Tech Talk

01/06/2006 12:00 am EST

Focus:

John Murphy

Head Market Analyst, Stockcharts.com

"This may be a good time to do some stock trimming," notes John Murphy, technician par excellence, and head market analyst at StockCharts.com. Here, he looks the technical state of the market, and offers a cautious assessment for the period ahead.

"Like most other market analysts, I had been expecting the traditional fourth quarter market rally, paving the way for higher prices through the balance of December. I also wrote, however, that I didn't think this last move up would be very long-lasting. In fact, I suggested that January might be a good time to start taking some money off the table if the rally lasted that long. Here, I'm going to show a couple of reason why I'm not that enthusiastic about the staying power of the market's latest upmove, and why I believe that it's on weak technical footing.

"First, is the New York Stock Exchange Advance-Decline line. This is one of the most popular of technical indicators. It's a cumulative total of the number of advancing stocks minus declining stocks. Historically, the advance-decline line is supposed to move in tandem with the market. When it stops rising with the market, a negative divergence is being created. That's where we are right now.

"The NYSE Advance-Decline line bounced off its 200-day moving average in late October (when the market stabilized) and has been rising with the market over the last two months. The problem is that it hasn't exceeded its September high when most of the major market averages have. As long as that negative divergence exists, the staying power of the current stock market rally is in question. As usual, there's more to the story.

"In addition, we are seeing the first negative divergence between the New York Advance-Decline line and the S&P 500 index in three years. The two have been moving up together since the last bull market started in the spring of 2003. The last two market corrections took place in 2004 and 2005 and in both instances the NYAD line moved to new highs before the S&P 500. The AD line hit a new high in August 2004, which was three months before the S&P 500. In June of 2005, the AD line hit a new high a month before the S&P. In both instances, the NY advance-decline line led the market higher.

"Now, the Advance-Decline line has failed to reach a new high while the S&P has already done so. That's the first time since the bull market started three and a half years ago that the NY advance-decline line has failed to move to new highs with the S&P. One of the first things market technicians look for in a mature bull market is a peak in the NY Advance-Decline line. That's because the Advance-Decline line usually peaks ahead of the market. It's too early to call this a peak. But it's not too early to start getting a little concerned.

"Meanwhile, fewer stocks are hitting new highs. In a healthy uptrend, the S&P along with the NYSE High-Low index (which measures the number of NYSE stocks hitting new 52-week highs minus new lows) should be rising together. Again, in the two corrections in 2004 and 2005, both fell together. When the 2004 correction ended, the two rose together. The same thing happened in the summer of 2005. A new high by the S&P 500 saw a corresponding move up in the NYSE High-Low readings.

"Now, however, at the end of 2005, the S&P 500 is hitting a new high but the NYSE High-Low index isn't. That means that fewer NYSE stocks are hitting new 52-week highs. Even worse, the index is dangerously close the zero line. That means that the number of new 52-week highs barely exceeds the number of new lows. That's not symptomatic of a strong uptrend.

"Finally, the four-year cycle turns down in 2006. Breadth indicators normally peak before the market does. In some cases, the lead time at tops can be considerable. However, the relatively long length of this cyclical bull market (three and a half years) and the fact that we're more than halfway through a seasonally strong period (November through January) heighten the significance of the negative divergences shown herein. 2005 also marks the third year of the four-year presidential cycle (which last bottomed in October 2002). Historically, the fourth year is the weakest of the four. That would be 2006. To me, that sounds like a lot of reasons to use the year-end rally for some stock trimming as opposed to stock shopping."

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