 Ominous Stock
Technicals
Adam Hamilton
Archives
July 23, 2004
So far 2004 has been one tough
year for the US stock markets, which have been excruciatingly
oscillating in an exceptionally
tight trading range.
In this curious environment
the bulls aren't making money because the markets just refuse
to move up significantly. These days the bears aren't faring
much better though as stocks also refuse to fall significantly.
The longer this unnatural placidness persists, the higher the
frustration levels are growing in both market camps.
It has been challenging trying
to analyze this bizarre stock-market scene this year, but each
day more data becomes available that is gradually fleshing out
a bearish picture. At the same time while US equities remain
grossly overvalued
fundamentally, the technicals are conspiring to reveal increasing
weakness. These ominous signs do not bode well for the US markets,
regardless of this being a fabled election year.
This week I would like to examine
some of these ominous stock-market technicals, using the mighty
S&P 500 as a proxy for the US stock markets in general. After
digesting these charts, I suspect you will agree that the SPX
action in 2004 has been anything but encouraging. Whether you
find yourself in the bullish or bearish camp today, the message
of these charts seems pretty unambiguous.
Our first graph is a 2004 candlestick
depiction of the S&P 500's trading action that we used to
highlight intraday trading ranges in the SPX and their
interaction with the prevailing downtrend in force. In light
of both the usual closing data and these intraday candlestick
range bars, the SPX is decaying in a series of lower highs
and lower lows. The resulting tactical downtrend is crystal clear.
To me, this looks like a classic
decaying top. Each subsequent interim high in the SPX, both closing
and intraday, has been lower than its predecessors. These gradually
descending short-term extremes have formed well-defined support
and resistance lines that are irrefutably sloping down. This
resulting bearish trend pipe is highlighted in all of our charts
this week with the dotted-blue lines.
Now you fellow market junkies
may get a strange sense of déjà vu as you view
this pattern. I sure did! It reminds me of a similar descending
trend pipe we witnessed last summer in the S&P 500. I wrote
about it at the time in "The
S&P 500 Interim Top," which has a couple graphs
you ought to check out.
A year ago I wrongly assumed
this earlier formation was heralding lower markets but I was
proven dead wrong. After consolidating between 975 and 1000 for
the better part of a couple months the SPX roared to life and
surged above 1150 at its latest high in February. If last summer's
decaying trend pipe preceded a major rally why couldn't this
summer's similar pattern once again yield to a major rally? After
all, the US elections are rapidly approaching and there is a
widespread perception amongst bulls and bears alike that the
markets will rally into early November.
While fractally similar at
first glance, there are actually some enormous foundational differences
between today's SPX chart and that of a summer ago.
First, the duration of our
current downtrend is far greater than last year's. So far in
2004 the S&P 500 has spent almost six months grinding lower.
Last year's downtrend only lasted about six weeks, or one quarter
of our present pattern's duration. In general in the financial
markets, the longer that a given trend has been in force the
more powerful and decisive that trend will prove to be.
Would you feel more comfortable
trading with a trend that was three weeks old or three years
old? So far our current S&P 500 downtrend has persisted about
four times as long as last year's suggesting it is much more
important in the grand scheme of things. Like all trends, this
SPX pattern gains more credibility with age.
Second, the behavior of the
S&P 500's key 50-day and 200-day moving averages is far more
ominous today than it was a year ago. Last summer the S&P's
downtrend only fell slightly below its 50dma for a couple weeks
or so, and the 50dma itself remained far above the 200dma. In
addition both the 50 and 200 continued rising strongly last summer
all throughout the SPX's downtrend pattern.
Our current SPX downtrend's
interaction with its moving averages is vastly different. Since
March, the 50dma has actually been grinding lower, with
the SPX's downtrend pipe centered around it. Today the S&P
500's 50dma is actually within spitting distance of its slower
200dma. A great deal of traders consider a major cross of the
50 and 200dmas of any market to be an important sign, so if the
SPX's 50 falls under its 200 the ranks of people expecting lower
markets could swell dramatically leading to more selling.
