Bad Breadth? New Highs? How About Some Sassy Insight…

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Irony at its finest! Ok, so maybe breadth is not breath, but you get the point. Of course the poor breadth measures that I’m sure you have read about is anything but a call for the bears to hibernate. The fact is, based on weakening internals, seasonality, and other facts that I have read this weekend the risk/reward seems skewed to the downside. Instead of rehashing all the great data I have read about next week I will point you to two bloggers that have already done great work on the topic and then highlight some work that I did that may give us good clues as to how the near term may unfold. The first us by @ukarlewitz who gives a comprehensive picture of what to expect next week based on many different metrics and the second by @steenbab highlights a few quick charts and notes on the topic.

What to Look For Next Week: Predicting what is to come in the week ahead I find is more a way to keep up to date with different market metrics and less about actual predicting. I say this because we all know predicting short term market moves is mostly a fools game. Having said that we can still use different measures and history to try to put the odds in our favor. Below is a chart of the last two years that can help us determine the next short term market move. The reason I am using the last two years (which I also have done in previous posts here, here, and here that in hindsight worked well and were very informative) is because the pattern of shallow V-shaped corrections to new highs have been very consistent. Until there is a shift in the recent rhythm of the market, we can gather information to help determine the risk/reward of what is to come.

In the below chart I have marked eight different occasions (with green dotted lines) where the S&P 500 has touched its bottom Bollinger Band (BB) and then hit the top of the band within five trading days. Beneath the chart I have highlighted three different measures:

  1. The number of S&P 500 issues trading above their 50-day moving average (MA).
  2. Moving Average Convergence Divergence (MACD).
  3. The financial sector (XLF) relative to the iShares Barclays 20+ Year Treasury Bond fund (TLT).

Screen Shot 2014-09-21 at 10.43.47 PMExcept for the two instances highlighted in yellow all of the bottom to top BB touches within five trading days move on to make higher highs in the very near term. The two instances that didn’t were April of 2013 and April of this year. Both times the S&P 500 failed to continue higher they did so within four trading days of their first top BB band touch and dropped 3.0% and 4.4% respectively (in the current situation three top BB touches were already made by Friday). Furthermore, both times the drop only took five trading days to bottom. Looking at the three measures beneath the chart there are also similarities between the two instances that pulled back versus the six that went on to new highs.

  1. As mentioned above, there has been a lot of discussion about week internals/breadth signaling a near term correction. In the two instances that immediately pulled back after hitting their top BB band, stocks above their 50-day MA were around the 80% level and took a sharp turn down. The other instances were more random; whereas some started at a high level (over 70%) and then moved sideways to higher as the S&P advanced others traded below 70% (as the current situation is) but then moved higher as the S&P advanced. To put in another way, although that particular measure of breadth is showing signs of weakness and waining momentum, it doesn’t necessarily mean that the market is going to correct or pull-back. The opposite could also take place in that we find breadth catch up to the new highs the S&P 500 are making.
  2. In the six instances that the S&P continued to move higher the MACD had either just crossed over bullish or was about to. The two instances that pulled back, the MACD  crossed bearish right away. Why is this important? Currently you can see the MACD appears to be crossing over bullish. If that immediately reverses then it is important information to take forward regarding a looming swift pullback similar to the April ones highlighted.
  3. Interest rates have recently broke out reversing the bullish trend in the TLT and sending financials higher. The third metric displays the correlation between the financials and the TLT against it’s 10-day moving average. In the six instances that the S&P went on to make higher highs the financials outperformed the 20 year treasury bonds and remained above the 10-day MA. However, in the two that failed the correlation reversed and went beneath its 10-day MA. Friday was the first sign of weakness in the financials as bonds began to move back up. Again the take-away there is to pay attention to bonds and financials early next week. Further out-prefromance of bonds versus the financial sector is more evidence that a quick pullback (possibly 3-4% within five trading days) is about to take place.

Putting it all together: Based on recent history and internal weakness market participants are prudent in taking a more cautious and defensive approach. However, that may be premature given the above information that I have presented. If during the start of next week stocks above their 50-day MA continue to drop, the MACD does not end up reversing bullish and the financial/bond correlation turns negative than the odds favor a quick pullback of around 3-4% where we can then reassess the information the market is providing. On the other hand, if the S&P continues higher supported by an increase in stocks trading above their 50-day MA and follow through of the bullish MACD cross and outperformance of financials to bonds then the risk/reward favors more new highs to come. This should all present itself within a day or two.

Good luck next week!

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