Wednesday, July 6, 2011

The Holes in Last Week's Rally

The Holes in Last Week's Rally
By MICHAEL KAHN | MORE ARTICLES BY AUTHOR

While the big jump in the S&P 500 looks great on the surface, the market is still fraught with technical problems.


As the second quarter ended, stocks staged their biggest weekly rally in two years with the Standard & Poor's 500 stock index gaining 5.6%.

Many technical indicators, such as market breadth, soared along with stock prices last week.

(On Monday, the broader stock market closed flat as many traders were stretching out the July 4th holiday weekend.)

Unfortunately for the bulls, the charts suggest that many nagging problems are still in force. Though surprised at the extent of last week's gains, I am not convinced that the trend has turned higher for the long run.

To understand why the market may not be as hot as it seemed, we have to look back to analyze how it go to where it is now. Over the past two months, as stocks moved lower, technical conditions deteriorated.

The short-term rising trend from August 2010 was broken to the downside. Key bull-market leaders, such as technology and financial stocks, lagged the broad market by significant amounts. And the market moved into its seasonally-weak summer months following the mantra "sell in May and go away."

Investors also worried about two big issues - the Greek debt crisis and the June 30 ending of the U.S. Treasury's bond-buying plan known as QE2.

Sentiment indicators may not have registered official readings of excessive fear, but they were playing a role in the market downturn.

Worried investors shun riskier assets such as stocks and move at least some of their money into the perceived safety of Treasury bonds and notes. Indeed, on June 16, the key two-year Treasury note yield set a record low of 0.30%, suggesting a serious flight to safety.

The market's decline finally pushed momentum indicators, such as stochastics, to low enough levels to suggest that some investors would start bottom fishing for cheap stocks. Called "oversold," this condition said the decline from May had moved too far, too fast and needed a cooling off period.

Put them all together and mix with relief that there was positive movement in the Greek debt crisis. Garnish with the relative illiquidity of a preholiday market and you get a deceptively strong rally.

To be sure, a couple of technical indictors did catch fire, suggesting a turn for the better might have some legs.

Market breadth, or the number of stocks participating in the rally, took a sharp turn for the better. It was not just the "usual suspects" rallying this time.

For example, the advance-decline line on the New York Stock Exchange, which keeps a running tab on how many stocks rise and fall each day, soared. Not only did it erase what appeared to be a breakdown of its own, but it moved into fresh high ground (see Chart 1).

[GT1-0705]


Chart 1
STANDARD & POOR'S 500

..Also, it appeared that there was another bullish indictor: the "breadth thrust." Attributed to analyst and money manager Martin Zweig, a breadth thrust quantifies the change from an extreme negative-breadth condition to an extreme positive one. Another way to look at it is the tide running out and then rushing back in.

The market experienced such a condition last week and it is supposed to usher in a new or continued period of market strength. The signal was rare but worked fairly well until a few years ago.

But Tom McClellan, editor of The McClellan Market Report, said that "since 2007, when the uptick rule was eliminated, we have seen 17 of these signals, and the reliability is not as good as it once was."

It is another example of how changing rules and new investment vehicles, such as exchange-traded funds, have devalued many technical indicators. In other words, the supposed breadth-thrust signal should be taken with a grain of salt.

With stocks now challenging price levels at which they sold off several times over the past six months, the sustainability of last week's rally is questionable.

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