December 13, 2004: The past two reports we have focused on all of the positive aspects of the strong rally and momentum surge off of the October 25 low. In a number of ways the market has performed in near text book fashion since the November 5 momentum peak. The momentum indicators have corrected their deep overbought condition with prices holding steady and in fact moving higher with the S&P up about 1.8% from its November 5 close. This was as pointed out in the November 15 issue as one of the key factors in support of a bona fide momentum surge. On this issue the market has so far succeeded.
The initial correction of the overbought condition in most cases is usually over very quickly and often sees a move back to overbought . These second overbought moves almost always fail to move above the initial thrust signal and produce the first divergence. The initial divergence most always fails to produce much of a decline if any. The indicators did bounce back from November 19 to November 24. The averages did move higher and the indicators did move up but only one of our four primary momentum indicators got back to even a weak overbought reading, and that was the breadth oscillator. The McClellan oscillator after spending one day below zero did rally but did not get close to even a weak overbought reading peaking at +83 on November 24.
The averages have continued to perform well from November 24 with the S&P up about 7 points and failing to react negatively from the initial divergences. Again, price is so far performing in text-book fashion. However, the indicators are not as they have all made a series of lower highs and lower lows. The breadth and volume oscillators are neutral but not far from where they stood in late July and late October. This is not all that bad because those were near good lows. The McClellan oscillator has been the weakest of the lot and moved slightly below its late October low. This poor performance from these indicators does add some weakness to the strong momentum reading in early November ands adds some support to our view that while the signal was most likely valid, and so far we are getting that confirmation from the price side of the equation, it did not have the same strength of signal as we saw from March to May of 2003 and is certainly not of the same magnitude as early October of 1998. We see it in similar vain as the post September 21 signal with a slight chance that it could be similar to May-June. But unless price just outright collapses the odds are high that the rally is not over but there is a growing possibility that the correction we get may be a bit deeper and more time consuming than we had initially anticipated.
All of this is great but there are also a huge number of potential problems and some are quite serious or have the potential to be. The most obvious is the fact that the DJIA has not been able to make it back to its February peak. It is only 1% or so below but it is failing at this time. Divergences between the DJIA and S&P are not common and often lead to a major trend change. For example, the DJIA moved below its August low in October while the S&P held well above its respective level. This lead to that dynamic rally. The DJIA made its high in February and failed to confirm the S&P in early March. The DJIA moved above its January 2002 peak in March 2002 while the S&P failed. The DJIA made its peak in January 2000 failing to confirm the S&P in March. The DJIA moved above its February 20001 peak in May of 2001 while the S&P failed miserably. The DJIA failed to confirm the lower low in the S&P in October 1998. In October of 1997 the DJIA failed to get above its August peak while the S&P did. That was followed by a 500 point drop in the DJIA in two weeks. The Granddaddy of them all was in 1974 when the S&P bottomed in October and the DJIA made a lower unconfirmed low in December. These are but just a few but as we can see they have been of some degree or another important. Of course 100 or so points for the DJIA is not a lot to confirm. And more importantly we are far confirmation on the current situation but it is important enough to be aware of and to focus on.
This does not end the myriad of potential divergences that are showing up. While the new highs on the NYSE did confirm price on December 1 from August they did lot on December 3 failing by almost half. New high divergences usually take longer than two days. In fact from their peak in early December 2003 it took until early March with a series of lower new highs. However, the S&P is well above its March peak and while the new highs did confirm for the post August rally they were barely above their early January peak and nowhere close to their December 2003 level. We see the same on the weekly new highs. The McClellan summation index did not make it past its January peak which itself was below its June 2003 peak. and at present we have two lower highs in the summation index versus two higher highs in price. The % of NYSE stocks above their 200 day moving average has not come close to its early April peak and is light years below its January 26 peak. The same indicator on the S&P is showing the same pattern. One of our favorite long-term indicators is the 52-week rate of change. Here too we are seeing a massive negative divergence with its early February peak. The key here is that while we are staring at huge number of potential medium and long-term divergences, not one has been confirmed and for now they need to be viewed as potential divergences. We would also like to point out that the list above is far from complete and is really only the tip of the iceberg. We would also be remiss in not also pointing out that all or most of these potential divergences can be corrected on a rally but this rally would have to be more dynamic than any we have seen in several years including 1998.
In the last two issues we have also pointed out that in periods of strong momentum, and by strong momentum we are referring to the indicators not only price, that negative sentiment will in 95 of 100 cases lose out over the short to medium-term. The best example we can point to is last years rally. Even so, the overall sentiment picture has continued to weaken. We did see modest up-tick in the put to call ratio but further deterioration in a number of other indicators. The 4-week moving average of the Consensus Inc survey is the highest since late January. That in turn was the highest since April 1998. What we can see on both of those instances their was a lag time between peak sentiment and a market top. That is the good news. Also the American Association of Individual Investors (AAII) survey while bearish is not close to the excessive levels seen in the November 2003-January 2004 period. We would be willing to bet that few more week of rally and it certainly could be. We have never found sentiment to be a good or reliable timing tool. We have seen some important tops occur with sentiment well below our expectations and have seen what looked to be extremely excessive levels get even more so. They do give us a keen insight to investors and traders future expectations and the more one sided they get the bigger the warning and more importantly the bigger the fall. Although some of the indicators are not at the extremes seen in the late fall of last year to the early part of; last year, a number of others are at or close to those extremes. This suggests to us that we are moving in to the mature phase of the rally. This phase can be dynamic for a while such as late 1999 to March of 2000 but it also tells us that the risk levels are getting higher. Stops should be tightened laggards deleted from portfolios and speculative activity should be cut back to a degree.
We see the post August and October rallies not as a continuation move from the 2002-2003 low but as a completion move. We have our concerns especially from the longer-term measures and they are mounting. The potential divergences are a mile long and growing. However, as bad as they look they have yet to be confirmed. In the meantime we do see enough positives to view the momentum surge in early November as real. Again we do not see it as the same magnitude as March of 2003 but we do think it strong enough to support a good medium-term advance. Our short-term indicators are troubling us and the daily trend oscillators are on a very negative signal. A strong surge early this week would be bullish but from the overall technical evidence it is more likely that the correction has more to go in time and price. We are going to remain neutral short-term. We are neutral medium-term but with a positive bias and we remain bearish long-term.
Larry Katz
email me at: lk1618@comcast.net
website link: www.marketsummaryandforecast.com
Larry Katz serves as both editor and research director of Market Summary and Forecast. Mr. Katz is a full member in the Market Technicians Association and is both one of the founders and the president of their Southern California Chapter. He also serves on the management committee chairing the membership committee. Mr. Katz is a regular contributor to Top advisors corner on America On Line. He is a regular guest on the Business Channel in Los Angeles with Richard Saxton. He has been a quest speaker of the Market Analysts of Southern California (MASC), the Omega users group of Thousand Oaks, Ca. and Orange County, the Market Technicians Association Atlanta Chapter as well as the Foundation for the Study of Cycles. He also ran a workshop at the Market Technicians Association 1999 Annual Seminar. He has been a regular commentator on the Reuters Financial network, both in the US as well as in Japan, as well as being published in the Market Watch section of Barrons Magazine on a number of occasions. He is currently ranked in the top five for intermediate term gold timing by Timer Digest.
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