Scoping Out the Climate for the Next BIG Stock Market Top

By Frank Barbera CMT. September 2, 2008

Since mid-July, stocks have experienced a lot of short term volatility with the DJIA posting 13 sessions of the last 30 days with daily closes in excess of 150 points up or down. Today, was more evidence of this wild volatility with the market soaring higher at the opening and then giving back all of the gains. Since roughly mid-July 18th to present, the net gain thru last Friday's close was only a gain of 47.39 DJIA index points -- how ironic. Essentially, stocks have been riding the roller coaster up and down, but overall have really been going nowhere fast. Unfortunately, this is not a good sign in the larger outlook for stocks as very substantial oversold conditions, which had previously built up going into the lows in March and in mid-July, are beginning to unwind without the market averages having made enough progress to reverse the larger bearish tide. This type of failing price action is indicative of bear market rallies, rallies ultimately pre-disposed to roll over into even larger declines.

So let’s go through some key gauges and see where things stand. One place we usually start is with the various ARMS Indices. Also known as the TRIN, the ARMS Index measures the degree of buying pressure taking place in the market versus the amount of selling pressure. In our work, we keep several versions of the ARMS Index which can help alert us to more important Intermediate Highs and Lows. In the chart below, we show our Medium Term ARMS for 1500 stocks, compared to the S&P 500 Index. In the recent past, and as is typical in bear markets, values down near .90 or lower can indicate bear market rally peaks. By this measure, the stock market could soon be skating on thin ice as the last week or two have produced a series of readings between .85 and .90.

Above: Medium Term ARMS Index

Yet it is possible for this gauge to move even lower with readings in the .75 to .85 range marking historical extremes in overbought conditions. With a closer study, we noted recently that looking back over the last two decades, the recent period of time has been one of the longer periods in which the stock market was able to remain depressed and NOT produce an extreme overbought value below .75 on the Medium Term ARMS. In the chart below, we show data going all the way back to 1986, for the Medium Term ARMS in the middle clip. At the bottom, we show a Time Span Counter that counts the number of days in which the market has gone without generating such a fully overbought value below .75. At present, it is has now been 385 trading sessions without such a reading. This means that the current rally may have more time involved before stock prices are ready to roll over into the next big decline. In our view, a few more weeks is possible leading into a very important medium term peak.

Above: The S&P 500 (top), the Medium Term ARMS (middle) and Time Span Counter (lower)

Looking back at some of the past bear market action, we see that the ARMS Index has a very long history of doing a good job at pinpointing important bear market rally peaks. In the 2000 to 2003 super bear market, the absolute bull market high was seen in mid March 2000, with the S&P closely approaching those highs in mid-April 2000. On April 12th and 13th, ARMS Index values plunged to .7608 and .7151 respectively, virtually calling the major market peak. This was followed by a long string of good calls including a value of .8203 two days after the November 2000 peak on November 9th, 2000, a reading of .8141 on February 2nd, 2001, a reading of .7477 on May 11th, 2001 four days ahead of the May 21st very major peak, and then virtual bulls eyes on November 27th, 2001 at .7427 and March 18th, 2002 at .7697. Had a trader taken heed of these low ARMS Index values, most of the damage from the bear market could have been avoided.

Above: The Medium Term ARMS and the 2000 to 2003 Bear Market with highlights on Overbought values below .85, in the .75 to .85 range. From left to right, peaks in the market in April 2000, November 2000, February 2001, May 2000, November 2001 and March 2002 were all highlighted by very low ARMS Index values.

Going back even further, we can revisit the bear market action of the stagflationary seventies which produced several powerful bear market declines. In the great bear market of 1973-1974 there were three substantial bear market rallies which each ended with medium term ARMS Index values below .85, and in the range between .75 and .85. The dates are as follows: October 3rd, 1973 and October 11th, 1973, readings of .813 and .842 respectively. The second cluster was seen on March 12th and March 14th, 1974, with readings of .761 and .752 respectively, and then a third cluster on June 11th and 12th, 1974 with readings of .740 and .75 respectively. Moving onward to the 1977-1978 bear market, a cluster of readings on Jan 7th and Jan 10th, 1977 (.830 and .825) called a very major peak which was later followed by lower highs on July 1st and 5th, 1977, .650 and .671, and then November 22nd and 23rd, 1977, .702 and .718 respectively. During the 1980-1982 Bear Market decline, peaks in the averages were seen with ARMS Index values in the range of .75 to .85 on June 19th and 22nd, 1981, .781 and .797, on December 8th, 1981, .810, and May 10th and 11th, 1982, .673 and .686 respectively.

Above: The Medium Term ARMS during the Bear Market of 1974 with three readings in the .75 to .80 range pinpointing three outstanding selling opportunities. Peaks in October 1973, March 1974 and June 1974 each led to further bear market declines.

Above: The Medium Term ARMS during the Bear Market of 1980-1982 again three very low overbought values between .75 and .80 highlighted important market peaks during the bear.

Above: The Medium Term ARMS and the 1977-1978 bear market again, low values on the ARMS Index pinpointed the highs of the more substantive bear rallies.

In addition to our Medium Term ARMS Index, we also recently did some work with an even longer-range version of the ARMS which covers a period close to 5 months. We were surprised to see that on July 22nd, 2008, this indicator actually closed at a reading of 1.21 which was the highest, most oversold reading seen since the March 2003 major lows. Typically, readings on this gauge between 1.10 and 1.20 have often marked very important stock market bottoms, so we need to treat this reading with respect. To that end, this may explain why the stock market has been fairly resilient thus far in terms of prices NOT going down, despite the fact that a lot of very negative news has continued to stream forth over the last few weeks. Again, the prior bear market of 2000 to 2003 may be the best guide. To this end, we note that important price highs during that bear market were seen on August 29th, 2000, January 31st, 2001, May 21st, 2000 and March 19th, 2002. In each case, the very long term ARMS Index values were as follows: August 29, 2000, .9623, January 31, 2001, .9384, May 21st 2000, .9630, and March 19th, 2002, .9435. In all cases, the medium term highs were seen with readings between .90 and 1.00.

