A Bipolar Market
By Chris Puplava, July 15, 2009
It was only a few days ago when everyone was commenting on the head and shoulder topping pattern and expecting a decline in the S&P 500 to the low 800s. CNBC anchors who know nothing of technical analysis were even commenting on it as the financial media were all abuzz with the pattern, with Google Trends key word search showing a dramatic increase in Internet search and news reference volume highlighting the frenzy behind the pattern.
Google Trends Key Word: “Head and Shoulders Pattern”
Often at times when everyone has the same view of the markets and have positioned themselves in a similar manner, the market will end up doing the very opposite of what market participants expect, with this week's action in the stock market a perfect example. The S&P 500 initially broke its neckline late last week and quickly recovered this week back up to its right shoulder, and it appears as though we are currently stuck in a trading range between 870 and 956 on the S&P 500. The question now is which will be the final outcome, a break above resistance or a break below support?
Support for the Bulls
Besides the fact that the S&P 500 held support near the May lows and has rallied strongly over the last few days, there are other positive developments in the markets. Not only did the S&P 500 hold above its 200 day moving average (200d MA), but so too did the Euro/Yen exchange rate (EY), which has been an excellent barometer for market risk aversion. The EY exchange rate served as a leading indicator for the market as it peaked in August of 2008 and warned of increased market risk aversion that came a month later and also pointed to improving conditions this year as it bottomed in February and failed to break its October lows. From October of 2008 to early March of this year the EY traced out a base (Base 1) and then broke out to form a second base (Base 2). As seen in the figure below, the EY is currently sandwiched between the 50 day moving average (50d MA) from above (red line) and the 200d MA as support below (green line). As long as the EY can hold the 200d MA and stay within Base 2 the stock market is likely to also hold, while a break back into Base 1 would be bearish. Similar to the EY is my Yen-Carry Index which is an equally-weighted composite of eleven Yen currency pairs. Like the EY currency pair the Yen-Carry Index is holding above its 200d MA and remains within Base 2.
An additional bullish support for the markets is that my Stock-Bond ratio is now back above the early January and May highs and the 20 day exponential moving average (EMA) has failed to cross below the 40 day EMA as it did at the end of last year’s spring rally, with the RSI of the ratio moving back above 50 into bullish territory.
Another positive is that the spread between B-rated corporate bond yields and 10 year US Treasuries continues to contract (shown inverted below) and Moody’s corporate BAA yields are also contracting, making it cheaper for companies to finance projects.
Of the most glaring inconsistencies in the rally off the March lows relative to prior bear market bottoms is a lack of volume. A hallmark of bear market bottoms is an expansion of volume as buyers aggressively purchase stocks with growing enthusiasm, and that dynamic has been absent since the March lows. One of the most fundamental laws of economics is the law of supply and demand, where rising demand and falling supply lead to rising prices. Similarly, rising investor demand for stocks and a decline by investors to sell leads to rising stock prices. Lowry Research has indicators that measure the demand (buying power) and supply (selling pressure) of the stock market, and have maintained their database going back to the Great Depression.
What is most troubling is that Lowry’s Buying Power Index peaked in May and subsequently fell below the March 9th lows while their Selling Pressure Index is also on the rise and approaching its peak seen in November of last year. Discussing this trend is Paul Desmond, President of Lowry Research in a video clip below from late June:
Source: CNBC, 06/24/2009
Also supporting the observations of Lowry Research is that there has been a declining trend in the NYSE up volume as a percentage of total volume, which peaked in March and has had a series of lower highs since. Perhaps a key tell to the market’s next direction will be a resolution of the key test coming up as the percentage of up volume to total volume on the NYSE is nearing its declining trend. A break through declining trend line would be bullish as it would signal greater accumulation while a retreat from the trend line and a break below the May and June lows would be bearish.
On the economic side, what also signals that more improvement needs to be seen in the economy before the markets give the all clear sign are the employment diffusion indexes and Philadelphia Fed State Diffusion Index. The S&P 500 witnessed a sizable advance in 2001 as the economy was beginning to move out of recession, but the bounce proved fleeting as the stock market fell to new lows. The manufacturing and non-manufacturing employment diffusion indexes improved in 2001 but did not show a greater number of industries hiring than firing (readings north of 50) until 2003, which was the year the stock market finally bottomed. Similarly, both employment diffusion indexes have improved this year but are far from moving above 50 and signal greater economic improvement needs to be seen for a sustainable stock market rally.
Along the same lines, the Philadelphia Fed State Diffusion Index remains deep into negative territory as it is currently below the deepest reading seen in the last recession, and shows no sign of real improvement as virtually every state is stuck within recessionary territory. It was only when the diffusion index broke above 50 in 2003 that the S&P 500 witnessed its final bottom.
Given the support for both the bull and bear camps above along with a host of other indicators on both sides, perhaps the best action at this point is to step back and let the markets tell us where it's going rather than make any bold predictions. Recent action in the markets over the past two months has frustrated bulls and bears alike as the trend remains uncertain and humans loathe uncertainty. With many indicators approaching key tests and levels we may not have too long to find out what the markets direction will ultimately be.
© 2009 Chris Puplava