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I hate to say it

but I think the put/call ratio is signaling another leg down in the US equities markets:

In the above chart I've plotted a four week exponential moving average of the weekly CBOE Put/Call Ratio ($CPC) against the S&P 500 ($SPX) going back for two years. Notice how each time the weekly $CPC dips below about 0.95 (horizontal yellow line) the S&P 500 usually peaks? And every time $CPC dips to an extreme of 0.90 or lower (horizontal red line) it always peaks? I drew vertical red lines on the charts to make it easier to see the relationships.

I won't pretend to understand why this works but so far, at least over the 2007/2008 bear market, it's got a pretty good track record. In the above chart there's only one instance (April of 2007) when it was dead wrong. And even then it seemed to forecast the period of crappy sideways trading over summer 2007.

Bailout causes credit markets to freeze even more?

Well, the huge Wall Street bailout passed Congress and President Bush signed it into law this afternoon. I suppose we should all be thankful that disaster has been averted. Yet, as indicated by the spiking TED-spread, the credit markets are still under enormous strain. As I type this the spread is sitting at 3.86, near an all-time high:

I know next to nothing about how the credit markets work, but shouldn't the spread be narrowing if things are going to be okay now? That the spread should widen to a new record high even as the bailout passes seems strange to me.

Another odd thing is that the S&P 500 rallied 3.5% into the bailout passage and then abruptly reversed course to close down 1.3%. How's that for a nice 5% intraday whiplash? My neck hurts after that. Obviously Mr. Market has gone insane.

A crisis of faith

The market is now back in full-on rally mode as I write this. Everyone is cheering the Fed and Treasury for coming to the rescue of the markets and saving us from all those bad mortgages and evil short sellers. I suppose that I should be glad that my 401k is safe and we've avoided Financial Armageddon for a while longer.

Instead I find myself grappling with a crisis of faith. No, not of religious faith -- I've long since sorted that nonsense out -- but of my assumptions and beliefs in the science and art of Technical Analysis (TA). Here's why:

Do you see that yellow circle marking the Thursday lows? Yeah, the 1PM Eastern Time low? The one that occurred just as news of the short selling ban and rumors of the mother of all bailout rescue plans began circulating? Yeah, that one.

Let's step back and take a wider view of it:

That's an artificial inflection point, my friends. It appeared in response to never-before-seen massive-scale market manipulation by the federal government and other large market participants. It was manufactured to stop the bear market in equities. That it occured right in line with a long term downtrend-line drawn across the bottoms of the troughs going back to mid 2007 is no coincidence.

And that brings me to the crux of my Technical Analysis crisis:

If a technically significant inflection point can be artificially induced on the charts, as it was yesterday, then isn't it possible that some of those previous inflection points were manufactured as well? And if that's the case, if even one of those points weren't caused by true market forces but rather by design, then doesn't that cast doubt on any analysis based on those points? I mean, the "designers" could simply change their minds and flip the market trends from up or down at will, right?

This line of thought, when taken to its logical conclusion, raises the depressing possibility that market technicians like myself who are (apparently) working from incomplete information may be little more than modern-day versions of Plato's "allegory of the cave" prisoners. We watch shadows moving on a cavern wall (the charts), build theories and draw conclusions from them, try to predict their motions, but ultimately fail because our world-view is not based on true reality at all. In the end we're no more accurate than the Fundamental Analysts pouring over their 10-K's and wondering why a stock is dropping even though the earnings are spectacular.

Just what the hell is Technical Analysis measuring, anyway? Are price movements simply the result of behind-the-scenes manipulation by large market participants with a dash of randomness thrown in? Do those lines drawn across peaks and valleys in a chart mean anything at all? Or are we like those pre-Copernican astronomers attempting to explain the erratic, retrograde motions of the planets with increasingly more and more complicated models that never quite fit? 

These are the questions I'm struggling with today. I don't think I like the answers...

FtQ - Flight to Quality update

As of last night my custom "Flight to Quality" FtQ indicator that tracks the 20 and 50-day correlation between the S&P 500 and the 10-Year Treasury Note yield is now in full-on panic mode:

No surprise there, I guess. You know things are getting rough when money managers are willing to buy 3-Month Treasuries with negative yields as happened yesterday.

