Charts To Start 2011, Part 2

In Part 1 I outlined several predictive indicators that have been raising red flags. While it is not unusual to see a divergence or an extreme here or there  if looking across the broad spectrum of indicators, when they start to cluster, that's when high probability trades emerge. Here are some other charts of interest.

Chart 1: S&P E-mini and Momentum

Momentum is literally the most overbought it has been going back years. I prefer simple momentum indicator with the fisher transformation applied. Signals are generated when momentum gets overbought then crosses back below the overbought signal line. While no signal has been generated yet, the fact that the E-mini is the most overbought according to this measure in years is a red flag, and adds weight to the bearish case, especially since this is occurring in conjunction with so many other reversal signs. (You can read more about fisher transformation here: http://www.tradingsystemlab.com/files/Using%20The%20Fisher%20Transform.pdf)


Another phenomenon is the number of new highs, but also new lows occurring at the same time. This manifested some months in the form of several Hindenburg omens. The media focused on them intensely, but the market since rallied to new multi-year highs. I also find it interesting that while there was a lot of media attention on the Hindenburg omens some months ago, recently there has been more Hindenburg omens triggered with almost no media attention whatsoever. This leads me to believe that the previous signals failed because there were too many bears prevalent in the market, currently however, this is not an issue.

Chart 2: High/Low Logic Index

The plurality of highs and lows is not only spiking but trending higher. The last few spikes have occurred with almost no reaction. I would say that this implies that something is brewing beneath the surface of the market, and the most recent rise if very vulnerable to a correction.

While on the subject of breadth.
Chart 3: Percentage of stocks above their 40 day moving average.

We can see that the percentage of stocks above the 40 day moving average ebs and flows with the tide of the market. This presents something of a similar picture to the McClellan oscillator; either stocks have a ways to run higher before getting overbought, or this is a huge bearish divergence. What makes me lean towards the later is market sentiment and the put call ratio. The put call ratio is showing that speculators are positioned for a huge rally (with leverage). It is just so rare to see any kind of sustained move when the put call ratio is so stretched. So if sentiment indicators are already at an extreme, and investors are fully invested, the more probable interpretation of this chart is a bearish divergence.

I'll close with Bob Farrell's rule number 7: Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. Momentum and sentiment are running at multi-year highs, however almost every measure of breadth is showing a deteriorating internal picture. While there is no confirmed negative price action jump onto, the next profitable trade is not to chase here, but to go against the crowd and sell when the next signal emerges.