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History repeating? | The Mesh Report

History repeating?

Christian Tharp, CMT December 16, 2010 0

I must admit, I believed the markets were on the way down back during the summer. I thought for sure that the next wave down in an ongoing secular bear market was unfolding. All signs seemed to point lower. Apparently not.

Now, months later while hitting new bull market highs, the question is: Do I still believe in the secular bear market case? Do I still believe that this almost 2-year bull run is just a bear market rally? Yes, and yes. Picking tops and/or bottoms is a difficult, if not impossible, thing to do. Generally, we do not know we’re right until long after the top or bottom is in. That being said, when we look back, there were always signs. Could the market be giving us signs now?

Below is a 2-year chart of the S&P 500 from the all time bull market high in 2007. If one believes in the bear market case, then the 2007 peak was the beginning, or the end depending on how you look at. Please review the chart with my added notations.

Now, interestingly enough, please review the next chart, which is the current 2-year chart of the S&P:

A picture, or 2, is worth a thousand words. Is it possible that history is repeating itself? Only time will tell. However, there are other factors that I believe are worth considering:  For example, momentum.

Although there are literally hundreds of momentum indicators, let’s look at a very popular, useful one in the RSI (Relative Strength Index). The RSI compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of a security.

The RSI can be helpful in many ways, but one of the most telling is when the RSI diverges from price. In other words, as the price of a security hits new highs, one would expect the RSI to hit a new high also. If a security hits a new high, but the RSI forms a lower high, this would be called a divergence.  Momentum usually leads price and this divergence simply implies that momentum is waning. Imagine it as if you threw a ball in the air. Although the ball continues higher, the momentum of the rising ball starts to decrease. Eventually, the ball will follow the decreasing momentum.

With all that being said, please review the following 1-year chart of the S&P with the RSI:

And there is the textbook definition of a momentum divergence on the RSI. HOWEVER, if the S&P were to continue to rally, thus pulling the RSI higher, this divergence could “work itself out”. Time will tell.

So, we have history sending a message and momentum seems to be waning. Is there more? Well, of course!

At major market tops and bottoms, investor sentiment tends to reach extremes. Keeping it simple, if everyone is bullish, who’s left to be bullish? The same would hold true on the bearish side. Although sentiment readings do not pick exact tops or bottoms, they certainly can tell us that the market environment is ripe for a reversal. With that in mind, please consider the following sentiment readings:

  • The 10-week moving average of the percentage of bulls reported in the AA II (American Association of Individual Investors’) weekly poll is at 49.3%, which is the highest level in 6 years. Higher than sentiment at the all time 2007 high.
  • The percentage of bulls among advisors, as reported by Investors Intelligence, is 56.8%,. This is the highest since the 62% reading of October 2007, the very week of the all-time high in the Dow.
  • The DSI (Daily Sentiment Index) at trade-futures.com reached a peak reading of 94% bulls in November. This is t he highest reading since the same measurement was reached in January 2007, almost 4 years ago. Just to contrast, there was a record-low 2% bulls reported on March 2, 2009, the start of the current bull run.
  • Mutual fund managers’ cash-to-assets ratio for November is at 3.6%, just 0.2 above its all-time low of 3.4% from July.

The Tale of the Tape: Be cautious. Protect your assets. Could I be wrong, you bet, but as I said earlier: There are always signs.

No matter what your strategy or when you decide to enter, always remember to use protective stops and you’ll be around for the next trade.  Capital preservation is always key!

Good luck!

Christian Tharp, CMT



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