From last Monday’s mid-day low, the equity markets marched upward through most of the remainder of the week, closing with gains of almost 4%.This rise constituted the biggest bounce in the second quarter, following a double-digit decline from the April 2 high.
Without doubt, the primary determinant of the market’s near-term progress will be investors’ perceptions of the unfolding Eurozone drama. Since the short-term twists and turns of that story are hardly subject to traditional investment analysis, I’ll take this opportunity to examine the technical condition of the market.
As usual, there are crosscurrents, especially if we look at the market in different time frames. Over the very long term, stocks began a long weak cycle (a secular bear market) in 2000. We believe that the secular bear market continues. So far, within the secular bear, stocks have experienced two shorter cyclical bear markets and two cyclical bull markets. The question facing investors today is whether or not the cyclical bull market that began in March 2009 ended on April 2 at 1422 on the S & P 500.
The Dow Jones Transportation Average failed to confirm the 2012 high in the Industrials. Stocks’ sharp decline in May broke important support levels and led Richard Russell, the nation’s foremost interpreter of Dow Theory, to declare a new bear market in force. Other data support that position.
The weekly graph of the S & P 500 comes from the excellent DecisionPoint site. Prices in the top portion of the graph reached successively higher peaks in 2010, 2011 and 2012. The momentum measures in the bottom section reached similar levels at the 2010 and 2011 highs, but have shown less strength at the 2012 peak. Such diminished momentum frequently characterizes a weakening advance, a long-term consideration. Similarly, the number of stocks hitting 52-week highs has diminished over the successive market price highs in 2010, 2011 and 2012.
It is also noteworthy that at the April high, the cyclical bull market had just exceeded 36 months, the approximate long-term average length for cyclical bulls. Stock market volume has been declining since the 2007 peak and throughout the rally over the past three years, typically a long-term negative.
While major U. S. stock market averages climbed to new four-year highs in April, most major world markets have been far weaker. In fact, almost all are below their levels of twelve months ago and of 2007. Ironically, China, the engine of emerging market growth, sees its stock market down for the past one, two, three, four and five years. Something is apparently very wrong that is not yet evident in China’s economic statistics.
A great many market technicians rely heavily on investor sentiment as a powerful contra-indicator, particularly at sentiment extremes. The price decline from the April peak turned sentiment quite negative (which is bullish), although the level is well above the negative extremes reached during the price declines in 2009, 2010 and 2011. Longer-term sentiment, however, as measured by equity valuation levels, remains near historic highs, except for the bubble period beginning in the late 1990s. According to Investors Intelligence, there are currently very few bearish investment advisors. Longer-term sentiment measures as well as the scarcity of bearish advisors point to lower stock prices ahead.
Analysts who look at cycles may find hope in a study done by Ned Davis Research. Placing equal weight on the one-year seasonal cycle, the four-year presidential cycle and the ten-year decennial cycle leads to a forecast for the current calendar year’s low falling near the end of June, followed by a rally over the year’s final six months. While it helps to know what historical records indicate, no forecast is foolproof. The presidential cycle prediction was dramatically wrong in 2008, the last presidential election year, when a positive forecast was followed by a 37% loss in the S & P 500.
While stocks became significantly oversold through the decline into Monday morning, June 4, the rally since then has moved most short-term indicators into somewhat overbought territory. Intermediate-term indicators, however, still remain somewhat oversold, which may reduce any potential decline from the short-term overbought condition.
Also still in the somewhat bullish camp is the moving average picture. Most major equity indexes traded below their 200-day moving averages early last week but bounced back above those moving averages as stocks rallied late in the week. Those indexes, however, remain below descending 50-day moving averages, which are threatening to break below the 200-day averages should the current rally fail. For the moment, moving average studies remain in the bullish category, but a 50-day break below the 200-day would prompt a bearish forecast.
Notwithstanding short and intermediate conditions, our major concern is the longer-term picture. On that basis, we believe the technical picture points to the probability that another cyclical bear market began at the April highs. At the April price peak, advance/decline statistics failed to confirm the new highs in prices. Over the past 80 years, such a condition has always been present before major market tops.
Major market tops are also characterized by expanding supply figures. The market has experienced such expansion over most of the past seven months, despite the price advance into April. Lowry Research Corporation has studied buying power and selling pressure since the 1930s. They note that the increase in selling pressure over most of the past year is typical of patterns exhibited prior to major markets tops. Lowry’s also highlights the rising number of new 52-week lows in recent market declines. In fact, they note that a large number of stocks are down by 20%, even 30% or more, indicating a diminishing number of companies holding up the major indexes.
As anyone who has studied technical analysis knows, there is no foolproof indicator. At best, technical analysis points to tendencies and probabilities. As I write this on Sunday, Europe is circling the wagons and pledging a bailout of insolvent Spanish banks. If past patterns endure, more rescue money will likely produce an immediate and potentially powerful short-term rally. If world central banks have decided to provide a coordinated “big bazooka” type response, our Federal Reserve could also add some additional version of QE3. Such a move would probably add power to the rally, but we’ve seen this act several times already. Before long it’s likely that investors will focus more on the deteriorating fundamentals than on historic central bank rescue efforts.
Whatever governments and central banks decide to do, we believe it probable that April’s highs will mark the top of the cyclical bull market that began in 2009. Since we believe the secular bear market still to be in force since 2000, another cyclical bear market poses a major threat. With banks and entire countries in danger of insolvency, technical conditions may be issuing a helpful warning.