Today these crucial 50 and
200dmas are only 1.0% apart! A year ago there was far more bullish
breathing room when these moving averages, both rising, were
running about 8.1% apart. If the S&P 500 continues down towards
its lower support line in the weeks ahead, there is a good probability
that today's contracting 50 and 200 gap will totally implode.
If it shrinks to nothing and the descending 50 crosses under
the 200, technically-driven selling in both S&P component
stocks and S&P futures could accelerate dramatically.
Finally, today the mighty S&P
500 is actively challenging its most crucial foundational bull-market
support at its 200dma. 200dmas are always the ultimate technical
dividing line between bull and bear. The last time the SPX traded
materially under its 200 was way back during the latest major
interim lows in its Great Bear straddling the final months of
2002. Due to the very mathematics of the moving averages, a market
trading under its 200dma for a period of time is almost always
a bear market.
As you can see above, back
in May the S&P 500 first began challenging its major 200dma
support on an intraday basis, but it held strong. After kissing
it during a few trading days, all three ended up closing off
their lows keeping the headline S&P 500 close a bit above
its 200. Just this week though this sacred line has been tentatively
broken, with several closes under the 200dma.
If you look at the last red
candlestick in this graph, Wednesday's data, it is interesting
that it pierced through this crucial 200dma support like a hot
knife through butter. The longer that the S&P 500 trades
below its 200dma cyclical-bull-market support, the more psychological
damage will be done to technically oriented stock and index traders.
And if this ultimately drags the 50 under the 200, then folks
in the bullish camp will start growing really nervous!
Thus, while similar visually
from a fractal perspective, our decaying stock top of 2004 is
quite different on multiple fronts from what we witnessed last
year. Today's pattern is bigger, has been running longer, and
has broken down through the SPX's critical moving averages. In
one word, the best way I can describe these technical developments
is ominous.
Although tactical technical
analysis centers on price charts, secondary technical data can
either strengthen or weaken the primary technical case. In order
to seek some secondary confirmations of the precariousness of
today's US stock markets, we also examined volatility, volume,
and internal index strength. All three of these side indicators
are also broadcasting bad vibes and buttress the bearish case
evident in the S&P 500 price chart above. Let's start with
volatility.
Amazingly enough, the anomalously
low volatility in the stock markets I discussed last
month has fallen even lower! A descending wedge has formed
with its sharp edge already below 0.5% 10-day absolute interday
volatility, which is about as low as the S&P 500 ever goes
on a 10dma basis historically. This abnormally low volatility
is a telltale bearish sign that supports the ominous interpretation
of the SPX price chart itself.
Like so many things in the
markets, volatility profiles are like a giant pendulum. High
volatility times are followed by low volatility times as the
pendulum swings back, and these low volatility times then inevitably
give way to high volatility times again, back and forth perpetually.
Today's anomalously low volatility will be followed by
high volatility, there is no doubt. And herein lies the bearish
interpretation.
A breakout from the volatility
descending wedge shown above will have to explode to the
upside, towards higher volatility. Historically the S&P 500
never lingers under 0.5% on a 10dma basis for long, and this
time is unlikely to prove to be the one exception. In addition,
volatility cannot fall to zero. Absolute interday
volatility treats both a -1% and +1% day in the S&P 500 as
a 1% move, so very low readings are not possible due to the absolute-value
conversion. As long as we emotional humans are involved in the
markets, there will be serious volatility.
So when volatility inevitably
breaks out higher and the pendulum swings back out of this anomaly,
there is a 90%+ chance that the S&P 500 will move sharply
lower. Just as in this chart, volatility tends to wane
during rallies but jump sharply when the markets start falling
and folks grow nervous. If you check out any long-term
volatility graph these well-established tendencies are crystal
clear.
In addition to the SPX piercing
its key 200dma six months into its decaying top, its unnaturally
low volatility is a fuse waiting to be lit. High volatility will
follow low volatility as inexorably as night follows day, and
the vast vast majority of the time surges in volatility accompany
selloffs in the stock markets. The coming upside breakout
of the anomalously low S&P volatility will almost certainly
coincide with a sharp move down in this flagship index and the
US markets in general.
