How to tell if this breakout is for real…

The market broke out yesterday. Is it time to get excited? Not in my view. In
fact, other than the price of the S&P 500 hitting a new high yesterday, I saw
predominantly bearish signs. Let me first discuss some of the characteristics of
market tops. Unlike market bottoms that often occur with capitulation selling
and sharp reversals, tops are more of a slow process. Two primary
characteristics of topping formations are declining momentum and declining
breadth. Yesterday’s action further confirmed we are seeing both.

Momentum can be measured a number of ways. On the chart below of the S&P 500, I
have included two momentum indicators — RSI and MACD. I have also marked with
horizontal lines the Jan 11, Feb 27, and yesterday’s highs. What you will notice
is that both RSI and MACD have made lower highs while the S&P has made higher
highs on each of these days. This is a negative divergence and not a good sign.

Now let’s look at breadth. Breadth measures what is going on under the hood. In
a study released by Lowry’s in January, they discussed the fact that the vast
majority of individual stocks top out before the market does. Of the 14 market
tops they studied, they found that, on average, only about 6% of stocks made new
highs on the day the market made its final high. (Yesterday about 5.4% of the
NYSE hit new highs.) Further, they found that in most cases a significant number
of stocks were already substantially lower (20% or more). They concluded that
breadth deteriorates before price when looking at the indices. Let’s look at
some breadth indicators that many of you may not follow. (In all these charts I
have marked the Jan 11, Feb 27, and March 14 new high days with red arrows):

This first chart shows the number of new highs divided by the sum of new highs
plus new lows:

Note the deterioration at each new high.

This 2nd chart shows the percentage of NYSE stocks trading above their 40-day
moving average:

From 82% in January to 57% yesterday. That is some significant deterioration.

Now let’s look at the percentage of stocks that are on the rise and trading at
least 1 standard deviation above their 40-day moving average.

Again — substantial deterioration.

Finally, let’s look at the percentage of stocks that are on the decline and
trading at least 1 standard deviation below their 40-day moving average. This
should give us an idea of how much selling is really occurring.

While the number of up trending stocks has been declining, the number of down
trending stocks has been increasing. Even though the market hit a new high
yesterday, over 22% of the stocks on the NYSE are trading at least 1 standard
deviation below their 40-day moving average.

Declining momentum and declining breadth do not bode well for the market. While
there may still be some life left in this rally, it is getting weaker and
weaker. I don’t think the next correction is too far off, and for many stocks,
it may already have begun. Finally, you should also note that even with the big
rise and new price high yesterday, volume stank — another bad sign.

Best of luck with your trading,

Rob