The Bank Index: The Single Most Important Index (part II)

Figure 1 is a weekly chart of the S&P Banking Index (symbol: $BIX.X), and this is the same exact price chart I showed in the May 8, 2009 article, "The Bank Index: The Single Most Important Index."

Figure 1. $BIX.X/ weekly

From the article, I quote:

In essence, the current bounce off the March 9 lows is no different than the prior 3 bounces before it as prices have only retraced back into key resistance levels or the prior breakdown point. If the market is going higher, than the S&P Banking Index will need to close above resistance at 126.80 and the down sloping 40 week moving average.

We did get the weekly close over the nearby pivot at 126.80 and that was a by a mere 7 cents, but prices have yet to close above the down sloping 40 week moving average. Prices are off about 13% from those closing highs 4 weeks ago while the broad market has been moving higher.

As stated in the article:

As I try to figure out if this bear market rally will morph into a new bull market, I should probably remind myself everyday that I only need to look at this one chart to get my answer.

Stocks are not going higher without the banks. The 40 week moving average and the key pivot point (resistance level) at 126.80 are technical hurdles for the S&P Banking Index.

Investor Sentiment: Extremus Maximus

As you would expect from the bullish price action last week, the "Dumb Money" indicator is moving to new extreme highs. Since 1991, this has been the 8th most extreme reading out of the 42 unique times the indicator went above the bullish extreme line (i.e., bear signal). Extreme readings, such as the current one, are generally associated with strong bull markets like those seen from 1995 to 1998 and from 2003 to 2004. The only real failure was in 2002, and this led to the flush into the July, 2002 lows.

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"/ weekly

As I have pointed out over the past couple of weeks, it takes bulls to make a bull market, and the current dynamic -an extreme bullish reading - is consistent with those times. For example, if you "bought" the S&P500 after similar extremes in the "Dumb Money" indicator and held your position for 13 weeks, 7 out of 8 of your trades would have been winners. 6 of the trades would not have lost more than 3.5% and the other two (1 winner and 1 loser) would not have lost more than 6.5% during the course of the trade. My interpretation of this limited data is the following: 1) we are in strong trending market and at this point, whether we label it a new bull market or a bear market rally doesn't matter; 2) dips will be bought even with a correction. In other words, if you bought today and held for 13 weeks it is unlikely that you would lose money in the end, and there is a real possibility of the markets being higher.

Now, let's slice and dice the extreme readings another way. In this instance, we will "buy" the S&P500 on a similar extreme reading in the "Dumb Money" indicator (as before), and we will sell our position when the "Dumb Money" indicator registers a bearish extreme reading (i.e., bull signal). In this way, we can see what happens to prices from the current point, an extreme bullish value, to the next bearish value (or buy signal). In other words, would it be best to sit on the side lines (because we don't like to hold our noses and buy high and sell higher) and wait for the next buy signal (where we can buy low and sell higher)?

In this scenario, you have 6 trades; 4 were profitable. One trade lost more than 6.5% during the course of the trade and the 4 of the other 5 never lost more than 3%. While 4 trades were profitable, only 2 trades produced any meaningful profits; these were the trades from February, 1995 to July, 1996 (32% gain) and from May, 2003 to May, 2004 (18%) gain. Only 1 trade lost anything meaningful and that was the trade at the top of the 2002 bear market. This trade lost 6.5%.

So waiting for the "Dumb Money" indicator to cycle into the next buy signal (i.e, investor becomes bearish) may not be the best thing to do as there is the fear (and real possibility) of missing out on extra ordinary gains. With sentiment at such a bullish extreme (and investors desirous of buying the dip), the market won't rollover so easily.

Of course, when it is comes to the markets, there is no free lunch, and we need to be ever mindful of the scenario like that seen in late 2001 and early 2002. The markets had a tremendous rally following the 9/11 disaster spiking 21% or so into the 40 week moving average in 13 weeks. The Fed had flooded the markets with liquidity, and the leading economic indicators showed an end to the recession, and prices on the S&P500 even closed above the simple 10 month moving average. Yet, despite all these fundamental and technical positives, the market rolled over by the end of April, 2002.

As I have stated over the past several months, I believe the current rally is a bear market rally; this is not the proper launching pad to a new bull market. Admittedly, the similarities between now and April, 2002 are striking, and honestly, this is my last "hope" that I will be vindicated. It's kind of looking like a bull market, but woops not so fast. We shall see. To me, the issue of bear market rally v. new bull market has yet to be resolved. I have outlined how I will manage such humiliation when and if it comes.

