In late April, early May as the S&P 500 was hovering around the recent highs of 1420, I wrote two articles discussing market internals not being consistent with a market on the verge of breaking to new highs.
Many of these expectations have been realized as bulls have been unable to push us to new highs. The main thrust of my thinking is that the S&P 500 is locked in a range between 1310-1420.
Now as the indexes have fallen from the highs to the lower part of the range, I am noticing some positive divergences that are belied by panicky headlines and plunging prices. In fact, I think there are more reasons to be bullish here than in the beginning of the month, despite the S&P 500 (SPY) being 5% lower.
In part 1, I will be discussing the following 'green shoots':
New York Summation Index
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Despite indexes such as the Dow Jones (DIA) making a lower low, breadth is making a higher low. This is evidence that there has been less participation on this down move than the previous leg down. Just like the declining breadth kept me sanguine about the prospects of a sustainable uptrend, the positive divergence in breadth makes me skeptical of a new leg down.
That being said, price action remains weak and breadth is of no use for timing, however it can serve as sort of a check on market health.
Equal Weighted Indexes
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Although more subtle than the previous chart, the equal weighted index is not confirming the lower lows on the indexes. This chart is again showing that some are buying individual stocks in the face of weakness in the indexes. A lower low in this ratio chart, would be reason for caution and a belated confirmation of the lower lows. This chart bears continued watching.
An ETF that tracks the equal weighted S&P 500 is the Rydex S&P Equal Weight ETF (RSP).
Large Caps vs. Small Caps
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This chart is quite an encouraging sign for equity bulls as small caps have admirably weathered the recent weakness by outperforming large caps. I have placed the Russell 2000 (IWM) at the bottom of this chart. I spend most of my time discussing the S&P 500 because it is what most traders follow, however the Russell 2000 is a better proxy for the broader market.
The small caps are most leveraged to the economy, therefore when traders sense the economy is worsening, they will dump them first and vice versa for when it is improving. The iShares Russell 2000 Index ETF (IWM) is the best ETF to track this index.
Conclusion
Put a gun to my head, and I would have to say that the market has not bottomed yet and we are still due for a lower low. One of my favorite Seeking Alpha contributors, Cam Hui, frequently talks about the conflict between one's inner investor and inner trader.
My inner investor is counseling patience and waiting for more fear in the markets. When the real move up begins, there will be ample time to take advantage, and no prizes are given for identifying tops and bottoms.
On the other hand, my inner trader sees an opportunity to take advantage of oversold conditions and weak sentiment for a reversion to the mean trade. Most attractive is a tight stop loss at this week's lows to minimize losses in case I am wrong.
Further, all the divergences discussed are not causal but rather coincident indicators, therefore they are necessary for a bottom to form but not sufficient.
I hope this article was of value. In Part 2, I will be discussing more constructive developments in the market related to international markets and other pieces of evidence, showing accumulation in the latter part of this correction.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
