Last week the US equity markets finally succumbed to the continuous barrage of excessive bullishness and had a rare down day. The excuse was the growing protest movement in Egypt that had started to disrupt economic activity there and shut down the stock exchange for a number of days. The CBOE volatility index (VIX) jumped higher for the first time providing a glimpse of market tremors that many experts presaged as the long awaited correction:
The chart above shows the S&P 500 index with the VIX 1 day rate of change – it looks a bit like a seismograph and you can think of it as showing sudden market instability. Usually what we have seen in the past is fast and furious movements in the VIX which precedes an intermediate low. The current VIX movement barely registers as the start of such a pattern.
In spite of this decline, the underlying health of the bull market seems to be intact. The S&P 500 index’s cumulative advance decline line looks healthy as it has not corrected or broken to the downside. This suggests that the average stock out there is doing rather well and did not succumb to the decline on Friday.
The Bullish Percent index for the S&P 500 index likewise is providing us with the same thesis. As the chart shows, it is once again approaching the thin-air altitudes that it has enjoyed during much of this cyclical bull market:
While I use the BP index as a contrarian indicator in extremes, during momentum bull markets it can sustain itself at a very high level for long periods of time. This is similar to the breadth measure, the percentage of stocks trading above their long term moving average, which we’ll look at a bit later.
During past market tops, the bullish percent index has indicated weakness by tracing out a pattern of declining tops. For example, you can see that while the S&P 500 index itself topped out on October 2007, the bullish percent index for the S&P 500 reached a high much earlier and had declined. We also saw this divergence pattern back at the technology bubble top in 2000.
While the market proxy had been liming higher and higher, the bullish percent index which provides a measure of underlying strength, had been declining for some time. In fact, it had reached a cycle high back in 1998 after recovering from the financial crisis earlier that year. So the fact that we are not seeing this divergence gives me reason to believe that the underlying structure of the market is sound and the bull market intact.
Having said that, the short term breadth indicators such as the percentage of S&P 500 components trading above their 10 day moving average did not reach a low enough point with the decline on Friday. Last week we only had 31% of issues trading above their short term average and preferably, I’d like to see between 10-20%. There is research from Lowry’s that suggests that very low levels of this short term breadth index provides for not just a short-term low but a major low. We certainly are not seeing that.
As well, the medium term breadth measures are also rather elevated. The percentage of S&P 500 issues above their 50 day moving average declined to appx. 70%. Important low risk buying opportunities arrive when it is between 10-20%:
So while the market is hovering very near its 52 week highs, the underlying issues are trading a bit heavy as not as many stocks rallied this time above their 50 day moving averages. Finally, other sectors of the market such as the small caps are also showing weakness, not keeping up with the large caps. The transportation sector, as measured by the Dow Jones Transportation index, is also declining in contrast to the robustness of the Dow Jones Industrial index itself and the S&P 500 index. This makes me cautious as I believe that the market continues to trade within a high risk zone making it prone to a short term decline.
tradersnarrative 
Investor sentiment too bullish? No problem — just ask the Federal Government to adjust it hedonically, like inflation. There . . . we . . . go . . . Okay. Sentiment’s lower. Any other pesky numbers need adjusting? Ah . . . unemployment . . . here . . . we . . . go . . .
Hey Babak; Few Comments:
1- Sentiment + Technicals are bearish, but in an up-trending market these measures, just like other indicators, can stay elevated.
2- It seems like whenever the market sells-off on middle-east related news, it comes roaring back like what happened during Dubai Bail-out (November 2009).
3- The growing number of impending calls for a corrections (previously mentioned on your blog), just might fuel a short-term rally.
4- Are we setting up for something like November 2010, where the market rallied at the start of the month and then declined during the rest of the month?
What happened to Tom DeMark’s call?! I’m outraged the market did not cooperate with his prediction –although this seems to happen a lot with his calls.
I’m inclining towards Farhan’s point no. 4. The sudden return of bullish conviction following a big one-day decline from a 52-week high is not a good technical sign. It’s very reminiscent of the April 2010 topping pattern, which made a new high after a big down day, sucking in the last longs and skewering the last shorts. That’s when the correction finally began.
Can’t see anything more than a modest drop though. Unlike April, Uncle Ben’s finger is still on the pump.
Yeah… the problem is, no one out there can’t see anything more than a modest drop of 5 to 10% “maximum”. And apparently every Daniel, Steve and Kon sees the index higher by the years end. And apparently the Fed has magical powers in a form of a “pump” or even better – “the Bernank Put”. And apparently the third year of the presidential cycle is always the strongest. And apparently the underlying health of this bull market is intact. And apparently the market only tops when breadth is diverging… so its all ok!
Don’t get me wrong, it is not as if I do not agree with any calls here, it is just that every one sounds like a parrot! I am long energy despite months of warning from Babak that it is overbought. And I think after a correction, energy will really fly as Oil cracks $100. This is Star Wars Imperial Empire Money Printing crack up boom, which is not sustainable, but in the same time very hard to be short against!
But don’t you worry… majority will be giving all these gains back by late 2011 or early 2012!
Agreed, no one is expecting a big correction – so maybe we should indeed expect the market to throw us a curve here. Perhaps we’ll get something a little scarier than the bulls are expecting, but not quite scary enough to satisfy the bears.
FWIW, my historical studies suggest a likely retracement to the 200-day SMA before we see major new highs: though that could happen in an orderly decline, a sideways crawl, a sudden plunge, or a combination of the above.
Volatility as measured by Bollinger Bandwidth is suggesting a large move or series of moves dead ahead, so a sideways crawl would seem less probable. I think it’ll pay to be nimble over the next couple of months.