March 21, 2005: Small cap stocks have been leading the way from not only the October 2002 low but as far back as late 2000. Every rally from that point has seen the Russell 2000 lead the way in terms of absolute and relative performance. In some cases, such as last spring the Russell made its peak after the S&P, in early April. It did the same in 2002 peaking in April versus the S&P in March. Even in periods of negative relative strength, such as 1997 and 1999, the Russell had a strong tendency to peak commensurate with the S&P. Going back to 1998 we fond only two instances where the S&P made a higher high while the Russell failed to do so. The first occurred in July 1998 and the second in September 2000, when the Russell failed to move above its July peak. Well here we are in 2005, and we are now faced with instance number 3. Yes, the Russell 2000 on March 9 failed to move above its January high to confirm the S&P. This was not as big a failure as 1998 but considerably bigger than September 2000 as it missed by nearly 1.5%. As far back as 2001, every rally, big or small has been accompanied by a rising relative strength line of the Russell versus the S&P. This did not always lead to a new high in the relative strength line on the short-term rallies such as from October to December 2002. It also ailed to make a new high in June of 2004 but so too did the averages. But from as far back as September 2001 the relative strength line has made a series of higher highs in early 2002, early 2004 and also late 2004 and up until now it has never failed to make a higher high with the S&P. It did move up from its January 24 low, leading the way following the initial rally into early February. But from that point on it ha made a series of lower highs while the S&P has made a series of higher highs. It like the Russell itself has failed to move above its December peak.
Does this mean that the rally is over? Although the last two times this occurred, it did so right at important tops this is not necessarily the case now. What it does do is add another piece of evidence to support the case that the post 2002 cyclical bull run is maturing quickly and that if we are not at the end that move now we are getting a heck of a lot closer. One of the still bullish arguments we hear is that the A/D line has confirmed the latest new high in the S&P and that no bull market has ever ended with a confirmed A/D line. With the exception of the 1974-1976 rally that is correct. However, in our view the A/D line over the past few years has been as misleading an indicator as we have seen in nearly 22 years in the business. This does not man to ignore this, as historically it has worked in all but on case, but we would not bet the house on it either.
Meanwhile, other measures of the markets internal strength are adding to the idea that the bull run if not over is entering into extra innings. The new highs peaked in late 2003 early 2004 both on a daily and weekly basis. From that point the S&P has gone on to a series of higher highs while the daily and weekly new highs have made a series of successively lower peaks. This indicates that as the rally has progressed less and less stocks are participating. Throughout most of this time the new lows have not been much of a problem. They have expanded on the declines but this is normal and should be expected. However, something has occurred with the new lows the past two months that has not occurred in a very long time and that is from the January 24 peak in new lows they have made a series of higher peaks while the S&P has made higher lows. This is another subtle or perhaps not so subtle indication of deterioration below the surface of the market. This has occurred on both the daily and weekly new lows. The last time we saw such behavior from the new lows was from December 1999 to March 2000.
Medium and long-term sentiment, as we have repeatedly pointed out over the last several months remains overly bearish. We see no need to get into the specifics at this time. Sentiment, in our opinion is the most important element on a long-term basis. This along with what is clearly a corrective wave structure is the primary reason why we do not see the 2002 low as the end of the secular bear market. The fact is that the 2002 low did not produce the type of psychology historically associated with the end of a bear market of the magnitude we saw from 2000-2002. While sentiment is the key long-term it is not a good timing tool and in nearly every case strong momentum will override excessive sentiment. We saw that in early 2000, and again in 2003.
To this end, we are seeing the same pattern from the medium and long-term momentum picture that we see from the new highs, namely that momentum peaked in mid to late 2003 and from that point we have had a series of higher highs in price and lower highs in momentum. This is not an isolated event but nearly across the board and from both price based momentum as well as internal based momentum indicators. The former are based on measures of the averages including RSI, rates of change and also our own trend indicators. The latter are based on measures of breadth and volume as well as the new highs and lows as discussed above. This is occurring on both a daily and weekly and against a declining Monthly trend oscillator.
Short-term the market is oversold but nearly all of the indicators have confirmed the post March 7 lows and have also moved to levels that have a strong correlation with lower prices. The McClellan oscillator for example has moved below where it still in early January and to its lowest level since early May. Both those instances lead to lower prices although in May we did see a fairly sharp rally into late June. The one area that is positive is short-term sentiment as measured by the put to call ratios and to a lesser degree the Rydex ratios. Of course, this has been the case for the last several days and so far to no avail. The oversold condition and short-term bullish sentiment support the potential for a bounce and a fairly decent one. However, the strong oversold readings, the declining daily and weekly trend indicators and the majority of the sentiment indicators argue that any bounce that may occur is part of a still incomplete post March decline. Short-term we are neutral looking for a bounce. Medium-term we are bearish looking for lower prices. Long-term we are bearish but with the idea that the rally is not over but far gone.
Larry Katz
Market Summary and Forecast
