Hang Time
By Chris Puplava, October 7, 2009
As we entered this year after the collapse in the markets in the fall of 2008, who would have thought it possible that the S&P 500 would put in a major low and then go on to advance by more than 50%? Granted the S&P 500 underwent a mini bear market (20% + correction) within the mamma bear that began in 2007 as it plunged roughly 25% from the start of the year into the March lows, but a 50% rally in just six months is quite the feat. The S&P 500 was incredibly oversold at the March lows and was due for a rally, which stands in stark contrast to the present condition in which we are entering severely overbought territory. The question to ask now is, how long do we hang out at these overbought levels, and/or will the markets become even more overbought? Essentially, what’s the hang time before the markets return back to earth?
Similar to the gravitational force that causes objects to return to solid ground is the 200 day moving average (200d MA) for many financial markets. The mean reverting phenomena so prevalent in finance is also present in terms of financial assets with their 200d MAs which tends to act like gravity, pulling an asset towards it when it stretches too far. This concept was highlighted in April of this year (Possible vs. Probable: "So you're telling me there's a chance!") as support for why the S&P 500 would rally as it was significantly below its 200d MA. At the March lows the S&P 500 was 36% below its 200d MA, marking the most oversold condition since the Great Depression, clearly in rare territory.
So after a more than 50% run up, where are we today? The answer lies in the chart below which shows that we have undergone quite the price swing from significantly oversold to significantly overbought. The recent market peak in September witnessed the S&P 500 above its 200d MA by 20.1%, with the positive 20% level marking significant market peaks in the past.
Source: Bloomberg
While we have reached significant overbought conditions there is nothing to say the market can’t rally even further. After the bear market of 1929-1932 concluded the S&P 500 rallied to 32.4% above its 200d MA by September 1932 before it corrected back down to its 200d MA. It then staged another rally in 1933 that carried it to 56.8% above its 200d MA by July 1933. The point is that anything is possible as the 1932-1933 example illustrates in which an overbought market can stay overbought for a prolonged period of time.
Source: Bloomberg
Below you can see a similar condition today to the initial 1932 rally. The S&P 500 reached significantly oversold levels at the November 2008 and March 2009 lows followed by a significantly overbought condition today after a dramatic rally. For comparison purposes, the second chart below compares the 1929 crash and the 2008 crash in terms of the S&P 500’s deviation from its 200d MA. As shown below, both crashes witnessed the S&P 500 fall more than 35% below the 200d MA, but the current recovery rally has far exceed the 1929 rally which never materially rose above its 200d MA.
Source: Bloomberg
Source: Bloomberg
What suggests that the S&P 500 may rally even further above its 200d MA before it materially corrects is that there is no internal divergence in terms of market breadth with the recent September high that would suggest a correction or significant market top is around the corner. For example, looking at the S&P 500’s peak in the summer of 2007 shows clear deterioration in terms of market breadth when viewing net new highs and lows on the NYSE, which warned of a significant correction and a market that was in the process of topping. From April to July of 2007 the percent of net new highs on the NYSE was putting in a series of lower highs at the same time net new lows were starting to creep up, suggesting fewer and fewer stocks were participating in the rally which often is a harbinger of a coming correction. A red flag is signaled when BOTH the net new highs and net new lows on the NYSE reach 2.5% of daily trading issues, which characterizes a significantly divergent market. This condition was seen at both the July and October peaks in 2007, with significant corrections following suit.
Source: Bloomberg
In stark contrast to the 2007 July and October peaks is the present situation in which NYSE net new highs has confirmed each new rally high in the S&P 500 and NYSE net new lows remain deafly silent at 0.03%, which would indicate a healthy market rally in terms of participation and breadth.
Source: Bloomberg
While the net new highs/lows data from the NYSE does not herald a major market top, we could still be in store for a consolidation period before heading higher, or possible correct down to the August/September lows. There are a few key relationships that should be monitored to help determine whether we rally higher or continue in a consolidation period.
One relationship that might shed light in terms of the market's next likely move are interest rates. Since the March lows, intermediate (5-year) to long term interest rates have rallied as money has flown out of the bond market and some of that has found its way into the stock market. However, starting in June interest rates began to fall with bonds rallying along side the stock market, which is sending a divergent message as bonds rally on expectations of a weakening economy while stocks rally on expectations of an improving economy. However, we may soon see bonds sell off as the yields on the 30-Yr, 10-Yr, and 5-Yr UST are all bouncing off their 200d MAs and may rally ahead, which would mean falling bond prices with potential flows into the stock market. If, however, yields break through their 200d MAs and continue to fall, then the decline from the September highs is not likely over. Thus, yield movement in the UST market should be watched intently in the days and weeks ahead.
Source: StockCharts.com
Other likely key barometers that should be watched are the Chinese Shanghai Index, the Euro/Yen exchange rate (XR), and the Volatility Index (VIX). The Shanghai Composite bottomed ahead of the S&P 500 when it made its final low in the fall of 2008 while the S&P 500 corrected until March of this year. As the Shanghai served as a leading indicator to the S&P 500 there is concern regarding the Shanghai’s recent correction from its July peak and that it may be foreshadowing a top in the S&P 500. The Shanghai firmed in early September and underwent a 50% Fibonacci retracement to roughly the 50d MA before a TD Combo sell signal was given and the composite turned south in middle September. It appears that a possible “W” formation is in play with the Shanghai as it appears to have made a successful test so far of the early September lows and a TD Combo Buy signal was generated showing short-term selling exhaustion. What’s more, the Shanghai is a stone's throw away from the all important 200d MA, and overall it appears the Shanghai Composite has undergone nothing more than a healthy correction from significantly overbought conditions. A renewed rally in the Shanghai Composite would likely be viewed favorably by the market in general and commodities in particular.
Source: Bloomberg
In addition to the Shanghai Composite, serving as a potential key barometer is the Euro/Yen XR that peaked in August and has been in a declining trend ever since. The June correction in the Euro/Yen XR preceded the S&P 500 peak and the S&P 500 did an about face in early July which just so happened to correspond to the Euro/Yen XR undergoing a successful test of its 200d MA. For this reason a successful test of the 200d MA by the Euro/Yen XR from last week may also be signifying a general market bottom as the Yen-carry trade appears to be in play as the Yen has not strengthened significantly relative to the Euro as it did last fall.
Source: Bloomberg
Source: Bloomberg
One big fly in the ointment since July has been the VIX. Since July it has been stuck in a trading range as it bounces above and below the 50d MA with the 200d MA falling closer to current prices. If the VIX breaks out from its trading range a test of the 200d MA is likely which could lead to the stock market falling further while a break down from its recent trading range would likely propel the market to new highs.
Source: Bloomberg
In summary, the S&P 500 is currently significantly overbought in terms of its relation to its 200d MA, but its hang time in overbought territory may continue if we see a sell off in bonds and a rally in the Shanghai Composite and strength in the Euro/Yen XR. Overall NYSE net new highs/lows data does not suggest a major market top at this juncture, but whether the correction from the September highs is over remains uncertain with the key market barometers highlighted above likely to help paint the picture in terms of the market's next move.
Chris Puplava
© 2009 Chris Puplava
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Christopher M. Puplava
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