Anyhow, the 20-day correlation is now reading very close to that magic 1.0 number, same as it did shortly before the July 15th intermediate-term bottom. However, looking at the raw correlation data for mid-July, the 20-day correlation actually peaked four trading days prior to the true bottom for that leg down. This means that although the FtQ relationship is now signaling that a bottom is close at hand it may not actually appear for a few days: more selling could definitely occur.

Applying more traditional technical analysis charting techniques to the monthly S&P 500 chart shows where that bottom may ultimately be:

If you overlay a Fibonacci retracement grid over the monthly S&P 500 chart using the 2002 low and 2007 high as starting and end points you'll see that we have three coinciding support points. First is the 61.8% fib retracement itself. The second is the support zone from the mid-2004 congestion area. And the third is the nice round 1,100 number (round numbers often provide support or resistance). I think the bulls will use that area as their line in the sand.

Of course, there is no fundamental reason for S&P 500 1,100 to be the bear market bottom. I mean, there probably aren't many fund managers who've been sitting on loads of cash for the past four years saying to themselves "Gee, I wish I'd bought back in 2004 when the market was at 1,100. If it ever gets back to that level I'm going all-in on this baby!" But, it's hard to say for sure. Maybe there are fund managers out there doing just that.

For now, we're seeing a lot of sell-the-pops behavior. Seems like every time the market rallies a little the sellers step in and unload some more. Until that stops and the FtQ weakens we won't have a lasting bottom.

Look out below?

Today we had the lowest close since the July "bottom" in the S&P 500, bringing us perilously close to "the abyss" that I spoke of back in early July. This is either a great buying opportunity or the beginning of another leg down. We'll probably find out which tomorrow or maybe the day after.

Here's the S&P 500 chart:

Bullish Points:

• We're now sitting within spitting distance of a major support zone.
• Stochastics(5) is low and looks to be priming for a bounce.
• The ultra-high volume today may be indicative of a panic bottom forming.
• If RSI(14) forms a bottom here then it'll make for a higher low, a bullish sign.

Bearish Points:

• RSI has lots of room to fall if we break support.
• Today and last Thursday's long red candles show that there are still some really large bears out there. I wouldn't be surprised if the weekend bailout of fannie/freddie got some big foreign holders of domestic stocks thinking that maybe they should move their money elsewhere.

The 10-Year Treasury yield has finally started to move back in line with stocks. The 20-day "Flight to Quality" correlation between the two is now above 0.5 which I believe means that some good, tradable swing moves are on their way. Which way those moves go remains to be seen. At this point I'd say down but who knows?

And now I'm off to watch a Diamondback's game I recorded earlier.

FtQ: Flight-to-quality update

My custom "Flight to Quality" (FtQ) indicator, which simply tracks the 20 and 50-day correlation between the S&P 500 and the 10-Year Treasury Note yield is starting to perk up (click for bigger, non-blurry version):

After dipping below zero, indicating a strong divergence between stocks and bond yields last month (blue fuzzy line), the 20-day correlation is now slightly positive at about 0.4. This is a healthier reading but still weak. Looking at the actual charts via the $SPX and $TNX indices on stockcharts shows what's actually happening:

The nasty divergence is still there but it is beginning to weaken. The past few days has seen the S&P 500 move in the same direction as the 10-year yield: that's why the 20-day correlation reading has improved. I'm happy to see this as it proves my custom indicator (FtQ) is accurately displaying what's happening in the market. Eyeballing charts looking for divergences is very subjective so having a hard, quantifiable number like FtQ handy is very helpful.

It's rather interesting to note that the 10-year yield is now below where it was back in July during the depths of the most recent Credit Crisis spasm. Obviously those bond traders know something.

Knowing when NOT to trade is the key

Sometimes when you're trading stocks it's like you have the Midas touch and every position you put on makes gobs of money. Every breakout play shoots for the moon. Even the lamest of the lame stocks in your shorts list take flight and no matter which one you buy it all just works. It's like magic.

And then, well, err... there are those other times... All the promising breakout plays turn in to bull traps. Every low-volume pullback you enter keeps on pulling back, right on through your stop. It all just fails, no matter how good the setups and which direction you trade. Nothing works and for you, at least, the Gods of Technical Analysis seem to have forsaken you.

Knowing the difference between these two scenarios and recognizing when conditions are not conducive for profitable trading is a very important skill to acquire and one that I'm still working on. Most of the time you can see these "bad times" on the indices after they've already been underway for a while because the price action just chops sideways. Attempting to trade anything but the shortest timeframes in a choppy market is a lesson in futility.

