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Breath Mints



For several weeks now, market breadth has been overbought. It is one of the many reasons I became convinced that the market would have trouble advancing without taking a more substantial breather first. After all, such extremes had given excellent heads-up that a correction was coming for five years now.

Why believe this time was different when the S&P hadn't even broken its uptrend line yet? I'm a big believer in playing the odds, and assuming that things will remain the same -- until they don't. Obviously, I've been completely wrong. Now that the S&P has broken its near-perfect downtrend since 2000 and exceeded a prior weekly swing high, the larger trend has changed from down to neutral. This requires that we look at things a bit differently.

Breadth on the NYSE has now been positive (more advancing issues than declining issues) for an incredible 11 straight days. Other than 12 days in March 2002, we have not seen such a streak since 1995. Just for reference, we have seen the following streaks of positive advance/decline days since 1965:

Not only that, the 10-day average of the a/d line is 958 issues -- the closest recent figure is 760 in October 1998 (values will differ a bit depending on your quote vendor). If we look at the a/d line as a percent of total issues traded, then we have the most positive 10-day breadth since 1991, at 26% of total issues.
I've been looking at such positive breadth up until recently as a negative for the market. After all, the overriding trend of the market was down, and overbought in a down market is not positive. However, now the trend of the market has changed from down to neutral, that suggests we may need to adjust our thinking a bit. Overbought breadth readings are relatively common immediately after an intermediate-term low. This makes sense, as the buying explosions in the first few days after the low typically record very lopsided breadth. However, it is EXTREMELY unusual to see this type of activity so far from a low. In fact, I could only find three other instances since the 1960s where we saw 10-day breadth at 20% or more of total issues, at the same time the market was 20% or more from a low within the past 60 days.

Each of the three is shown below, with situations equal to the current one circled in green:

Such fantastic gains and overbought market conditions didn't lead to a rollover in any of the instances. In each case, the market continued higher, albeit in a choppy fashion, over the next few months before resuming the bull move in earnest. The occurrences in 1975 and 1982 marked about the halfway point of the move before a substantial correction of greater than 10% set in. The 1991 instance occurred at about the 40% mark before a setback of about 9% in 1994. If we stretch a little and project this out to our current situation, it would estimate a move to about 1180 (close to the March 2002 high) for this current rally before a substantial correction would be likely.

Maybe I'm being pig-headed, but I continue to believe that there is great risk to taking intermediate-term long positions right now, despite the three charts above. Based on a broad cross-section of measurements, my opinion is that there is excessive optimism currently built into the market. Not just optimism - EXCESSIVE optimism. That, to me, suggests that we are likely due for at least a minor correction over the coming weeks to wring out some of these good vibrations. But more and more signs are emerging that a substantial dip may only be temporary, and new lows are not necessarily in the offing.

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