Option Investor
Trader's Corner

When Bearish News No Longer Drives Stocks Lower

Printer friendly version

There reaches a point in a bear market cycle where bearish news on the economy, on inflation, etc. no longer drives the market down much lower. This is what happens when we say that the market gets 'oversold' in a major way. Looking at the underlying dynamics at play here, it takes continued SELLING to drive prices lower.

On the way down, when the market is factoring in a bearish economic outlook and a bearish outlook for earnings, there is a lot of selling on each piece of negative news and the market keeps selling off. However, after so much of this, the market also reaches a state of equilibrium for the CURRENT outlook. Most everyone who is going to sell has sold, so to speak. A number of big market players are also SHORT a number of bellwether stocks.

If prices stop declining, it doesn't even take overtly bullish news to cause a rally. It's enough that the bearish news stops for a while. Shorts will start to cover (by buying) if prices rise on just a minimum of speculative/trader buying. The dynamic in an oversold situation is that there are not a lot of sellers tending to come in until the market rebounds some distance up from the low; e.g., a 10 percent rise.

Or, in terms of retracements, we could look at the rally potential, before substantial renewed selling, as a retracement of half (50%) or a bit more (e.g., 62%) of the last major downswing.

Bear market rallies tend to run out of steam due to it taking substantial new BUYING to drive prices up more than, say 10 percent off the low or to more than a 50-62% retracement of the last major decline.

One of the historical precursors for rallies that have extended above and beyond a nominal 8-10 percent up off the lows is a technical type measurement or 'indicator' that looks at the number of NYSE stocks trading above their 200-day moving averages; to use a shorthand: "percent > 200-day SMA". This is not a fast-gauge type indicator, as it can take weeks or even months for an oversold condition suggested by this indicator to play out with a sustained rally.

The concept is simple. The 200-day moving average is perceived to be the dividing line between a stock that is technically healthy and one that is not. Most traders, including myself, use the simple moving average (SMA) for this measure. (Some also employ exponential moving averages, which give more weight to recent data.)

A stock that is trading above its 200-day moving average is said to be in an uptrend and is being accumulated; one below it is in a downtrend and is being distributed.

On the surface, it seems as though the higher the 'percent > 200-day SMA ' goes, the more bullish the market is and the lower it goes, the more bearish. In practice, however, the reverse is true. Extremely high readings are a warning the market is becoming quite vulnerable to a reversal to the downside. High readings reveal that traders are far too optimistic. When this occurs, fresh new buyers are often few and far between.

Meanwhile, very low readings signify the reverse; the bears are in the ascendancy and a bottom may be near. You'll see examples of both situations on the chart below. Some weeks (or months) may pass before there is an upside or downside reversal that comes AFTER the low or high extremes.

We also need to take a look at just what levels represent high and low readings. On the LOW side (very oversold) are readings at 20 to 40 and BELOW and 70-80 or ABOVE (e.g., at or near 90) are on the HIGH side.

On the upside, traders should have been very cautious when the number of stocks above their 200-day moving average went above 80-85%. Historically, readings in this area have precipitated either a major correction or a bear market. The readings above 90%, which lasted into the early part of March 2003, was the most extreme seen on the chart below. When this percentage figure reversed to the downside in late-2003, there was a steep decline, but also an approximate year and half period of a broad sideways trend.

In the last 20 years, readings around 20 or lower have consistently marked key reversal areas, although rallies have sometimes been a few weeks off; for option traders, these low extremes may simply serve as a warning to not get too attached just to bearish plays. As the chart below shows, but not quite as clear as I would have liked, the 20 level and below marked a major market bottom in October 2001, late July 2002 and October 2002. With this in mind, when the percent above the stocks 200-day averages nears gets to 20% or below, traders should be on the alert for the possibility of a sharp, V-shaped reversal.

Chart from Bloomberg

Readings below 20% are noted on the chart above, where the market has been oversold enough to turn around. From the low in the S&P 500 (SPX) at 1270 until today, the recovery rally has only been 6.6 percent. So far at least, the recovery rally based on the percent of stocks below their 200-day moving averages (with a low extreme near 10 percent), has not carried very far relative to the rallies of around 23-24 percent back at the bottom of the last bear market.

CONCLUSION? We may not be near a bear market bottom; OR, it is going to take a while, such as if there is to be a long sideways (trading range type market) ahead.

From that January 23rd trough low, SPX gained 9.6% over 10 days; from that February 1 peak, the next 4 days brought a 5.7% decline. From the January low to today's close, as noted already, SPX is up 6.6%.

The current number of NYSE stocks above their 200-Day Moving Averages as an indicator, is a reading that, at least in the early part of a possible recovery cycle, have led to strong rallies in the short run. The first 3 readings (far left above in my FIRST chart) were deeply oversold conditions caused by a) the initial collapse from March 2,000; b) The 9/11 sell off; and c) the sell off following that 9/11 sell-off/bounce.

The recent 'percent < 200-day SMA' reading preceded a rally of 9.6% from its low to recent SPX high at 1400. The maximum rebound seen so far is a far cry from the past bounces after such low numbers of NYSE stocks above their 200-day averages.

IF you believe that history will repeat itself, then we still have a ways to go on the upside. IF you anticipate that those prior bounces were materially different than today, than this rally may not have a lot of upside potential before the current rally (from the 1317 area in SPX) runs out of gas.

I'm just taking a wait and see attitude and have a somewhat skeptical attitude about sustained and strong rally potential ahead, but I'm not going to pretend that the market couldn't climb a 'wall of worry', at least as long as the Fed is able to keep lowering interest rates. And, they're in a tough spot to keep doing that, given the inflation pressures.

Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.


Trader's Corner Archives