(originally published for BullBear Trading Room members on 9/12/10, re-published here with updates)
In the last BullBear Weekend Report on I concluded:
...the likelihood of continued upside in defiance of bearish expectations is high. Whether this represents an intermediate term blip or something more significant is as yet unknown, although there are some long term divergences and indications that point towards a long term bullish conclusion.
We did get that continued updside, though as indicated it was limited by overhead resistance and the exhaustion of the first wave up off the low:
...the short term overbought condition could get even more overbought early this week...Most market observers are already calling for a top and this rally has been greeted with skepticism. In this context I would be looking for a sideways abc formation over the first few days of the week. Traders who are out or looking to add to their long positions could buy the a and c wave lows of wave ii ahead of iii of 3 which should rapidly take the market back to 1131 resistance.
The wave count together with certain technical indicators leads to the conclusion that the first wave is now complete or very nearly so and that we should expect a wave ii pullback this week. Bulls should welcome this as a buying opportunity, particularly fortuitous since most of us likley missed the very rapid rally from the recent low. The ensuing decline should be of sufficient depth and strength to shift sentiment back to solidly bearish in very short order, setting up a powerful iii of 1 of 3 of (3) move back above the downtrend and horizontal resistance.
To sum up the findings of this report: the advance in equities that began near SPX 1040 is most likely the start of a significant bull move, but the first leg of that move is likely at or near its end and will correct soon. Long term, there are a number of developments which auger well for the price of risk assets going forward. We are seeing significant signs of the early stages of a shift from safety back to risk as safe havens such as bonds, Yen and, possibly gold, show signs of topping out. After a brief bout of fear and selling (which bears will misconstrue as the Big Kahuna to the downside), intermediate and long term bullish forces will gain the upper hand and the market will trade higher.
SPX Chart Analysis
Let's have a look at the index comparison chart:
This chart shows that but for the Dow, all of the primary indices are challenging the primary downtrend and most closed the week above resistance. Some have taken out the June high but most have not. It's not uncommon for the first challenge of a major downtrend to fail and together with a wide variety of other technical factors this could stop the advance soon and usher in a substantive pullback.
The bullish scenario shows a reverse head and shoulders pattern in the latter stages of development. Although fairly well formed and evident, this pattern has received little if any attention (which increases its chances for completion). Symmetry with the left shoulder may call for a comparable second dip, perhaps even a double bottom. For now we will assume that, as a bullish pattern, the right shoulder will be stronger and the pullback will be more shallow. The 50% Fib retracement level seems reasonable, but rather than specific levels we will be watching for the completion of a clear three wave abc correction to set up a buying opportunity. Indeed, if the above does represent a bottoming pattern, we can see that bulls have been exceedingly patient in their purchases, waiting for a wave of panic selling to step in and buy in size. These patient, strong hands can be seen at the green arrows.
The short term chart of the move off the August 31 low shows a fairly clear 5 wave bullish impulsive move terminating with an ending diagonal wedge pattern. Although an additional push to 1115-1120 is possible on Monday, there are many technical signs which tend to strongly suggest that this first move may be overbought and exhausted. A clear break of the wedge below 1105 would likely initiate a selling wave. Wave counts on the very short term chart can be somewhat diffucult to peg and there is some risk that the count is wrong and there is still upside in this move. But then again, there are many techincal indications which support the view that this wave is complete (coming up later in the report).
Early action in the US futures and Asia has markets jumping on positive economic news out of China, so should these gains hold markets will likely open in the 1115-1120 zone.
The question then becomes will the apparent technical setup fulfill with sellers emerging and dumping into the strength or will volume increase with a power continuation of the dowtrend breakout? Basically, it's short term technicals vs. intermediate term technicals.
The weekly chart shows the lowest weekly volume this year, a sign that buyers have decided to wait for another dip. Again, the pattern has been for patient buying on the dip. Buyers are not chasing this market higher. However, the level at which buyers will have to step in and make their purchases is likely higher now as bears begin to capitulate and traders gradually shift their bias to the long side, so another test of 1040 becomes less likely.
This bearish scenario is now in play and would gain weight on a move back below the downtrend. A move to the lower rail of the triangle would certainly call for a reevaluation of any bullish thesis.
The larger bearish scenario involves a year long head and shoulders topping pattern with the final right shoulder now starting its trip to the 1040 neckline.
Both of these bearish scenarios are valid but at this time the weight of the technical evidence tends to support the bullish thesis. I might also add that bears have had repeated setups handed to them and they have failed to break the market below support. And in spite of the recent swing towards bullish sentiment in investor surveys the overall sentiment backdrop remains overwhelmingly bearish. Having said that, there are many bearish short term technical indications.
