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Something's Gonna Give



This is a very powerful market that took a bit of a breather yesterday. Most viewed the day as constructive because nothing can go straight up without needing to regain momentum.

Having some profit-taking without much damage is constructive because that theoretically takes stocks out of week hands and puts them into strong hands. The question in the current market is whether there is enough demand to overcome the supply that typically hits the market as it reaches prior tops and significant overbought conditions.

My view is that a sustainable broad market move through the upper end of the range (I have defined as 945 to 955) is unlikely. The various "off the beaten path" indicators I use suggest a market that is likely to experience an intermediate-term pause or an explosive near-term rally with very little in between.

That sounds like a wonderful hedge doesn't it? Let me explain using one of the indicators I track.

Each morning, I track the various market statistics like advancing stocks, volume, new highs/new lows, etc. While that's not unique, I also track various moving averages of the different market gauges. One measure I take each day is the 10-day moving average of the NYSE new highs minus new lows. These type of signals are not meant to catch the daily fluctuations in the market but they are designed to identify periods where there is a sustainable shift coming. That shift could be acceleration or a reversal. The 10-day moving average of new highs minus new lows on the NYSE shows just that right now.

Since late 1997, the 10-day reading was above 175 on four occasions, and each time that reading preceeded a big move:

What is interesting is that the 10-day reading never reached that level during the post-Asian Economic Crisis equity market bubble, but it reached 175 three times since the bubble burst.

As this table shows, the first time that happened was in February of 1998 after the S&P 500 made a new high and surged a further 8.8% before experiencing a correction and then continuing higher. The other three times have been in the middle of the current bear market at intermediate-term peaks. The average decline without experiencing a meaningful pause in those three instances was 22%.

So now you see why I said that there are indications of either an explosive rally on a breakout or a meaningful pullback. At this juncture, I find it hard to believe that the explosive rally is coming, but it is also important to remember there is a better possibility of it than any other time during the bear market because as Brian Reynolds has been pointing out, this is the first time in the last five years that the bond market is providing liquidity to both consumers and businesses. Lower bond yields continue to cause the Refi market to boom, benefiting consumers, and tighter corporate spreads have allowed companies to access the capital markets for funding.

The bottom line is that the potential for the rally argues against being heavily short and supports my rotation thesis, while the potential for a sharp technical retreat means that you should asses your exit strategy on indications of decline. The best time to assess an exit strategy in either direction is when things are good - not in the middle of an emotional move up or down.

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No positions in stocks mentioned.
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