Market Sells Off after New Year Rally: Long Term Technical Outlook

After a strong start to the new year, the market has given bulls a wild ride. Since the minor sell-off ending on 12/30/2005, the SP tacked on 3.68% in a mere 7 trading sessions, with that rally ending on 1/11/2006. Technology issues in the Nasdaq sprinted to a 5.72% gain during the same period. Small caps, to the surprise of most market analysts, continue to outperform, and posted a 5.64% gain, and are at all time highs.

How quickly things can change. On 1/20/06, all of the major averages were down in excess of 1%, Large caps, especially the Nasdaq, led the way down, losing 2.35% The SP-500 lost 1.83%, and the small cap Russell 2000 lost 1.45%, leading Reuters to describe it as the worst single day decline in 3 years.

Despite all of the talk about great earnings, low interest rates, and good economic numbers, the financial markets, and the global economy, are in a very precarious position. The technical factors as I see them are as follows:

Long Term:
1. Breadth negatively diverging from the major indices: This weekly chart below compares the percentage of NYSE stocks above the 200 day moving average to the Russell 3000, a broad based index.

There are 2 ways to interpret this indicator. The oscillator method looks for extreme highs and lows in the indicator. Technicians and fundamentalists alike use the 200 day moving average as a long term trend measure. If the price is above the average, the stock (or index) is considered to be in an uptrend. Likewise, when below, it is assumed to be in a downtrend.

When the market advances, you want a majority of stocks to go up with the market. But you can have too much of a good thing. The oscillator method attempt to determine when too many stocks have advanced, which suggests the market uptrend should pause, if not decline outright.
There are some interesting ways to use this indicator in conjunction with volatility bands. But I will save that for a future post.

The method I prefer is the divergence method. Breadth should expand with the market. If the market is making higher highs, breadth should also. When it does not, that signals some signs of a weakening trend. This is what we see when plotting this indicator against the Russell 3000–a series of declining peaks for breadth, and a series of rising peaks for the index. Fewer and fewer stocks are carrying the market higher.

The advantage of market breadth is that it can give significant advance warning of a weakening trend, particularly on longer time frames. Long term breadth divergences are often early by many months, the 1998-2000 market shows.

2. Price momentum diverging. This monthly chart of the Russell 3000 shows a significant divergence in momentum. One of the major technical principles is that momentum leads price. A significant reversal in trend is much less likely if there are no momentum divergences. Like cars, price needs to slow down before it can reverse.

3. Price formation is a rising wedge. Price is the technicians most important indicator. On all time frames, you can see a converging set of trend lines connecting highs and lows. Rising wedges suggest a sharp sell off when the lower trend line is broken.

A look on shorter time frames will show similar technical deterioration. When there is a convergence of technical signals on different time frames saying the same thing, it is time to listen.

Next installment: Intermarket technical analysis and global economics.

Charts: Courtesy of Worden Brothers Inc. Telechart 2005 Gold.