The Beginning of the End or the End of the Beginning?
By Chris Puplava, November 4, 2009
The markets have corrected since peaking in the middle of October and there appears to be a decisive rift in the financial community between the bulls and the bears, with the bears calling for an end to the rally off the March lows while the bulls maintain that we remain in a cyclical bull market. Based on a few observations that will be shared below, I believe it is too soon to call an end to the current rally, though I believe a sizable correction is still in our future that may have begun from the October highs.
A Correction is Long Overdue
One tool to measure how extended the market in either direction is to measure its spread relative to its 200 day moving average (200d MA). Significantly oversold markets are identified by readings that are anywhere from 10%-30%+ below their 200d MA and overbought markets are seen with readings north of 15% from the 200d MA. You can see this in the image below in that it shows the spread of the S&P 500 to its 200d MA going back to 1928. In the span of less than a year the S&P 500 has moved from extremely oversold to overbought in vertical fashion. As the severely oversold market in March was warning of a stock market primed for a rally, the current overbought condition of the market is warning of the potential for a sizable correction. As bear markets are identified by a 20% or more decline, it would take a bear market to bring the S&P 500 back to its 200d MA from the October peak, which just underscores the risk of piling into the markets at this juncture.
What is also highlighted in the figure above is that the S&P 500 is in a similar condition to what was seen after the lows in late 1974, in which the S&P 500 displayed a dramatic rally into 1975 that catapulted the S&P 500 to more than 20% above its 200d MA. How did the overbought condition get resolved? The S&P 500 corrected nearly 15% down to its rising 200d MA and traced out a bottom for another month before rising higher, climbing in parallel with its 200d MA into 1976.
I believe we could witness a similar experience in which the S&P 500 corrects more than 15% down to its upward sloping 200d MA, which is 922.14 presently and would imply more than a 100 point drop in the S&P 500.
Breadth Deterioration Typical of Major Market Tops is Absent
One characteristic that is a hallmark of a market top is that near the end of a bull market, less and less stocks are participating in the rally with fewer and fewer new 52 week highs as the market’s bullish ranks thin out. When looking at the current picture for the NYSE, we can see below that the recent high in the S&P 500 was confirmed by net new NYSE highs and the percentage of net new lows remains absolutely silent.
In stark contrast to the current picture was the climate seen at the 2007 market top where the peak in NYSE net new highs was seen in April and began to diverge with price into the June peak as well as the October peak. What was also seen was that the percentage of NYSE net new 52 week lows began to expand as several stocks were already undergoing their own bear market. Again, even during the recent decline the percentage of NYSE net new lows is virtually zero, nothing close to the deterioration that was seen in 2007 and so market breadth is not warning of a coming top at this juncture.
One Warning Flag, the USD
One thing that perhaps could lead to a decline in the markets is a rally in an oversold USD. When analyzing the USD I prefer not to use the USD Index (DXY) as it is heavily skewed by the Euro, which represents 57.6% of the entire index with the Japanese Yen coming in at a distant second place with a 13.6% weight. I’ve created equal weight USD indices to get a better feel for how the USD is stacking up against foreign currencies. I’ve created a G10 Index (composed of the 10 largest world economies) as well as an Asian USD index.
When looking at the various USD indices, while the USD Index (DXY) has still further to go before it retests its 2008 lows, my G10 USD Index has already touched its 2008 lows and looks to be tracing out a bottom, and my Asian USD index is also quite close to its 2008 lows. The 2008 lows are a likely place for the USD to stage an oversold rally that would likely correlate with a market selloff, and we may be closer to this point than most think.
I track the 50 day moving average of the USD against 21 world currencies in order to track its breadth and I am beginning to see signs of a bottom taking shape in the USD as it is failing to fall against all 21 currencies despite making new price lows, a development last seen at the 2008 lows. You can see this in the figure below that shows in 2007 that as the USD made new lows that it was beginning to strengthen against some currencies as the % of USD currency pairs above the 50d MA was failing to reach 0% as it did at prior lows. A similar occurrence is taking place currently as the lows in the % of currency pairs north of their 50d MA has not been confirming the lows in the USD Index, warning of a potential rally in the USD.
A rally in the USD is likely to spark further weakness in the markets and help send the S&P 500 back down to its 200d MA, which just happens to be rising towards its breakout at 950, a point of resistance at the January and June highs that is now likely to act as support. Additionally, the 38.2% Fibonacci retracement level comes in pretty close to the 950 mark and will likely contain the markets leg down if in fact a correction takes hold.
If the S&P 500 does correct further risky assets that ran up the most since the March lows are likely to show the greatest weakness, as they have already done so since the October 19th top. To see the character of the decline from the recent top Bespoke Investment Group has broken out the market into 10 deciles by various variables and a clear picture emerges. Small cap, high P/E ratio, low dividend yield, high short interest, and worst analyst ratings are variables that have marked issues that have declined the most and will likely fall further if the correction continues.
Source: Bespoke Investment Group, B.I.G. TIPS (11/03/09)
At this stage in the game I think it is too early to call an end to the current cyclical bull market that began off the March lows, and I’d have to see a break below the 200d MA and key support levels to join the bear camp. While a correction in the S&P 500 down to its 200d MA from its October top would not be a pleasant experience, it is by no means abnormal as the 1975 example illustrated above shows. If the S&P 500 does correct down to its 200d MA, it will be interesting to see where the USD ends up if it rallies and how it handles key resistance levels at 78 and 80. As the 200d MA for the S&P 500 conveniently approaches key support, the 200d MA for the USD Index is also conveniently approaching key resistance at 80, which I would assume would act as strong resistance to any USD rally that develops.
Thus, if the markets correct further the S&P 500 has a strong chance of finding support at roughly the 200d MA and the USD finding strong resistance at its 200d MA near 80, which may mark the next significant leg up in the markets if the S&P 500 does undergo a correction in the intermediate term.
© 2009 Chris Puplava