Stretched Breadth Swings Investors Back To Bullish

Posted At 9:00 AM EST

Good morning...We begin the day with some selling pressure in the pre-market futures.  Traders have become very clued in to inter-market movements lately, with the Dollar, Treasury yields and commodities taking up residence on quote screens along with favorite stocks and sectors.  So far this morning, moves in those markets have been consistent with the selloff in stocks.

Over the past few weeks, we've looked a few times at the various sentiment surveys.  They've shown a large rebound in investor confidence, and more recently we've seen a few hints that that confidence has reached excessive levels (the Investor's Intelligence Bears and AAII Bulls are two examples).

That swing in confidence has moved our AIM Model into an extreme territory as well.  This model looks at a handful of sentiment surveys and compares each to its recent range.  When sentiment becomes more bullish than usual over the past year, then we get bearish (for the market) readings in the model.

When we've seen it reach this level of extreme over the past decade, the S&P 500 has normally run into trouble sooner rather than later.  Every time but once, when it was able to enjoy some additional short-term gains, those were given back at some point.

That exception was in the spring of 2003.  We've spent a good amount of time ever since March 11th looking for signs that "this time is different" in terms of bear market rallies, and along the way the market has checked off a number of studies suggesting that what we were seeing was, indeed, different.

Because of that, I've been leery about becoming too negative in the face several overbought conditions other than on a short-term basis, and I think that's still the right path here...until the market does something wrong, which it hasn't so far.

By "doing something wrong", I mean failing to rally from short-term oversold conditions, or violate technical patterns that should lead to a rally.  When we become overbought and see something like that, then it usually leads to longer-term selling.

On Friday, we looked at a couple of signs of heightened speculation in penny stocks and Rydex mutual funds.  Last month, traders in those low-priced lottery tickets turned over almost as much total volume as on the regular Nasdaq, which is usually a warning sign going forward.  Same goes for too much enthusiasm in the Rydex bull funds.

It's hard to blame these guys.  Breadth on the Nasdaq has been pretty good, and we've even seen a number of stocks hit new 52-week highs, while only a couple each day languish at new 52-week lows.

That kind of price action has pushed the New High / New Low Ratio on the Nasdaq above 80% on a 10-day moving average basis, and to 85% over the past week.  That 5-day reading is the most extreme since February 23, 2007.  The red arrows on the chart below show other times the ratio neared 80%.

What's so remarkable about this reading is that it has occurred with so few stocks actually hitting new highs.  Last week, no more than 75 stocks on the Nasdaq actually hit a new 52-week high on any given day.

If we look back since 1984 to other times the 5-day NH / NL Ratio reached its current level of extreme, the current period is the only time we've seen it become so overbought with so few new highs while the Nasdaq 100 was reaching multi-month highs.  In fact, at no other point had it become this overbought with fewer than 100 stocks hitting new highs during the prior week.

Only one other time did it occur with less than 150 stocks hitting a new high.  That was in mid-February 1991, which was another time when the market was trying to recover from a bear market.  After that point, the NDX flattened out for a couple of weeks, spurted higher into April, then basically went nowhere for the rest of the year.

Bottom line - Intermediate-term Outlook:  Neutral  (since April 9, SPX 843)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

During mid-April, several of our measures like the Indicator Score and Dumb Money Confidence reached levels that usually result in either a flattening out of the price rally, or an outright decline, especially during a bear market.

But the market held up extremely well in spite of some of these overbought types of indications.  This is very rare during an ongoing bear market, and is important to keep in mind especially given many of the "this time is different" kinds of studies we reiterated in early May.

While there have been - and continue to be - many reasons to consider this rally something different than we'd seen previously in the bear market, I've been looking for the S&P to run into trouble if it traded into 940-950, which it happened last week.  I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

The S&P did fail on its first attempt to get over that hump, but on Wednesday afternoon we discussed the first pullback to the breakout over 920ish, and the market once again passed with flying colors, taking us once again into 950ish by Friday.

It's hard to become too negative on the market as long as it continues to do nothing wrong, but we're leery of it being able to sustain a breakout over 950, especially coming on the back of an economic report like the payroll report from Friday.

Bottom line - Short-term Outlook:   Neutral  (since June 3, SPX 924)

On Friday, we discussed the market's tendency to have some trouble after gapping up and holding on the heels of a major economic report like the payroll release.  It's just not very often that we see an enthusiastic response to a report like that that leads to a sustained move.

If the current selling pressure holds, then this will be the fourth straight month that the S&P has gapped lower by -1% or more the morning following a payroll report.  In March and April, the S&P managed to claw a bit higher into the close, while in May we saw a bit more selling.  March's occurrence actually marked the very end of the decline on both a short- and intermediate-term basis while in both April and May we saw another day or two of selling before a rebound.

Over the past decade, there have been 9 times the S&P gapped down -1% or more the morning after a payroll report.  Performance that day was mixed, but by three days later the index was higher than Friday's close only twice (March and April of this year).

On Friday I noted that we were running into some overbought conditions and poor seasonality (in addition to the tendency to reverse from strong reactions to economic reports), so I was looking for the early gains to be pared back this week.  That's still the case, so it will be instructive to see how the markets react if the S&P makes it back down to the breakout level at 920ish.  We bounced right on schedule last week - an inability to do the same this week would raise the spector of a "false breakout" and should take us back down to the lower end of the prior range around 875 - 880.

All the best,