Stock indexes near 2011 highs -- New paradigm or something else?

Market Snapshot:

In the 1948 stock market classic, Technical Analysis of Stock Trends by Edwards and Magee, the authors suggest that “A Rising Wedge on an arithmetically scaled weekly chart is almost invariably a Bear Market phenomenon, expressing as it does the diminishing vigor which is the normal property of any reaction against a prevailing Primary trend.”

Over the past few months we have alluded to the potential Rising, or Ascending, Wedge we believe has been developing since the October lows. The chart pattern can include three price movements with an initial upward thrust, the “a” leg, that is followed by a corrective pullback, the “b” leg, and then a “c” leg rally that carries prices to the final highs of the overall move. The pattern is also characterized by diminishing trading volume, or as E&M suggest, “diminishing vigor.” The rally since the October 4 short and intermediate-term lows meets the requirements of an Ascending Wedge price pattern.

"Ascending Wedge" Index price targets and attainment – or not

Currently, the potential wedge pattern has become interesting because all of the major indexes including the S&P 500, Dow 20 and 30, NASDAQ Composite, Value Line index and Russell 200 have nearly reached our upside price targets, or have slightly exceeded those levels.

To calculate the upside target in the S&P 500, we first measured price movement from the top of the “b” leg on October 27 (1292.66) to the trough on November 25 (1158.66). We then took the average of the two prices (134 points) and subtracted the October 4 low price from the median price, 1225.66, and came up with 150.89 points. That number was then added back onto the median price of the “b” leg and equaled an S&P 500 projected price of 1376.55, or the measured move target. Last week the S&P 500 reached 1368.92 on an intraweek basis. Its May 2, 2011 price high was 1370.58.

Market Overview – What We Know:

• Dow Jones Industrial Average and NASDAQ Composite rallied to new highs last week relative to 2011 highs, but S&P 500, Value Line Index, Dow Jones Transportation Average, and Russell 200 did not.
• All indexes, however, remain within range of upside measured move targets as re-calculated from October 2011 lows and via potential “Ascending Wedge” price patterns.
• Most Actives Advance Decline Line (MAAD) was positive Friday by 13 to 6, but indicator remains below February 8 high which bettered 2011 peak and equaled March 5, 2008 level. Weekly MAAD, a better reflection of longer-term trending, remains weaker.
• Daily MAAD Ratio has corrected virtually all of recent “Overbought” readings and was last toward “Neutral.” Weekly MAAD Ratio remains toward “Overbought” territory.
• Trading volume in S&P 500 declined by nearly 30% last week.
• Weakness below lower edge of 10-Day Price Channel (1343.90 / S&P 500 --Monday) would suggest beginning of end of Minor Cycle trend in effect since December low (1202.37 / S&P 500).
• Cumulative Volume (CV) in S&P 500 made new short-term high Friday, but S&P Emini CV peaked February 20 and remains just below that level. On longer-term basis CV in S&P 500 remains about 35% below 2011 highs while CV in S&P Emini is nearly 50% below similar level.
• Daily CPFL made a new short-term high a week ago on February 20, but has yet to better that level. Indicator remains substantially below February 25, 2011 plot high.

In the accompanying “Ascending Wedge” table notice that of the six indexes listed, the NASDAQ Composite index is the only bellwether that has hit and slightly exceeded its price target. All of the other indexes are within reach of their targets, but have yet to reach those goals. Also notice that of the six indexes, only two, the Dow 30 and the NASDAQ, have hit new highs in that they recently traded above their 2011 price highs. In a word, all are within range of upside measured move targets as calculated from the October 2011 price lows using the same formula by which we calculated the S&P measured move price target.

But the wedge pattern aside, there are still other bearish considerations. Both the short and intermediate-term trends are “Overbought.” While such readings can persist in a strong uptrend, it’s a certainty the market is in a far less advantageous statistical place now than it was five months ago at the October lows. It is also a sure thing those upside extremes will be erased at some point.

Daily S & P 500 Emini Futures contract with Cumulative Volume

Weekly S & P 500 Emini Futures contract with Cumulative Volume

There is also the fact that while Daily MAAD rallied on February 8 to its best level since March 5, 2008, Weekly MAAD has demonstrated a less stellar response and remains back at levels reached in September 2008 while still holding modestly below its 2011 highs in moderately “Overbought” territory. Weekly MAAD also remains in a defined downtrend stretching back to the 2000 highs.

