Wonderland: Touring the Upside-Down Room
By Frank Barbera CMT. March 17, 2009
Over the last few days, as stock prices have continued to rebound we have seen a significant number of longer-term ‘super bears’ reverse their gears and become bulls. The likes of Marc Faber, Robert Prechter, Doug Cass come to mind, as a few who have swung from the bearish to bullish camp. Looking back, we note that as recently as March 6th, at the S&P low of 667, at least a few sentiment data points moved to important extremes, the most prominent of which was the much discussed AAII Sentiment Survey, which recorded a record number of bears at 70.30% the week ended March 6th.
To make greater sense of this number, we like to NET the Bulls minus the Bears to arrive at a calculation of Net Bulls/Net Bears. We then compute an exponential five week moving average on the weekly raw data and arrive at the indicator shown in the chart below.
Historically, when the AAII five week moving average has been below –20 to –25%, it is usually a good sign that the stock market is nearing an important extreme. Unfortunately, like all indicators, the AAII survey is not perfect and in very strong markets it can stay in one area for some time. Yet, the early March reading on this gauge was quite extreme at a reading of –36%, the second most extreme reading in history going back to the 1989 time period. With the market now up 16% from those lows, the question now becomes, is the stock market engaged in a sustainable bear market rally, or is this advance coming to an end?
In my view, I would argue that at the moment, the correct view the stock market is one of ‘reversed polarities.’ Call it the ‘Alice in Wonderland’ point of view, starting as the story does in the fabled ‘Upside-Down’ room of the White Rabbit’s home. This is the tiny room Alice falls into, and from which she begins her adventure in wonderland (Lewis Carroll’s “Alice’s Adventures in Wonderland’ -1865). The room is referred to as the “Upside-Down’ room where everything is upside down on the walls and the ceiling and is the first room on the ride, Mr. Toad’s Wild Ride at Disneyland.
So too do we see a stock market climate where from the technical point of view, an inverse topsy-turvy equation is in force. Simply put, we are now at a very important fulcrum point, one of the most important points in many months; an ‘inflection point-among-inflection points.’ The larger path ahead will be decided by what happens, or what fails to happen in the days just ahead.
Within the realm of technical analysis, reverse technical dynamics now apply. To this end, with the rally trumpeting the attention of virtually every money manager with a pulse, there is potential for a major, and quite rapid sea change in sentiment. This sentiment change would be amplified greatly if prices continue to move higher from current levels with the S&P at the 760-770 range. I would argue that should the market manage to move directly higher from present levels that sentiment will quickly shift toward the bullish camp, which perversely enough will short circuit the rally leaving it as a failing bear market rally in the larger scheme of things. In fact, I would argue that if prices move still higher from here, the rally will last only a few more weeks and then yield to a renewed bear market decline and a long series of lower lows yet to come. So in this case, the short term bullish outcome is actually quite bearish.
Conversely, if prices halt the advance at these levels and begin to decline again in the near term, this could then set up the potential for what would ultimately become a much larger and more sustained stock market advance, one which could last many months. Thus, the ‘reversed-polarity’ and the ‘upside-down’ condition where a decline from here could actually be good news. It is of course ironic, as so many perceive the stock market rally as the first tangible sign of hope. For most, simple logic would argue that still higher prices would suggest that things are going to get better. Perversely, this is not likely to be the case.
From the technical point of view, the stock market lows of early March did not encompass a “well developed base.” Major bear markets invariably end and yield to bull markets with the construction of a well-developed base. To construct a well-developed base, markets need to push down, create a panic low as they become deeply oversold. From there, markets then need to undergo a rally sharply (for a time) off those lows, and then a “retest” where they go back down and revisit the original panic low. The retest portion of base construction is absolutely critical as this is the phase where lots of positive divergence is seen. It is the positive divergence on indicators of breadth, volume, momentum and occasionally sentiment, which hints that a truly sustainable turn is at hand. To date, the stock market rally of the last few days is NOT coming from a well-constructed base.
To sound a hopeful note, it should be pointed out that it is very possible that this rally could be the early indications of a base under construction, but (there is very important BUT that applies), the retest phase must be the next event to develop from here. If this is a base under- construction, and prices really are getting ready to stage an important, multi month advance, it is crucial for prices to halt the rally in this area and slowly begin to reverse lower, ultimately retesting the lows. This is the all-important next step.
Without that, the odds are high that the current rally will end up looking very much like one of the five or six stock market rally attempts seen during the Great Depression, where prices rallied sharply, but could never sustain the advance.
Above: the DJIA in the Great Depression staged at least five high percentage compact rallies, none of which ended the nightmare.
As a result, we are in a paradoxical environment, where for stock prices to truly begin a sustained advance, and truly indicate a real improvement ahead, prices need to go DOWN FIRST. DOWN is GOOD in the current climate. Conversely, at this juncture while it flies against the overwhelming instinct of the broad populace, at this moment in the great scheme of things, UP is BAD. UP from here, (present levels SPX 775) likely produces heavy overbought readings, swings sentiment to excess bullishness rather quickly, and on a contrary basis will likely short circuit the stock market rally a lot sooner rather than later. Already 15% in 7 trading days runs the risk of a rocket launch where the booster fuel is expended too soon. Once the fuel supply is expended, there is no fuel left to sustain the orbit, the orbit gives way, and the rocket burns up in the atmosphere. Thus, contrary to popular views, DOWN is GOOD.
For the stock market, a gradual decline back down to the lows over the next few weeks could allow the S&P and the DJIA to set up a potential “W” bottom complete with lots of potential positive divergence. From an engineering point of view, this is akin to constructing a proper foundation for a home. A foundation laid in haste, one with cracks, will yield an unstable and ultimately untenable structure. Conversely, a proper foundation can yield a structure that endures. At the moment we have no idea which way the market will tilt in the next 5 to 6% but we do know that an important inflection point is now at hand, and the inverse rules of Alice’s ‘Upside-Down Room’ apply. If the Mad Hatter is the dark character in the inverse world of Wonderland, today’s real world version of the Mad Hatter for the stock market has to be the financials, and most importantly the Bank stocks. In my view, the Philly Bank Index and other banking indices are engaged in a higher percentage (starting off a very low base) bear market bounce. ‘30’ is key resistance on the PHLX Banking Index. Perhaps a few more days of bounce, and then prices should roll over. A double bottom with attendant divergence would seem to be a MUST for this sector to take on a potentially healthier look, as without the Banks the rest of the market is bound to founder. In the charts which follow, I show the kind of retest decline in the Banks which would get us thinking that perhaps the long bad dream is over, and that the sun is really coming out in Wonderland. We’ll see.
Above: the GST Bank Index with Cumulative Volume on lower clip. Note that as the bank stocks collapsed into the March low, there was no divergence of any sort on cumulative volume. That means that the rally is likely a violent bear market bounce, and until a low is seen with more divergence, the odds of a final low having been seen are not high. Major trends like this seldom end in a V-Shaped low.
Above: What a real bottom might look like in the Banks, the ‘right side’ retest of the lows to form a “W” is crucial.
© 2009 Frank Barbera