Provocatively volume also augments
the bearish message of these price charts. Relatively heavy volume
during a decaying top on the charts is a telltale sign of churning
and distribution, suggesting that big players are unloading equities
at a furious pace.
Trading volume is an interesting
auxiliary technical indicator. On the chart above, you can see
that SPX volume averaged between 1.0b and 1.5b a day during last
year's cyclical bull market. But, since the S&P 500 peaked
in early February, volume has been much higher generally
meandering between 1.5b and 2.0b per day, or 33% to 50% higher.
Higher volume considered in
isolation is not necessarily bullish or bearish, but when examined
in the context of price trends it can be revealing. The major
increase in volume this year relative to last year was accompanied
by the decaying topping pattern in the S&P 500. Therefore
even accelerated trading, the prize that Wall Street covets the
most since it earns commissions on all trades, has not been able
to push the SPX higher even after six months.
On the contrary, this higher
volume coincides with decaying prices suggesting that, on balance,
there are more offers to sell stock than to buy it. Whenever
sell orders outweigh buy orders, the prevailing prices must fall
until a new market-clearing equilibrium is established at a lower
price. In 2004 as hours turned into days then weeks then months,
the S&P 500 prices have continued to fall so the high volume
is apparently decidedly bearish with sells outnumbering buys
on balance.
Higher volume over a half year
with decaying prices looks like a textbook distribution. A distribution
occurs when big market players first drive up stocks as high
as they can in an attempt to get the public interested. Once
the public is excited, the big players begin gradually systematically
unloading their positions to the public, selling as much as they
can at any given time without tanking the markets. Once the distribution
is finished, the big players have cashed out and the public is
left holding the bag before the fall.
A century ago legendary speculator
Jesse
Livermore had much to say about distributions in "Reminiscences
of a Stock Operator." He said, "Usually the object
of manipulation is to develop marketability that is, the
ability to dispose of fair-sized blocks at some price at any
time. In the majority of the cases the object of manipulation
is, as I said, to sell stock to the public at the best possible
price. It is not alone a question of selling but of distributing."
Livermore continued, "Stocks
are manipulated to the highest point possible and then sold to
the public on the way down. When it came to the actual marketing
of the line he did what I told you: he sold it on the way down.
The trading public is always looking for a rally" Livermore
wisely pointed out that the only way for big players to liquidate
huge positions at decent prices is to attempt to drive a price
higher and then start unloading to the public on the
way down once the price stops moving higher. This strategy
is as old as the markets.
In our current S&P 500
chart, note that volume was relatively low until February of
this year, right as the SPX hit its latest interim top. Three
attempts were made in rapid succession to rally the index significantly
above 1150, but all
three failed in January, February, and March. It is interesting
that just as this topping was occurring that trading volume would
soar by 33% to 50% on average. It is even more curious that this
massive increase would persist for the next six months!
What if big players, maybe
Wall Street banks, maybe corporate insiders, maybe hedge funds,
fully realize that the Great Bear in US stocks never ended? Historically
Great Bears don't end until stocks are fundamentally
undervalued in P/E and dividend-yield terms, and we haven't
even come anywhere close to undervalued today yet. What
if they suspect that the cyclical
bull market of 2003 was just another powerful bear-market
rally ahead of a vicious downleg?
If so, they would want to unload
their long positions in general US stocks to the public (via
mutual funds or individual stock purchases) before the next major
downleg commences. As Jesse Livermore astutely pointed out a
century ago, the best way to do this is to rally the markets
as high as they want to go, and then start selling on the
way down into the decline. But this distribution selling
must happen gradually over time so it doesn't take the markets
down too fast before the big players' positions are unloaded.
I don't know for sure if this
is indeed a classic distribution from big players to the public,
but its volume profile sure looks like it! How else could the
persistently low volume during last year's rally and the persistently
high volume during this year's decay be explained? Provocatively,
US corporate insider selling has reached nearly unprecedented
levels in 2004 as well, strongly suggesting that the inside guys
don't think the markets are headed higher in the coming year
or two.