For the record, the "Smart Money" indicator is shown in figure 2. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders.

Figure 2. "Smart Money"/ weekly

EWJ And The USDJPY

I would like to explore the relationship between the i-Shares MSCI Japan Index Fund (symbol: EWJ) and the US Dollar Japanese Yen (symbol: USDJPY) cross match. What piques my interest is that the Dollar is up almost 2% today against the Yen. Furthermore, the "next big thing" indicator suggests that both assets have a high likelihood of undergoing secular trend reversal.

Figure 1 is a monthly chart of the EWJ with the "next big thing" indicator in the lower panel. I have also placed pivot points on the price chart and a close above one of these pivot points provides a good entry point when the "next big thing" indicator is in the zone. Now look to the current time frame. Due to the "v" shaped bounce there is no pivot point to "tag" an entry. Nonetheless, price has yet to penetrate the very steep down trend line.

Figure 1. EWJ/ monthly

Figure 2 is a monthly chart of the USDJPY cross match with the "next big thing" indicator in the lower panel. Once again, I have placed pivot points on the chart, and a close above of these pivot points provides a good entry point. Several failed signals are noted with the down red arrows, and in the current time frame, USDJPY has yet to close above the most immediate pivot (or resistance level) at 99.679.

Figure 2. USDPY/ monthly

What should be clear is my pursuit to try to define those technical dynamics that lead to secular trend changes. Just a casual look at the charts show that when the "next big thing" indicator is in the buy zone, there is a high likelihood of a secular trend change leading to a multi year upward price move. We want tailwinds - not headwinds!

Now let's contrast EWJ to USDJPY. See figure 3 a monthly chart; USDJPY is in the top panel and EWJ is in the bottom panel. From 1992 to 2005, the relationship is pretty clear. As the USDJPY fell (i.e., Yen strengthened), the EWJ rose. When the USDJPY rose, the EWJ fell.

Figure 3. USDJPY v. EWJ/ monthly

Starting in mid-2005, both assets have moved in lock step. The USDJPY and EWJ moved together into the highs of mid-2007, and both assets fell together in the deleveraging of 2007 and 2008. During this time period the JPY strengthened and the EWJ fell as well, and I believe this would fit with the new dynamic seen in the US and throughout the developing world in the non-commodity currency countries. Currency devaluation leads to higher asset prices.

USDJPYand EWJ are worth watching because they are both in a position to undergo a secular trend change. Whether the pattern fits the new dynamic or the old one is yet to be determined.

Market Ramblings

With regards to the recent post on key price levels, a reader emailed and asked me if I was "throwing in the towel". I can only presume he detected a sense of bullishness in my comments. Yes, the price action has been bullish, but I am still uncomfortable calling an end to the bear market as I don't believe this is the proper launching pad for a new bull market. I know I make a lot of noise about this launching pad stuff, but I have to ask myself this question all the time: how do we get there from here? Without the proper set up, I don't see a new bull market happening.

But then again, why does it matter if we are in a new bull market or bear market rally? It really doesn't matter what we call it, but all that I am trying to do is determine if we rollover or if we continue to march higher in a nice 45 degree ascent on the price chart.

As I stated in this week's sentiment commentary, I have not resolved the issue of new bull market versus bear market rally:

My own work suggests bear market rally, but I do acknowledge that the persistence of the bulls is very reminiscent of 1995 or 2003, when sentiment got stuck in the bullish extreme while prices continued higher. As the equity indexes continue in a range, we haven't seen the "much higher" yet to confirm the new bull market scenario. On the other hand, we haven't seen the market break down and confirm the bear market rally scenario. We are stuck in a range, which means lack of resolution.

So how can I be bearish when the price action has been bullish? It isn't so much that I am bearish because I really don't have an opinion, but the sum of the data that I look at suggests that the rally should rollover within a couple of weeks. Yes, I have been stating this since early May, and it has not happened, and in my mind, I always think of the old market adage: when the market does not do what you expect, then sit up and take notice.

Several readers have emailed stating that I should change the name of the sentiment indicators. The "smart money" should now be the "dumb money" and the "dumb money" should now be the "smart money". Of course, I should be the "dumb money" and of course, the peak of the emails were after Monday's close and possible breakout from the range 4 week range.

Let me remind readers that the purpose of the sentiment indicators is to get in front of the potential trend changes before you have an 8% sell off in a week and you have given back a majority of your profits. In trading, it isn't so much where we are today but where we will be in the future. Most of the time -nah, more like 85% of the time - the sentiment indicators work without remorse. In other words, I expect to be happy with my choices most of the time. On the other hand, if you want to trade or invest like it is always 1995 or 2003 when it was all bull all the time then go ahead.