Bearish Short Term Technicals
I have already noted the low volume towards the end of the rally last week. This comes at a time when we would suppose that trading and investing activity should be picking up, not diminishing. Again, bulls are not chasing (and neither should you). We should also note that the bullish wave count supposes that we are in a 3 of (3) and such low volume does not jive with that assumption (as the very low volume August decline did not confirm a bearish wave 3 down either). Here we can see that Total Market Volume is back down to levels seen at the April top:
The following charts show very short term bearish technical divergences between the indicator and SPX price action (see the white circles). Note that each of these follows longer term bullish divergences, so the setup is for a short term pullback within the context of a larger advance.
These divergences are minor non-confirmations of the recent new closing highs, but are alarm bells worth noting. They could turn out to be nothing at all in the larger context. Here we see that the Summation Index (a longer term indicator based on the McClellan Oscillator), while not showing a divergence, is performing poorly during the rally and so far does not seem to be giving the move a vote of confidence:
Recently small caps have been performing poorly as shown by the divergence between market price and the ratio between small caps and big caps:
Put/Call Ratio Analysis
The 5 Day EMA of Total Put/Call Ratio has been an excellent timing tool with divergences signaling tops and bottoms in the market. Generally this indicator has run inversely to market price, but during this rally it has run sharply higher with the market.
There are a number of ways to interpret this technical occurence. In most cases it represents a common divergence resulting from a surge in put or call buying on the part of Equity option players. In this case the divergence is being caused primarily by a sudden, sharp increase in open interest by Index option players. Unfortunately, there is no way to know whether this represents a jump in put BUYING (bearish) or in put SELLING (bullish). Index options players are generally using options to hedge longer term positions. It is possible that they are selling put premium in a hurry to hedge short positions in the face of this rally. (Note that I do not maket he blanket assumption that Index options players are at all times "smart money"). That could be an indication of the unexpected and counter-to-anticipated nature of the rally and thus quite bullish. On the other hand, they could be buying puts in a big way in anticipation of The Great Collapse. I have seen in the past that CPC running together with the market has preceded big moves.
The longer term chart of the 21 SMA of CPC shows that the market exhibited very similar setups in 2006 and 2007 and in each case resulted in an upside continuation, not a downside break. It's worth noting the similarily between the multi-month pullback in 2006 and the current setup.
Another highly predictive use of Put/Call data is the ratio of the Equity to Index Put/Call Ratios. When Index put sellers have dominated (selling put premium as the market has climbed the wall of worry) the ratio has declined as the market has risen. When Equity put buyers have dominated (buying puts as the market has declined) the ratio has risen as the market has fallen. Recently the ratio has started to decline sharply as (apparently) Index put sellers once again take control of the options market.
Put/Call ratio data is notoriously difficult to interpret well and it is clear to me that the popular "smart money/dumb money" paradigm is quite simply erroneous. If it once worked it does no longer. Separately, Equity and Index PCR are virtually useless, however, analysis of the relationship between the two data sets via Total PCR and a ratio between the two, smoothed with a moving average, is evidently very useful.
Bullish Longer Term Technical lndicators
There are a number of indications that a longer term bullish turn in in progress. I had thought that the recent rise might continue without a substantive pullback to the 1131 resistance zone (and it may yet, as early indication in the futures markets and Asia appear to be bullish). But the following indicators do lead to the conclusion that follwing a wave ii pullback we can expect to see strong buying into the dip and higher highs for the move.
New Highs moved laterally throughout the August decline and have gone on to higher highs ahead of the market:
New Highs-New Lows Ratio chart has done a good job of pegging bottoms in the past and appears to be breaking higher:
Nasdaq 100 and S&P 500 are both breaking strongly out of declining wedges against the Dow:
SPX as measured by US Treasuries is making a double bottom and a strong breakout, showing that capital is beginning to flow back into equities from bonds:
Junk bonds are showing strength versus Treasuries, another indication of increasing risk appetite:
During the 2008 Financial Panic, the US long bond rose together with bank credit spreads as represented by the TED spread during the initial phases. Later, bankers returned from panic mode far earlier than investors as the latter continued to pile into the safety of bonds even as banks relaxed credit spreads. Finally, as markets recovered, both bonds and spreads fell together and equities rallied. We are seeing the same pattern unfold now in relationship to the Sovereign Debt panic of April-June of 2010.
While preliminary, there are signs that another measure of risk aversion, the Japanese Yen, is putting in a bottom against the Dollar:
The Australian Dollar, generally recognized as a measure of risk appetite and world economic strength, has broken out strongly and is within striking distance of fresh highs:
Commodities appear to be leading asset prices higher (as they did off the 2008-2009 lows) and the CRB is showing its 20, 50 and 200 EMAs in bullish alignment.
The Baltic Dry Index, a measure of dry goods shipping, has quietly taken out its 200 EMA. The prior decline was the subject of much bearish commentary. Now that it's rising no one seems to notice.
A variety of world stock markets are showing decidedly bullish developments.
Canada is close to its April highs:
Korea and India have closed at new highs on a weekly basis:
Emerging markets ETF has broken out of a year long diamond pattern:
London FTSE has taken out its June and August highs and its EMAs are now in fully bullish alignment and rising:
Disclosure: Long SPX