highs that dwarfed new 52-week lows; a signal that the bulls were now in control of the market. While new 52-week highs continued to exceed the peaks in new 52-week lows throughout 2003 to mid 2007, they did not dominate. This was seen on the NYSE, given technology was weak as it was still recovering from the excessive valuations of the tech bubble in the prior decade. However, in the summer of 2007, new 52-week lows spiked well above peaks in new 52-week highs and marked the tipping point of the NASDAQ transitioning into a bear market.

Click to enlarge:

nasdaq
Source: Bloomberg
(Click here for larger image)

Like the NASDAQ, new 52-week highs on the NYSE surged in 2003 to signal a new bull market and peaks in new 52-week highs were well above peaks in new 52-week lows well into 2007. Similar to the NASDAQ, peaks in new 52-week lows surged during the summer of the 2007 correction to mark the transition into a new bear market.

Click to enlarge:

nyse exchange
Source: Bloomberg
(Click here for larger image)

Looking at the present situation, we can see that since the bull market began in 2009. We can see that the bulls have maintained control as peaks in new 52-week highs have exceeded peaks in new 52-week lows. While there is a clear momentum loss in new 52-week highs, there is no major momentum thrust in new 52-week lows to signal the market is transitioning into a bear market.

Click to enlarge:

nasdaq bulls
Source: Bloomberg
(Click here for larger image)

Looking at the NYSE, the picture is even more bullish as new 52-week lows have remained milder than on the NASDAQ. And the peaks in new 52-week highs are clearly above the peaks in new 52-week lows.

nyse
Source: Bloomberg
(Click here for larger image)

Looking at the S&P 500 over the last few months shows the market is still healthy. For example, at the March low, only five stocks within 500 in the S&P 500 were making new 52-week lows. Meanwhile at the peak this year in early May, 25 stocks within the S&P 500 made new 52-week highs and 0 made new 52-week lows. This showed the peak in new 52-week highs was five times the number of new 52-week lows in the prior trough. During the recent correction, there were four new lows on June 16th. When the S&P 500 retested the 200 DMA on June 23rd, there was only one new 52-week low and there were actually two stocks making new 52-week highs. Looking at the data for the S&P 500 today shows 57 stocks hitting new 52-week highs and 0 new 52-week lows. This is an even stronger picture than earlier in the year. As mentioned above, the May peak showed five times as many new highs as was seen at the prior bottom. Today shows more than 10 times the number of new 52-week highs than was seen at the June low. This is not the stuff of a market in the process of topping out.

Click to enlarge:

sp500
Source: Bloomberg
(Click here for larger image)

While Market Posture Remains Healthy, Headwinds Remain

It is never wise to be a “perma-bull” or a “perma-bear” as you are going to be wrong at some point, and not without a cost to your portfolio. Instead, the most successful investing practice is to remove one’s bias and look at incoming data and then take a weight-of-the-evidence approach to the markets and economy. It is for this reason in my early June article (“In the Words of William Wallace: “HOLD…HOLD…HOLD”), that I said the following:

In short, just as I saw bullish signs to suggest that the 2007-2009 bear market was coming to a close but not quite yet, I see some bearish signs which indicate the present bull market is beginning to show its age but do not yet feel a bear market has begun and that the bulls remain in control.

While the technical picture does not suggest a bull market peak is in, there are still many headwinds that pose risk to the market and economy. These may eventually prove too much for the bulls to contend with, which is why I remain cautious at this time. Last week I highlighted that global monetary policies were seeing their efforts play out in an attempt to slow overheating economies and why economic risks are still to the downside (“Global Monetary Tightening Taking Its Toll, Risks Mount”). These risks are being overshadowed today as the bulls argue the current weakness in the economy was only temporary, as seen by a rising ISM Manufacturing Index for June. However, a temporary uptick in the ISM Manufacturing Index was to be expected, as both our Monetary Flow Indicator and sector relative performance numbers were suggesting. The key is what comes next. Both indicators suggest the ISM Manufacturing Index declines for the remainder of the year, falling below the key 50 level which would indicate a contracting economy.

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money flowing
Source: Bloomberg
(Click here for larger image)
ism money flow
Source: Bloomberg
(Click here for larger image)

If both of the indicators above are correct in illustrating that the ISM should continue to decline for the remainder of the year, then we are likely to witness a temporary reprieve this month. Bearish sentiment and oversold conditions are worked off to set up for the next decline in the markets that continues through most of the remainder of the year. If this is to be the case, then we would likely see the S&P 500 fail to exceed its May peak of 1370.58. The number of new 52-week highs will contract and new 52-week lows should begin to expand. Additionally, the weekly RSI for the S&P 500 should diverge significantly with price as it did in 2000 and 2007 (see red arrows in RSI versus green arrows in price). They would then subsequently decline below 40. However, if new 52-week highs remain strong and the weekly RSI for the S&P 500 remains above 40 and does not diverge with price, then the market is likely discounting a stronger economy and possibly more monetary easing by the Fed.

Click to enlarge:

spx rsi
Source: StockCharts.com
(Click here for larger image)

Summary

The hallmark of a market in the topping process is a weakening of breadth in terms of expanding new 52-week lows that take the dominant position over new 52-week highs. This has yet to be seen in this cyclical bull market and so the bulls remain in charge. However, various economic and market leading indicators suggest a temporary reprieve during July, but then a resumption of a weakening economy and stock market through the remainder of the year. If these indicators are correctly forecasting a market and economic decline through the second half of the year, then we should see a contraction in new 52-week highs and expansion in new 52-week lows. We should also see a divergence in momentum, such as the weekly RSI for the S&P 500. However, if these bearish developments do not materialize, then the underlying economy and market are stronger than leading indicators are suggesting and/or the market is discounting potential Fed easing to address the economic weakness. It is for this reason that July is likely to prove a pivotal month for the markets as the current rally’s strength and breadth will likely answer the question of whether a bull market peak is in or if this was just a healthy pullback in a continuing bull market. The stage has been set and now we watch the actors perform and then judge the strength of their performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.