Once I realize what's going on I'll usually stop trading but only after I've given back a sizeable portion of my gains. A good example of this is what happened after the intermediate-term bottom this past July: I caught the bottom in some tech and consumer discretionary stocks, rode them upwards for some decent gains and then watched them get stopped out one by one. A couple of subsequent trades also failed even though the setups looked perfect. By the time it was all over I'd given back over half my profits. Frustrating!

Six weeks later it's painfully apparent that immediately after the initial rally the market shifted into chop suey mode. It sure would've been nice to know that at the time!

Okay, so how do you know when a rally is souring?

There are a lot of ways, but the easiest method is to gauge the market breadth via the Advance-Decline line on stockcharts.com:

When the A/D Line failed to make a higher-high after July 28th (red arrow) it was a sign that the rally had soured. Advancing issues were not significantly outnumbering the declining issues. Strong rallies are not built on that relationship. Tightening up stops and not opening new trades around that time would've been prudent and saved me a good deal of my profits.

There are other ways of quantifying the health of a market, all of which have their strengths and weaknesses. One very simple method is to just watch the relative performance of the major indices. If you see divergences between the Dow, S&P 500, Russell 2000, and the Nasdaq then something's wrong. In a healthy market the tide should raise all the boats, not just a few large stocks or one or two sectors:

Get a load of all the chop post mid-July bottom in the above chart of the S&P 500 versus the Dow Jones Industrials, Nasdaq Composite, and Russell 2000 indices. If you'd known ahead of time which sectors or stocks to be in then you could've done well but how could you have known that before the fact? I mean, really known? You couldn't have, not with any degree of certainty, anyway.

My new favorite breadth indicator is simply the relationships between the different market sectors via their ETFs and how they're moving in relation to each other. If you adjust the timeframe so that the chart starts around the time of the mid-July bottom you can see that except for a couple of sectors things weren't working well right from the start:

On the other hand, the previous two months were great times to trade -- provided you were willing to go short or buy inverse index ETFs:

Everything was pretty consistently down, an indication that the money tide was flowing out of equities, taking prices down with it. Trying to trade against that force would've been unproductive at best, tantamount to salmon swimming upstream. It can be done but it's much harder than just going with the current.

What I'm getting at here is that you to have to recognize when money is flowing into and out of the market as a whole and ignore the minor sub-themes that inevitably fail. In other words, you need to be watching the tides and not the ripples on the surface of the water.

Fortunately, actually doing that, and doing it in real-time, is easier than you'd expect. This post is getting very long so I'll leave the description of my new indicator for another post. In the meantime, go study the Sector PerfChart and think about correlation coefficients.

Back in the doldrums but a storm's a comin'

Well, it's finally Friday and the long Labor Day weekend is upon us here in the U.S. What better than a little technical analysis on a Friday night? I know I'm not the only one stuck at home so here's the S&P 500 for your viewing pleasure:

Get a load of that sideways chop we've been dealing with. Talk about an indecisive market! Even the RSI(14) oscillator is moving sideways, unable to get a reading on the mood.

Your three bullish points:

• RSI hasn't given back any ground during the recent choppy trading. This is generally a good thing as it means the up days are about balanced with the down. Neither bulls nor bears have the advantage.
• Stochastics(5) still has some room to run before getting oversold. If we can break the resistance at 1,300 before things get too overbought then maybe there's some hope for this rally yet. With RSI still showing neutral readings in the low 50s we could be setting up for a breakout.
• This sideways chop on declining volume could be normal consolidation and for it to happen on low volume is probably a good thing.

And your three bearish points to balance things out:

• The bulls keep butting their heads up against overhead resistance at 1,300 and fighting with that 38.2% fibonacci retracement of the big Summer slide. Every time we touch that thing we burn a little more of our bullish "fuel".
• Stochastics(5) is nearing overbought levels again.
• Volume has been declining since the mid-term bottom in mid July. That it's doing so isn't a good sign for the health of this rally.

A fourth bearish point has to do with the weak market internals. If you look at the relative performance of the internal market sectors since the rally began from the back in July you'll see that it's all been on the backs of but two of those sectors, namely Consumer Discretionary and Financials (click for bigger, non-blurry version):

Both of these sectors were heavily oversold during the Summer slide and it was only logical that they be the ones to rebound the hardest. The next closest sector behind these two high-fliers is the Industrials (orange) and it's lagging a full 5% behind. Everyone else is sitting at a loss or a middling 2 or 3% gain. Strong, meaningful rallies are not built on such pathetic sector participation.

