Breadth Supports Continuation of Bull Market, Though Risks Remain for a Correction in Near Term
By Chris Puplava, April 21, 2010
Co-Manager of PFS Group's Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account
Stepping back and taking a weight of the evidence approach to analyzing the stock market and economy suggests that the economic expansion that began last year continues, and so too the cyclical bull market that was given life in March of 2009. The biggest support to this opinion comes from looking at both economic and stock market breadth, which shows strong participation in the stock market and improving economic statistics in which the economic recovery is spreading. That said, there are several reasons to expect some type of pullback in the near to intermediate future before the market stages its next strong leg up, and at a minimum argues for a level of caution.
One of the best analogies I have heard of the evolution of a bull market top was given by Paul Desmond from Lowry Research Corp., who described an approaching bear market much like the approach of winter. Just as winter does not occur overnight, neither does a bear market. The tell-tale sign of winter approaching is watching leaves fall off trees one by one and a general decline in temperatures. Similarly, when a bear market is approaching more and more stocks on an exchange or broad market index like the S&P 500 begin to roll over into their own individual bear markets to the point where there are enough stocks falling to bring down the overall market. Additionally, like a general decline in temperature marks the transition from fall to winter, so too does a loss in momentum mark the transition from a bull market to a bear market.
Back in January I penned a piece that looked at economic and technical breadth which suggested a bear market was not on the immediate horizon (Market Tops are a Process, Not an Event). Today’s piece is an update of that article and, like the readings in January both economic and technical breadth indicates that the transition from fall to winter has yet to occur and suggests the beginnings of a bear market are likely months away.
Technical Breadth Remains Bullish
As stated above, one of the hallmarks of a developing bull market peak is that fewer and fewer stocks are making new highs, which shows up as a decline in the percentage of NYSE listed issues making new 52-week highs. A healthy market trend is one in which the progressively higher peaks in the stock market are confirmed by progressively higher peaks in the percentage of NYSE issues making new 52-week highs. As a bull market top begins to form the percentage of NYSE issues making new highs falls while issues making new 52-week lows begins to rise. This is what we saw in 1999-2000 and 2007-2008 as seen in the figures below.
Looking at the current situation of new 52-week highs and lows on both the NYSE and NASDAQ show new highs confirming the recent new bull market high in the exchanges while new 52-week lows are silent.
Looking at 52-week lows/highs can be problematic depending on one’s point of reference. For instance, for many stocks to make new 52-week lows they would have to drop below the lows seen at the March 2009 bottom, which could represent declines of more than 50% before such an event would occur and would not provide much of an early warning as was the case in the mature 2000 and 2007 bull market tops.
While using 52-week data may be problematic, even looking at six month data shows a very healthy market in which new six month lows are virtually non existent while new six month highs remain strong. I look at the 60+ industry groups within the S&P 500 and calculate the percentage of industries making new six month highs and lows. Back in 2007 the percentage of industry groups making new six month highs was much weaker at the October 2007 peak than the July 2007 peak, while at the same time the percentage of new lows was rising, indicating an unhealthy market.
In stark contrast to 2007, the percentage of industry groups making new six month lows is almost indiscernible and what makes the new lows data even less concerning was that for the industry groups making new lows the bulk came from traditionally defensive areas such as telecommunications and utilities. What was of concern was that in the final months of 2009 the percentage of industries making new highs weakened, which in hindsight was warning of a coming intermediate correction that took place in January and February of this year. However, since it was an intermediate top and not a bull market top the percentage of new six month lows was muted during the correction, and new six month highs expanded significantly off the February lows and shows a healthy rising trend. As of April 15th there are 0% of the S&P 500 60+ industry groups that are making new six month lows.
In addition to 52-week highs/lows confirming the recent cyclical bull market high is the cumulative advance decline lines on various indexes and exchanges. For example, in addition to the S&P 500 advance/decline line breaking out to a new bull market high were the advance/decline lines for the NYSE and AMEX, all showing a broad participation in this market rally in which the leaves are clearly still on the tree, so-to-speak.