So let's contrast the sentiment analysis with the key price level analysis. The sentiment analysis attempts to define where we expect prices to be in several week's time. So typically, there are too many bulls and too many bulls usually means lower prices ahead. With the key price level analysis, it is more after the fact as in prices closed above a key resistance level, so therefore we are now bullish. So yes, the price action has been bullish as resistance levels have fallen, but sentiment is getting very bullish, which historically isn't a good sign.

Think about it this way: after a plus 40% run folks are now only getting bullish. The time to be bullish was 40% ago. You should salivate at lower prices and cast a skeptical eye at higher ones.

So what technical evidence would I like to see to call the end to the bear market? I discussed this in the May 5, 2009 commentary and I will summarize briefly here. My research shows that this is not the correct launching pad for the end of a bear market. Markets usually consolidate for long periods of time before heading meaningfully higher or the sell off goes on for a longer period of time. Time or the x-axis is one of the concepts of the "next big thing" indicator, and this indicator has not cycled into position yet (with the exception of the Russell 2000). Going back to the 1920's on the Dow, every market bottom but 2 saw either a period of consolidation or the "next big thing" indicator suggest that a secular trend change is at hand.

I openly acknowledge that I could be wrong - that my indicators and use of pivot points to characterize the price action cannot detect the current "v" like bounce seen on the monthly charts. From my vantage point, this doesn't seem likely as I utilize my indicators across multipe markets, and they have worked well in backtests over the past 50 years.

Of course, this time could be different. If this turns out to be the case and we are embarking on a new bull market, then I have back stopped myself by adapting the simple, yet elegant strategy credited to Mebane Faber. I will buy the S&P500 on a monthly close greater than its simple 10 month moving average. Now there is nothing magical about the 10 month moving average, and in fact, the 9 month simple moving average works just as well. The success of the Faber strategy isn't the buy signal, but the selling discipline. If wrong, you know it as prices close below the simple 10 month average, and you move on. Nice and neat. Once again, the success of the Faber Model isn't the buy signal, it is the aversion to risk.

It should be noted that a monthly close greater than the simple 10 month moving average doesn't mean the market is entering a new bull market. A noteworthy failed signal occurred in March, 2002, and this was the top of the market that led to the flush into July, 2002. All I am saying is that the Faber Model is a "safe" and reasonable way to participate in a rising trend.

In summary, I am constructive on the price action. Yet, I still believe that this is a bear market rally. If I am wrong, that is ok and I have a plan, which I will execute. It isn't so much where we are today that bothers me, but where we will be tomorrow. I just don't see the market getting to that promise land just yet. But all that will be put aside when and if prices close above their simple 10 month moving average.

Key Price Levels: June 3, 2009

Since early May, I have been expecting market weakness. The sentiment picture has been overly bullish, and inflationary pressures or expectations have been present as the trends in gold, crude oil and Treasury yields have been strong. These would be considered headwinds. Clearly at odds with this view of the market has been the price action, which has been nothing short of fabulous. Breakout levels have been re-tested and support has held. There is nothing wrong with that. My expectations have been trumped (so far) by market strength.

Please review the methodology and the significance of the key price levels by clicking on this link.

A weekly cart of the S&P Depository Receipts (symbol: SPY) is shown in figure 1. The break out from the 86.78 level has led to a break above the highly watched 40 week moving average. Support is at 90.48, and resistance comes in at around 97.

Figure 1. SPY/ weekly

A weekly chart of the Diamond Trusts (symbol: DIA) is shown in figure 2. The break out over various trend lines or resistance levels is noted within the gray oval. Support is at 82.64 although a weekly close below the 40 week moving average would dent the bullish case. 90 is the next level of resistance.

Figure 2. DIA/ weekly

Figure 3 is a weekly chart of the Power Shares QQQ Trust (symbol: QQQQ). The QQQQ is entering a resistance zone at 36.15, which essentially is the gap down area from October, 2008. On the other hand, the QQQQ is breaking out from the rising trend channel. I am not a big fan of this kind of breakout - i.e., a breakout from a rising trend line - and I generally associate this kind of breakout with an accelerated move that ends in a market top. I would prefer to see the QQQQ spend some time back in the channel before heading higher. After 36.15, the next level up is the down sloping trend line at 40.

Figure 3. QQQQ/ weekly

Figure 4 is a weekly chart of the i-Shares Russell 2000 Index (symbol: IWM). Price is now above the key price level at 47.58, the 40 week moving average and the pivot point at 50.13. 50.13 and the 4o week moving average become the support zone; we don't want to see a close below this level. Surprisingly, the September, 2008 gap down area at 60 becomes the next target.