Another bearish problem is the divergence between stocks and the 10-Year Treasury Note Yield, which as I've discussed before, should be moving in roughly the same direction.

Here's another way of looking at it, this time using my custom "Flight to Quality" correlation indicator:

Note the sub-zero correlation in both the 20 and 50-day timeframes. One of these two markets (stocks or bonds) is right. At this point I'm leaning towards the bond market being the correct one as it is the one most directly affected by the ongoing Credit Crisis. Time will tell.

And on a final note, I'd like to wish those living along the Gulf Coast the best of luck as they prepare for this season's first really strong storm. From Weather Underground's tropical storm tracking page it looks like Gustav will be a strong category 3 or 4 hurricane when it reaches landfall sometime Monday evening.

The broken wedge

Yesterday's selloff broke the rising wedge to the downside just as I expected in my last market post the rising wedge between us. Today's intraday whip-saw price action was primarily a reaction to that. If we're lucky yesterday will turn out to be a bear trap. If we're not then it could mean the beginning of a slide back to retest the July lows and possibly break through them to fresh yearly lows.

The S&P 500:

My "flight to quality" (FtQ) stocks and 10-Year Treasury yield correlation chart:

Look at how far the 20-day correlation has moved from the 50-day correlation. The last time we had a divergence of this magnitude was back in mid-May, right at the 1,440 market peak.

Bullish Points:

• Stochastics(5) is reaching oversold levels and could rebound any time now.
• The selling stopped yesterday and today at the 1,260 level meaning that there may be short-term support there.

Bearish Points:

• We broke the uptrend (blue dashed line in the S&P 500 chart above).
• RSI(14) made a lower-low after failing to break clear of the bear market ~60s.
• The negative divergence between the S&P 500 and the 10-Year bond yield has deepened.
• Oil (not shown) looks to be catching a bid at current levels -- levels that just happen to coincide with that market's 200-day moving average, a 38.2% fibonacci retracement of the massive 2007-2008 rally, and a 3-inflection-point trendline going back to May of 2007. We all know what happens to stocks when Oil starts bidding up!

For now I'm probably going to stay in cash until the "FtQ" 20-day correlations work themselves back towards a more sane level north of 0.5. The odds of being on the wrong side of the major inflection point it's forecasting (or already forecasted -- you can never really tell with this thing) are pretty high.

The rising wedge between us

I've been away from the charts for a few days so I'm not totally plugged in yet, but a quick glance at the daily S&P 500 chart makes me think that the bears are starting to grind down the bulls' resolve. The declining volume action belies problems with the underlying internals. And I don't think it's just because everyone is off watching the Olympics...

Some bearish points:

• Rising wedge patterns are usually bad.
• Volume has been declining, especially on today's bogus smoking-hot CPI rally.
• Stochastics(5) failed to make a new high Monday when price touched the top of the rising wedge channel. It also failed to push into the 80+ range on the recent rally.
• RSI(14) is beginning to push into historically oversold levels (~50's). That it couldn't break into the ~60's on the recent rally isn't too bullish.
• We seem to be fiddling around with that 38.2% fibonacci retracement a lot (red arrow), almost like it means something...

Bullish points:

• Today's inexplicable rally on the back of the hot CPI report must mean something. What, I dunno.
• We've got a solid uptrend line forming from the July lows with 5 inflection points.
• RSI(14) is making new highs. Until I see a lower high in this indicator I won't totally throw in the towel on this rally.
• I got shaken out of all my long positions late last week. Normally that means the market is about to shoot for the moon (because I won't be with it).

I guess I'm not feeling too bullish on the market right now. Perhaps it's the divergence that's forming between the S&P 500 price action and the 10-Year Bond Yield (see my recent Stocks and Bond Yield Correlation post for info on how I use this) that has me doubting this rally:

That the 20-day correlation is weakening while prices rise can only mean one thing: Money is flowing out of equities. That doesn't seem like a good thing. Of course it might be normal fluctuations and I'm just helping to build the wall of worry. But on the other hand, it could be a sign of an impending reversal or weeks of crappy, sideways trading to come.