Economic Breadth Continues to Broaden Out
Turning now to economic breadth measures, an indicator I particularly pay close attention to is the Philadelphia Fed State Coincident Index. My personal indicator is to take the percentage of states whose coincident indexes are rising on a monthly basis. Prior to the onset of a recession and bear market the diffusion index begins to weaken noticeably, which provided an early warning to investors in the last three recessions. In the current case, the economic recovery (artificial or not) is broadening out as more and more states within the U.S. are showing rising coincident indexes with the diffusion index reaching its highest level since 2007.
In addition to an improving state coincident diffusion index is the improvement in employment breadth as the employment diffusion index has finally broken into positive territory and is at its highest level since 2006. Readings over 50 indicate that more industries are hiring than firing while readings below 50 indicate more industries are shedding payrolls than adding. Perfectly coincident with the market’s bottom in early 2009 was a bottom in the employment diffusion index which, like the S&P 500, has continued to improve for more than a year now as the employment situation has markedly improved over the last year.
While not an economic breadth measure per se, one other bullish development associated with economic recoveries are declining credit card delinquency rates. There is a clear trend now in place in which delinquency rates on credit cards from Target to American Express are moderating.
Another useful tool I use to monitor economic deterioration or improvement is the leading economic indicators (LEIs) for countries around the world, and whether the LEIs are collectively falling or rising. To help visualize economic turning points I color code LEI rates of change. Below is a snapshot of LEIs around the world from early 2007 to late 2008, and you can see that between July and November of 2007 economic conditions began to erode and the key point was that they continued to erode well into 2008, warning market participants to remain skeptic of all the market bounces from oversold territory in the last bear market as the LEIs were not confirming the various market rallies.
Fast forward a bit and you can see that November 2008 to February 2009 was the zenith of the economic downturn, and from March 2009 onward the LEIs steadily improved across the globe and continue to do so as of March of this year, indicating economic conditions are improving globally and support the global stock market rally.
While Breadth Measures Support Higher Stock Prices, Near-Term Caution Advised
One of the developments responsible for the January/February selloff this year was the debt crisis in Greece. When it looked like the situation would be worked out in February the markets rallied and credit default swaps (CDS) for Greek debt began to subside. However, since early March not only have the CDS on Greek debt begun to rise again but so too have the yields on Greek 10-year bonds, with both now exceeding the February highs that marked the intermediate low in the markets.
So far it looks like the rising risk levels evident in the credit markets remains predominantly a Greek phenomenon, though my PIGS CDS composite is also rising with CDS on Portugal debt closing in on its February highs.
With rising risk levels in Greece and the other PIGS the overbought nature of the market takes on greater importance as the markets wouldn’t need much of a catalyst to correct from significantly overbought levels. Market corrections often occur when the S&P 500 rises to 5% or more above its 50 day moving average (50d MA), which is where we find ourselves today while market bottoms often occur when the S&P 500 is 5% or more below its 50d MA. The current overbought reading in the indicator suggests the potential for a market pullback remains elevated.
Another indicator using the 50d MA is the percentage of stocks above their 50d MAs on the NYSE. Overbought readings in the market associated with tops are seen when the percentage of NYSE issues above their 50d MA rises above 75% while bottoms are often witnessed when the percentage falls to 25% or below. The current reading that is north of 80% highlights the markets overbought nature, suggesting caution at current levels.
In addition to the overbought nature of the stock market is a sense of complacency by market participants that is often associated with significant peaks. One measure of market complacency is the ratio of put to call options where a high put to call ratio suggests excessive fear that is associated with market bottoms while a low ratio suggests excessive optimism associated with market peaks. Looking at the put/call ratio in the bottom panel below shows that we are at a level of complacency not seen in over six years, where these levels back in 2004 marked a multi-month consolidation in the market before the S&P 500 rallied to new highs late in 2004.
The Long and Short of It
As highlighted above the momentum in terms of economic and technical breadth continues to support the bull’s case as there does not appear to be any signs of an approaching bear market or recession. Quite the contrary as technical breadth supports a healthy market trend and improving economic breadth indicates a recovery that is broadening out. However, near term risks and the overbought nature of the market suggests a degree of caution is warranted in which a correction may develop before the market makes another significant leg upwards.
© 2010 Chris Puplava