As of this past Friday, this gauge closed at 1.051, still well above this zone. In my view, this implies that the stock market counter-trend rally of the last few weeks probably still has a bit further to run, if not in terms of price, most certainly in terms of some additional time. I also believe that within a few weeks it is possible that both ARMS Index series could be generating full scale sell signals all over again. This would be especially likely if the S&P had an upward bias over that period of time.

Above: Very Long Term ARMS Index

In addition to our ARMS Index moving averages, we still see a mixed picture on the technical front. In the bull case, we can list the following gauges as all arguing for additional time spent in the counter-trend rally phase. Using the daily A/D Line for our universe of 1,500 stocks, we plot a 200 day moving average on the A/D Line and then plot the difference between the A/D line and its 200 day moving average. This oscillator shows us when the broad mass of stocks is extended down and away from its long-term trend. To interpret the gauge we have horizontal lines at +3,000 overbought and –3,000 oversold. At the recent July 14th panic low, a reading of –3,103.96 marked the extreme July bottom. Since then, the indicator has recovered back up to
–984.50 as of last Friday, but has not yet moved back to zero. The mid May high was seen at a reading of –334.72; just under zero. As a result, we can argue that a couple of additional weeks would allow this gauge to continue to unwind the oversold condition back to a more neutral value which could attend a more important bear market peak. In addition, we also track a number of important sentiment gauges which have been very slow to come off the recent lows. Among these we track a composite gauge of all four major sentiment surveys, the Investors Intelligence Newsletter Poll, MarketVane, Consensus Inc, and the AAII (American Association of Individual Investors). So far, our Composite bottom at –22.17 in the last week of July has recovered to a reading of –9.09 as of this past Friday. Here again, more typical bear market rally peaks have been seen with this gauge closer to +10, then –9.00, so there is an argument that sentiment has room to improve before the market peaks. Ditto the AAII four week moving average which is very volatile, but which also has not yet moved back to the kind of hopeful mindset which we would expect to see at a more important bear market high.

Above: Detrend Oscillator with 200 day Moving Average Daily Advance Decline Line

Above: GST Sentiment Composite – MarketVane, Consensus Inc, Investors Intelligence, AAII.

Above: AAII Sentiment Survey Poll – 4 week moving average Bulls Minus Bears

Above: CBOE Weekly Options A/D Line with 9 week RSI on A/D Line.

Two other gauges also appear to have more running room to reach overbought conditions. Of these, the first is the Options A/D Line. Each week, I compile what I call the CBOE Options A/D Line which is a gauge based on how many options contracts rose and fell that week. To compute this gauge I label Rising Calls and Falling Puts as Bullish forces, and Rising Puts and Falling Calls as bearish forces. I then compute a weekly A/D Ratio which I plot as a cumulative sum. This is shown on the top clip of the chart above and represents an excellent trend gauge as to the true direction of the broad market. At the moment, there is formidable Double Top on this gauge with the ratio sluggishly clawing its way back to the underside of resistance and a now strongly declining long term moving average. Looking back at bear market activity, Ie plot a 9 week RSI on the CBOE A/D Ratio and note that often the RSI will peak in the low positive figures within the context of a continuing bear market. Here again, with this gauge at +49.90, there is still room on the upside where bear market peaks are often in the +55 to +60 range. Like the other gauges, this upside could be quickly exhausted over the next few weeks.

Above: Operating Company Only 10 day Put-to-Call Ratio

The second indicator which I still see as fairly high is the medium term Put to Call Ratio. Thus far, this gauge has not come down very far from the upper band, an area which usually marks important bottoms. While it is possible we could see a rather dramatic swing to the downside in coming weeks, so far, the message from this gauge still suggests excessive bearishness and is decoupling rather sharply from the VIX Index, which has already come down by a very substantial degree. Current VIX Index readings are quite low, and would be a gauge in the corner of the bears. As a result, I believe the S&P will continue to maintain a largely sideways trading pattern, similar to the last few weeks with lots of volatility on both sides of the zero line. In addition, I would also expect a slightly upward bias to the price structure of the S&P which could end up peaking in the 1320 to 1340 range sometime in late September/early October. For now, it appears that stock prices will be relatively buoyant heading into the Presidential Election, but in my view could be setting up another major top a few weeks ahead of the November ballot. If my hunch is right, the downside fireworks could begin in earnest post the November outcome and trend strongly to the downside for months on end thereafter. As a final thought, I continue to focus on the Financials as perhaps the key indicator for the beginning of the next big stock market decline and so far, the ARMS Index for Financials has not yet moved to overbought values, even though it has come down tremendously from its July oversold extremes.

Above: GST Financial Banking Index with Medium Term ARMS for Financials.

At the close, stock prices reversed course as the strong early morning gains turned into afternoon losses. The DJIA lost 26.63 index points to close at 11,516.92 for a loss of 0.23%. The S&P 500 shed 5.257 to finish at 1277.58 for a decline of 0.41%, while the NASDAQ Composite lost 18.28 index points or 0.77% to finish at 2349.24. Yields on the 10 Year Bond ended at 3.746%, with spot Gold ending down $12.25 to finish at $805.45.

That’s all for now,

Frank Barbera

© 2008 Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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