Bear or Bull Market? Debate Rages on

07/15/2010 1:00 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Since our mid-June article, in which we looked at some of the past sharp stock market declines, there has still not been a clear winner in the battle between the bulls and the bears. The stock market’s performance now seems to be an even more important measure of consumer confidence, the economy, Obama, the November elections, etc. So has there been any dramatic technical change in the past month?

After holding on the two prior tests, the S&P 500 broke sharply through the 1040 level and quickly reached the 38.2% support of the rally from the March lows at 1010. This decline encouraged the bears as they began looking for targets in the 980 area, as well as at the 50% support at 950. There seemed to be little that was bright on the horizon for equities as we headed into the long July 4 weekend and bearish sentiment increased with stocks having little appeal. But since the July 1 lows, the S&P 500 is up over 6%, so once again the bear and bull debate has resumed. Before we get to the current charts, some historical perspective might help.

The NYSE Advance/Decline (A/D) Line is an indicator that I watch regularly because in bear markets, it usually leads prices on the downside, and in bull markets, it generally acts stronger than prices. The A/D line is calculated by keeping a cumulative total of the number of advancing issues on the NYSE stock exchange minus the number of declining issues. The primary level of analysis is to determine whether the A/D line is moving with the NYSE Composite or if it is diverging from the price average. If the NYSE Composite makes a new high, does the A/D line? In a bull market or strong intermediate- term uptrends, it can be very valuable and can keep you with the major trend. In bear markets, it can keep you on the short side or stop you from buying too early. I have also found that using trend lines on the A/D line can provide further insight.

Figure 1


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The period from early 2006 through the end of 2007 provides several good examples of how the A/D line works. Stocks peaked in early May 2006 and corrected sharply into June, and after a sharp rally, the market again approached the lows in July before turning higher. The A/D line formed a nice continuation pattern that was completed in July (line 1) when resistance (line a) was overcome. By the latter part of August, the A/D line had moved above the May highs even though the NYSE Composite was still lower. The A/D line confirmed the February 2007 highs before the sharp correction, and by March, it was again making new highs (line 3). The first signs that the market was weakening occurred in June 2007 as the A/D line confirmed the price action before dropping sharply. Then in July, as the NYSE Composite was making significant new highs (line 4), the A/D formed a six-week negative divergence (line d). This divergence was confirmed by the breaking of the prior lows and the uptrend (line c). Stocks rallied impressively from the mid-August lows and the major averages made new highs in October (line 5) while the A/D line failed to overcome the bearish divergence resistance (line d). This four-month divergence between the NYSE and the A/D line gave a stronger warning than the six-week divergence that occurred in July.

Lesson Continues on Page 2

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Figure 2


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The stronger relative action of the A/D numbers going into the March lows was a very positive sign for the intermediate-term trend as another of my favorite A/D indicators, the McClellan Summation Index, gave strong bottoming signals.

Since those lows, the A/D line has been leading prices higher, while chart formations in the A/D line have kept us on the right side. On Figure 2, I show the S&P 500 with the A/D line and have also included a 20-day exponential moving average, which is a favorite of traders. The A/D line confirmed the September 2009 highs, setting the stage for further new highs in October, which were also confirmed (click here for chart). The A/D line then stayed in a trading range for two months, finally overcoming resistance (line a) in December (click for chart).

The A/D line was much higher at the January 2010 highs and then formed a nice triangle formation (lines b and c) that was completed a few days after the February lows (line 1). Once again, the A/D line was much stronger than prices and the pullback from February 22-25 (see circle) was a good buying opportunity as the A/D line was making new highs by the end of the month. If we get a similar pullback in the next week or so, it would set up a similar situation.

After confirming the April highs, the A/D line has again traced out a triangle formation (lines d and e). The break of the uptrend going back to the November lows may be giving an early warning, however, and it necessitates close watching. Clearly a break below the May/June support (line e) would be negative. The triangle formation was completed on July 13, which is a positive sign. A convincing move above the past two peaks in the A/D line would be further evidence that the S&P 500 can move back to and above the April highs. There are further new Fibonacci targets at 1280.

Figure 3


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Another one of the technical indicators that I have found very useful since the stock market lows in 1982 is the number of stocks making new highs and those making new lows on the NYSE stock exchange. In a well-defined downtrend, the number of stocks making new lows should continue to expand, while in a bull market, the number of new highs should keep increasing. The chart above covers from June 2005 through October 2007. I have identified three divergences between the new highs and the NYSE Composite and labeled them using lines b, c and d, each of which formed over several months. I will not go into these in detail, but in each case, when the number of new highs failed to confirm the price highs, there was ultimately a sharp correction. All of these declines did hold above the key Fibonacci support levels. The number of new highs peaked on May 31, 2007 at 489, whereas when the NYSE Composite was 2.2% higher in July 2007, there were only 389 new highs. The spike in the new lows in August to 1104 should have been a clear sign (and one I missed) that the market was in trouble, as it was well above the highest level for the past few years (line a). The number of new highs diverged further in October 2007, reaching only 345, even as the major averages made new highs.

Lesson Concludes on Page 3

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Figure 4


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The number of NYSE stocks making new lows diverged nicely at the March 2009 lows as there were 2476 new lows in October 2008, but only 805 at the March 2009 lows. (Click here for chart.)

The number of stocks making new highs did not pick up until July 2009, which was further evidence of how bad the bear market had been. In October 2009, there were 433 new highs, and at every new high in the NYSE over the next six months, more stocks made new highs (see chart).

At the January 2010 highs, there were 496 NYSE stocks making new highs, and on April 26, 2010, there were 647, as indicated by line b. The number of stocks making new highs dropped off sharply in May, and a move above the 100 level would be the first sign that the new highs were again expanding. If the NYSE does move above the April highs, the number of new highs may have trouble confirming. The new lows hit 161 on the day of the “flash crash” in early May, and even though the NYSE was lower in June, there were only 146 new lows (line a). This is potentially a positive sign.

My reading of the market internals is still positive from an intermediate-term standpoint and is supported by the fact that the Dow Transports, the Nasdaq Composite, and the financial sector are still holding above the lows made early in the year. On the negative side, the Dow Industrials and S&P 500 have broken below the early-2010 lows. We should get a better reading in the next week. If we get a shallow pullback in the S&P that holds in the 1050-1065 area and the S&P then moves above this week’s highs with strong market internals, it will set the stage for a challenge of the year’s highs.

Tom Aspray, professional trader and analyst, serves as video content editor for MoneyShow.com. The views expressed here are his own.

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