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.