Figure 4. IWM/ weekly

The Final Word On The Coppock Guide

The final word on the Coppock Guide should go to MarketWatch.com's Mark Hulbert. He has written two articles on the subject over the past month that were brought to my attention by a blog reader.

Hulbert states:

The bottom line? Don't get seduced into believing that the Coppock Guide has some magical ability to identify new bull markets. Yes, a buy signal from the indicator would suggest that the market's trend has shifted. But, as history has amply illustrated, that trend could quickly reverse course.

The articles can be found by clicking on these links: "Your Guide To The Coppock Guide" and "June Is An Important Month".

Question: What Does The Bullish Signal From The Coppock Guide Mean? Answer: Absolutely Nothing!

I am seeing several articles in the main stream press and blogosphere regarding the "bullish signal" given by a technical indicator known as the Coppock Guide or Coppock Curve. As we can see in figure 1, a monthly chart of the Dow Jones Industrial Average (symbol: $DJIA), the Coppock Guide has turned up from a very low level. Thus according to the above referenced sources, this indicates a new bull market.

I am not so sure about that interpretation.

Figure 1. $DJIA/ monthly

Let's take a look at the indicator which was developed by E.S.C. Coppock and presented in Barron's in 1962 as a very long term buying guide. Coppock advised buying stocks when the indicator was below the zero and then turned up. The formula that I use to calculate the Coppock guide is:

1) use monthly data

2) use closing prices

3) calculation A: 14 month rate of change

4) calculation B: 11 month rate of change

5) summation of: (calculation A + calculation B)

6) take the 10 month weighted moving of the value in line 5

In TradeStation Easy Language code this looks like:

(WAverage((RateofChange(C,14) + RateofChange(C,11)),10))

My Coppock indicator, as presented in figure 1, is then wrapped in trading bands with a 36 bar look back period (or 3 year) to assess for extremes in the data.

In the one article that analyzes the current buy signal the author writes:

"Valid signals are those that turn up from under the zero line. And historically, the deeper the level at which the signal arrives, the more strength the following bull market has. This most recent signal is coming from a deeply oversold level - the most since 1938 (-417 to -400) and even further, 1932 (-643 to -616)."

This is a true statement. However, in the article the author is utilizing the S&P500 Index, which was not in existence until 1957, so one must assume that the data from 1920 to 1957 is the synthetic index that linked the S&P90 (pre 1957) with the S&P500 (post 1957).

More importantly, if we use a differernt (but similar) data set, like the Dow Jones Industrial Average, we get very different results. For example, in 1931 there were two deeply oversold signals (using DJIA data), when the Coppock indicator value was actually at or below the current and 1938 levels of the indicator. The first turn up of the Coppock Curve was in February, 1931, and the Dow closed at 190.30. The second turn up of the Coppock Curve was in August, 1931 with the Dow at 139.40. In both cases, the indicator turned down 1 month later, and the ultimate low was at Dow 40.60. Ouch!

Furthermore, the deeper the oversold level doesn't necessarily equate to a strong bull market once the indicator turns. Following the 1938 signal, the Dow only went about 15% higher before rolling over.

The author does acknowledge that "the Coppock Curve has given its share of false signals", but I am not sure what he means when he states that "we haven’t seen any (false signals) occur when the metric has curled up from such a deeply negative level." I know I have only shown you these two very, very oversold signals from the Dow in 1931, but very, very oversold didn't work for the Nikkei in the 1990's or for gold in the 1980's and 1990's either.

I have "sliced and diced" the Coppock Curve many ways and found that it does have some merit of identifying trend momentum. For example, if you buy the DJIA when the Coppock Guide is rising and sell when it is falling you get an equity curve that looks like figure 2.

Figure 2. Equity Curve

Since 1924, such a strategy yielded 6830 DJIA points versus buy and hold of 8600 DJIA points. There would have been 72 trades of which 50% were profitable; your time in the market was 47%. The strategy draw down is about 40%, which is not much of an improvement over buy and hold. From this study and by following the Coppock Guide, you can make 80% of buy and hold with approximately 50% market exposure, but it doesn't improve draw down over buy and hold.

My impression is that the Coppock indicator functions like most oscillators. They are great in a range bound market (like the 1960's); I don't believe they are very useful in an oversold or overbought market. Across multiple markets and in the Dow, there appears to be nothing unique about the Coppock Curve to indicate the onset of a new bull market.