Among the many problems plaguing the broad market in the previous months, a lack of synchronization among the market’s main pillars of strength was perhaps the most prominent. Students of market analysis are aware that a strong market environment is typically characterized by a harmony of the tape, including strength in some key indices and measures of market breadth. As it turns out, most of these key components are getting back in sync now that a short-term bottom has been confirmed. We’ll go over them in today’s report.
One of the most valuable lessons I learned when I entered the financial market business over 20 years ago was the five basic signs of how to recognize a stock market bottom. This list of five measures of broad market strength was brought to my attention by the late Ralph Bloch, who for many years was the chief market technician at Raymond James. This list emphasizes the need for all five components to be in sync when the stock market is trying to recover from a major decline. When all five components line up, it’s generally safe to assume that the market is well on its way to a sustainable recovery. Over the years, I always ask myself these five questions after the market has bottomed and has begun a recovery rally. Let’s take a look at the list.
- Is the NYSE advance-decline (A-D) line in sync with, and preferably leading, the major averages?
- Does the Dow Jones Transportation Average confirm the Dow Industrial Average?
- Does NYSE trading volume confirm the rally?
- Is investor sentiment mostly negative?
- Do the NYSE new 52-week lows remain below 40?
A quick check of the above list returns a definite “yes” to each of the five questions. Starting with the first question, the NYSE advance-decline line is confirming the rise in the major indices. In fact, when we compare the A-D line with the benchmark S&P 500 Index (SPX) from a ratio perspective, we find that the A-D line is in fact leading the stock market. The following graph illustrates this leadership of market breadth. The significance of this sign cannot be understated, for rising market breadth is one of the most basic signs of a strong and healthy stock market. Thus we have an important indication that the rally now underway is potentially more than just a dead cat bounce.
The next question concerns the health of the extremely important transportation sector. The famous Dow Theory states that in a bull market, the Dow Transports should confirm the movements in the Dow Industrials. This is especially true at critical turning points. The Dow Jones Transportation Average (DJTA) has recently established a bottom as evidenced by the series of higher highs and lows in the following graph. Granted that the Transports aren’t leading the Industrials right now, but at least there is a confirmed rally in the DJTA. This is the minimum requirement for a sustainable bottom.
Trading volume on the Big Board has also confirmed the rally of the last several days. This is easily discerned by the fact that advancing volume has outpaced declining volume on a cumulative basis during the January rally, as confirmed in the chart below.
Sentiment is also still negative according to some widely watched indicators of investor psychology. The latest readings in the CNN Business Fear & Greed Index have been around 30 (out of a possible 100) in recent days. A reading of 30 means that only 30% of the components which comprise the index are currently bullish. This is also regarded as a clear-cut “fear” reading, according to the structure of the index. With fear still present among retail investors, the implication is that there is plenty of short interest to fuel an additional rally in the stock market. The current readings are therefore bullish from a contrarian’s perspective.
Another well-known gauge of market sentiment is the Rydex Funds Nova/Ursa Ratio Sentiment Indicator. This indicator measures the optimism or pessimism of investors in the Rydex series of bull/bear funds. When the ratio falls below zero, the majority of fund traders are considered to be bearish, and vice-versa. As the following chart exhibit shows, most fund traders are currently bearish on the broad market outlook. In fact, the Rydex ratio indicator recently hit one of its lowest reading in many years which suggests an outright capitulation on the part of the bulls. This is also encouraging from a contrarian’s perspective.
Source: Market Harmonics
The final consideration in the list of the stock market’s five most important factors is the number of NYSE-listed stocks making new 52-week lows. This is a key measure of the incremental demand for equities and forms the most important aspect of my daily reading of the “tape”. Historically, when there are fewer than 40 stocks making new lows over a period of several days, the market is considered to be in a healthy state. If there were more than 40 new lows right now, it would certainly be a reason to question the strength of the market’s rebound. But with new lows having collapsed to well under 40 in the last several days, the indications are good that selling pressure has dissipated and that the recovery has legs. Below is a histogram which shows the sharp decline in the number of daily new 52-week lows.
In summary, all five major components of a worthwhile market bottom and sustainable recovery are now in sync. This marks a dynamic shift in the stock market’s internal health from the last four months. It’s also a reason for shifting from pessimism to optimism if you are an investor. As long as these five key components of market strength continue to improve, investors should maintain a bullish bias and expect better things ahead for the stock market. On a strategic note, investors should also focus on the strongest performing sectors and industries, including consumer staples, gold mining, and pharmaceuticals.
Disclosure: I am/we are long IAU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.