In order for this volume profile
to be bullish, it would have to be flipped. If players really
believed in the markets, the volume ought to be heaviest on the
way up in 2003 as players of all sizes bought positions ahead
of an expected multi-year bull market. And the consolidation
in 2004, in order to be bullish, should have been lower volume
as players rested and waited for their accumulated positions
to start rallying again. Instead, we see far more conviction
and volume during the decaying top and not a lot during last
year's rally.
Combined with the ominous stock
technicals, the distribution-like volume profile in the S&P
500 is not encouraging. In a broad distribution ahead of a major
Great Bear downleg, we would expect to see broad selling of almost
all stocks, not just weakness in the headline market darlings
that dominate the indices. Indeed, if we look at the S&P
500's Bullish Percent Index, we do see widespread internal
decay across the entire elite S&P 500.
The S&P
500 Bullish Percent Index records what percentage of all
S&P 500 component companies' stocks are exhibiting technical
point-and-figure buy signals on their individual charts at any
given time. The SPX BPI peaked way back in late January, just
ahead of the S&P 500 itself, at a mindblowing 88.8%! This
means that nearly 90% of all the 500 SPX companies had
bullish P&F buys on their respective price charts. Talk about
a greedy sentiment extreme!
Since its own early 2004 top,
the S&P 500 has only slid 5.5% as of Wednesday of this week.
This modest headline action is the primary factor lulling folks
into complacency on these exceptionally dangerous 2004 markets.
But if we look at the S&P 500's BPI, the internal damage
done to the component companies has been nothing short of catastrophic.
Peak to trough in 2004 the SPX BPI has already plunged by over
a third from 88.8% to 57.6%!
During last summer's S&P
500 consolidation lower, its BPI only fell by a tenth
or so from 82.8% to 73.4% before recovering and surging higher
into early 2004. Thus there is simply no comparison between what
we witnessed last year and the widespread carnage evident today.
The selling that is dogging the S&P 500 has not been limited
to modest selling in the couple dozen huge companies that dominate
this market-capitalization-weighted index, as SPX components
across the board are being actively dumped.
For each of the 500 companies
represented in this ultimate proxy for the US stock markets,
it takes targeted individual selling in them alone to
cause their individual point-and-figure price charts to no longer
show buy signals. With the absolute 31.2% drop in the SPX BPI
since January, this means that 156 S&P 500 component companies
have already experienced individualized heavy selling so far
in 2004. The internal damage being done by this decaying S&P
500 top has been enormous, even while the headline index remains
deceptively placid.
And major S&P 500 bottoms
in recent years have not been witnessed until the SPX BPI trades
below 20%, sometimes well below. At just under 60% today we obviously
have a long way to go yet, a lot more selling ahead, before we
are blessed to experience another major interim bottom along
with its tradable V-bounce.
In addition to the S&P
500 piercing its own 200dma for the first time in its cyclical
bull this week, the brutal internal damage being wreaked in the
index as evidenced by its huge BPI slide in 2004 concerns me
the most. If we were just witnessing a bull-market consolidation
instead of a major trend change then the SPX BPI would have been
very unlikely to fall so far so fast. Unfortunately the US stock
markets are decaying from within.
The bottom line is the current
US stock-market technical situation looks ominous at best. It
appears that a significant slide or outright Great Bear downleg
is brewing, in spite of the tremendous popular complacency and
general feelings that the markets are in relatively good shape.
This week the S&P 500 fell
below its crucial 200dma support for the first time in this bull
to date. This warning is being compounded by unnaturally low
volatility that inevitably has to leap higher soon. And high
volatility is almost always spawned only during sharp selloffs.
On top of all this, heavy selling
from big players and insiders is relentlessly driving the markets
lower. It looks like a classic distribution top where big guys
unload their positions to little guys on the way down ahead of
a major market decline. This apparent distribution is obviously
widespread as well, as the enormous slide in the SPX BPI betrays
rampant internal damage in the very heart of the index.
In light of all of these ominous
stock technicals, it is probably not wise to be heavily
long the US stock markets at the moment.
July 23, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
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