On the options front, while our Call/Put Dollar Value Flow Line (CPFL) has demonstrated marginal improvement since reaching a short-term low on December 19, the indicator is nowhere near breaking above its February 25, 2011 highs while continuing to hold below the downtrend line stretching back to that level.

Note: Stop levels, a function of the extant trend, are based on the trailing moving average price channels for the Highs or the Lows of an index. Whether or not a specific index is suggesting a “Buy” or Sell” is determined by whether or not index prices are above or below the current channel Stop levels. Stop levels should only be used as an entry or exit guide and in conjunction with other market entry and exit strategies.

Although the effect of everything preceding upward price breaks to new highs, including price targets and overheated statistical readings, is pure conjecture so long as index prices remain in an uptrend, as prices reach targets in the face of extreme readings, historical norms suggest the potential for price reactions increases. It is also true that as new highs are reached, many of the less wary will be inclined to think that the “old rules” are not working and that “new paradigms” have taken hold. From our point-of-view, we can only suggest that those “old rules” don’t change much and that “new” paradigms are often illusory.

McCurtain Most Actives Advance/Decline Line (MAAD)

Divergence between Daily and Weekly MAAD indicators continued last week. After reaching a new short to intermediate-term high February 8 and best levels since March 5, 2008, Daily MAAD has remained in a lull and below that new high since then. At the same time, Weekly MAAD continues to underperform, remains toward “Overbought” territory as measured by the MAAD Weekly Ratio, and is also holding in a defined downtrend stretching back to early 2000 even though underlying S&P 500 index pricing has done better.

If history is any guide, and despite the perkiness of Daily MAAD, the plodding performance of Weekly MAAD could be an indication Smart Money continues to view the rally over the past five months with skepticism. If we are wrong in our assessment, then Weekly MAAD must begin to outperform its lesser cycle brethren.

Click charts to enlarge

McCurtain Call/Put Dollar Value Flow Line (CPFL)

CPFL continues to plod along with slightly better performance over the past few weeks. But the indicator has yet to break above a defined downtrend line stretching back to the February 2011 highs, let alone those highs themselves.

The ongoing failure of CPFL to do better in the face of improving market prices over the past five months is yet another indication that one segment of the market, options players, have on balance been reluctant to be long this market. While that stance could change, the failure merely underscores the notion that price strength since the October lows is not all it should be and, in fact, could be a lot less as time goes on.

Click charts to enlarge

Conclusion

It’s a certainty that when the Dow Jones Industrial Average rallied above its May 2, 2011 high (12876.00) on February 7, there were telephones ringing across the investment world as many brokerage clients were told that the Dow had “broken out” on the upside and that net long positions were warranted. The fact that blue chip prices were doing a solo performance with only some NASDAQ issues to keep them company was probably not an element of those phone conversations. Or that after five months of higher prices both the short and intermediate-term trends have moved into historically “Overbought” territory.

While we cannot deny the profitability of any powerful rally, nor would we choose to stand in front of any freight train, higher prices have a tendency of attracting less informed buyers the higher the prices go. Although this rally could prove to be the exception to that rule, we somehow suspect it will not. Also, given the fact that a defined Ascending Wedge price pattern with nicely traced volume confirmation can be seen in our Cumulative Volume charts, we can only continue to wonder just how much bigger the “hook” will get before this market will stage a healthy pullback. Ultimately it will be the extent of that pullback that will determine whether the rally since October proves to be a house of cards, or something else.

MAAD Weekly data for past 30 Weeks* CPFL data for past 30 Weeks

*Note: All data is for calendar week ending on Friday even though ending date may be a holiday.
Unchanged issues in MAAD calculations are not counted.

MAAD Daily data for past 30 days**　　　　　　　　 　 　CPFL data for past 30 Days

**Note: Unchanged issues are not counted.

Robert McCurtain is a technical analyst/market timer, private investor and financial markets consultant based in New York City. He is a member of the Market Technicians Association and can be reached at traderbob@nyc.rr.com.

If you would like to read more about how the CPFL is constructed, read a Futures article on the concept. This link will take you to the MAAD article.