Sunday, August 26, 2007

Big Week Ahead

After a great road trip, I got back to LA last week and found myself working on four projects simultaneously. It's a great problem to have, but one that will impact my posting schedule for many weeks to come.

Thanks to everyone for the thoughtful e-mails, messages and comments. I'll do my best to keep in touch as I work through one of my busiest schedules in years. ---- dk


The raging debate in the financial press, blogosphere and on message boards is whether or not we've tagged an IT bottom. With such a divergence of opinion, it's critical to try and grasp what the market itself is saying. Read everything you can, but always trust the market.

From the market's perspective, the outlook is still murky, but with a bullish bias. How long this bias lasts is unclear, but last week the sellers lost momentum.

An important consideration going forward is that V-bottoms are extremely rare. As the story goes, if money managers feel that a bottom is in play, they simply stop buying to get better prices. Without huge money, stock prices eventually slide, weak hands sell and the pros scoop up the slop at prices that interest them. In the world of TA, a double-bottom is born, and they're painful, uncomfortable experiences for the unprepared.

The rub is that the few times that V-bottoms actually work is during market events like this one. Two weeks ago, perfectly good positions were sold -- and perfectly bad ones were covered -- all to raise cash for reasons unrelated to those positions. The market hiccuped on non-fundamental selling, and this raises the odds for a spastic V-bottom to hold.

Of course, this is no prediction. Charts map market fundamentals and not the other way around. The fundamental question is whether the credit market has another shoe to drop, and what the market will do if this proves true.

To help understand these two questions, below are eight observations of the market itself:

1. Sizing Up the Correction

In just 20 sessions, the NASDAQ corrected 12.4%. While this felt dramatic at the time, the chart below shows that this was the skimpiest "correction" of the five since the Oct 2002 bottom.

Even more interesting, last week's skinny red spike shows that the market was very reluctant to give up even that much. The Composite spent just 40 minutes below 2400, and only 20 hours below 2500. Then, in just 7 sessions it regained more than half of the pullback.

This is quirky behavior. It's also consistent with derivative-based unraveling -- a grand "margin call" -- and not necessarily some sea change foreshadowing an economic slowdown.

Image Hosted by

2. Volume

Last week's light volume caught everyone's attention. NASDAQ trade came in 14% below normal, and it was the 4th lowest weekly total of 2007. Making matters worse, the other three weeks were all holiday-shortened.

Meanwhile, the Composite gained 2.9%. It broke out of a descending price channel, closed above the 50-day, confirmed above the 13-day and cleared the 61.8% Fib re-trace. Those are important moves, made even more so by their pack-like proximity.

It's worth remembering that two weeks ago trading volume saw it's highest total in US stock market history. After big selloffs, markets are famous for leaving the station with the fewest number of investors on board. Sellers are exhausted and buyers are skeptical. So, markets rise on low trade, and this is exactly what happened in August 2006.

A low-volume rise is technically a red flag. However, the market has just had a big convulsion. In this context, it's a murky signal at worst, and only more trade can clear it up.

Image Hosted by

3. McClellan Oscillator

One of the most compelling charts continues to be the McClellan Oscillator. The McClellan Oscillator measures breadth, and is a momentum indicator of advance/decline statistics. It charts the difference between moving averages of gainers and losers, a process which smoothes out the noise. It's also very fussy and difficult to impress.

Therefore, it's remarkable that, after four weeks of positive divergence, the McClellan Oscillator is now printing a new 2007 high! This is a one-two positive punch for the stock market, and it's a sign that the selling has been focused on a narrow set of targets. Crossing zero marks the "buy" signal.

Image Hosted by

4. Volatility

Would you buy this stock? While it looks ripe for a bounce, the VIX is also making an impressive case that an IT top is in. Someone thinks the worst is over, and this is bullish for equities.

Image Hosted by

5. Bond Contagion

The chart below shows that bonds swooned heavily before the equity market did, then began recovering. As equities fell apart, all three classes of bonds held on to their recovery. In a world of credit hurt, this is important.

The mortgage market is a complete mess, liquidity is an ongoing problem and consumer credit is next. However, the bond market continues to avoid the signal of a more widespread catastrophe.

Image Hosted by

6. 5-10-20 Timer

If the market holds up this week, the 5-10-20 Timing Indicator will trigger a buy in the next few sessions. That's a big "if", and timers can give false signals in either direction. However, if the signal is decisive, the 5-10-20 is one of the most reliable timers of all.

Image Hosted by

7. TOF Ratio

For all the VIX shenanigans, the option market itself stayed surprisingly cool-headed. As a result, the TOF Ratio didn't even stretch down to its lower boundary, and is setting up for a buy signal.

Image Hosted by

8. Investor Sentiment

Finally, like the Hulbert Index, Investors Intelligence tracks the sentiment opinions of professional advisors. It's hard to see in the chart below, but the Investors Intelligence Bear Percentage is now 37.4%, a 4 1/2-year high. While individual investors are still very sanguine, the pros are noticeably bearish, and this indicator is reaching extremes typical of bottoms.

Image Hosted by

The market gets a slew of economic data this week and ends with a three-day weekend. This week is going to count, and all signs point to higher trading volume. It will be interesting to see if the bulls can capitalize on their thin-volume bias.

Have a great week, and I'll check in when I can.




Woodshedder said...

Well done!

Anonymous said...

I enjoy your blog.

One question: why do you say the TOF is "setting up" for a buy signal when the 2 ema's are >150 + points apart? Is it because a but always follows a sell or is it a gut feel that the indicator will turn bullish in short order?



dk said...

Thanks, woodshedder.

Hi Jim...Regarding the TOF Ratio, it's not so much the absolute distance between the two MA's, but their ongoing, relative relationship. This could all change of course, but for now these MA's are in a range and not worsening. In fact, the 21-day day is moving up. Here a list of live charts that includes the TOF Ratio (5th chart down). It continues to print a positive setup for this indicator.

Babak said...

What's TOF?

re volume, we just saw the highest summer volumes in many years.

dk said...

Hi babak...TOF is an abbreviation for The Old Fool, the screen name of long-time message board veteran, Richard McRanie. Richard was the first person I saw use a ratio of NASDAQ price divided by the CPC as a timing indicator, and hence I coined it the TOF Ratio.

It uses 21- and 50-day EMA crossovers as Buy/Sell triggers. While the CPCE version has notable advantages (I track it also), the CPC version is Richard's fav and is very accurate.

Anonymous said...

DK - This is the developer at I wanted to do a write up on the 5-10-20 strategy comparing it to other more traditional trend following strategies. I put it through some initial paces, and it looks good. Do you know of any existing reports? I would hate to duplicate anyone else's work if it has been done well already.

You can reach me at my contact page on the website (sorry, I couldn't find an email addy for you on your blog).

Best Regards,