Overbought Bear Market Rally or New Bull?

Are we in a mother of a bear market rally, and is the market overbought? Or is this 1982, or better yet, 1974 all over again, and as some are suggesting, the beginning of a new bull? Several ideas below are worthy of debate at this time.

First, investor sentiment seems to have rebounded far too quickly, considering the absence of strong indications that the economy is recovering, and quantitative easing moves have failed to re-ignite lending so far. Second, winning streaks this long are rare. Third, it appears that according to breadth measures, the market is in an overbought state. Is it different this time, or is it the topping out of a large sucker rally? Has the market just chosen to forget that there are still widespread problems in the banking systems of the US, Japan, Europe and the UK?

Sentiment may have changed too quickly, a characteristic of past bear market rallies.

"I've lived through a lot of bear markets, and I must say I've never seen sentiment change so quickly after an horrendous drop in the market." So wrote Richard Russell, editor of Dow Theory Letters, after the close on Monday, following yet another impressive day for stocks, in which the Dow Jones Industrial Average tacked on another 214 pts," writes Mark Hulbert for Marketwatch.com.

Winning streaks this long are quite rare for markets.

With the Nasdaq Composite index working on its 9th consecutive positive week, many are curious about just how unusual this is.

I'm not a huge fan of "streaking" in and of itself to try to determine when a trend might exhaust, but it can be quite useful in helping to time shorter-term entries and exits.  For example, if the S&P is up 5 weeks in a row and then it gaps up +0.5% one morning, that can give us a better edge than not knowing where we are in the streak.

Anyway, the tables below give the number of weekly streaks for the S&P 500, Nasdaq Composite and Dow Jones Industrial Average since the dates given under each index.  There is an interesting wrinkle that becomes evident very quickly.

The current stretch of 9 weeks (maybe) for the Nas would be pretty unusual, but not unheard-of.  12 other periods went for this long or longer since '71.

We can see from that tables that the "down" weeks one is quite a bit shorter, and is much more heavily weighted at 1 and 2 weeks.  This shouldn't be too much of a surprise, but it means that the market is less likely (or has been less likely, anyway) to stage long stretches of down weeks without an interruption.  Those bulls just get way too antsy and need to jump in.

Also interesting is the streakiness of the Nasdaq compared to the others.  It's more heavily weighted towards the longer streaks, and has the record for both up and down stretches.  The suggestion from that would be that some higher-beta indices like the Nasdaq are more prone to trends than are the more-staid indexes that are used far more for benchmarking purposes.

Breadth measures suggest the market is overbought.

Quantifiable Edges says "I’m seeing some breadth measures again hitting all-time extremes. Worden Bros. measures the % of stocks trading at least 1 and 2 standard deviations above their 40-day moving average. I mentioned the 1-standard deviation indicator (T2110) in the blog a couple of weeks ago. At the time it was hitting an all-time high of nearly 81%. Tonight it broke that record registering over 83%. The number of stocks closing 2-standard deviations above their 40-day ma (T2112) also hit a new extreme Monday - and in a big way. Before Monday this indicator had never reached 40%. Monday it spiked up to 52.14%. A chart with the complete history is below."

"This suggests the market is incredibly overbought. As I went over a couple of weeks ago, this doesn’t necessarily mean we’ll see a sharp selloff. At such incredible levels, though I’d certainly be careful taking long positions. These overbought levels will be worked off at some point. A selloff is one way to accomplish that."

Barry Ritholtz offers this view:

Over the past month, I have heard quite a few people declare this to be the start of a new bull market. The kindest thing I can say in response to that is the jury is still out, but the weight of the evidence is inconclusive.

In terms of historical analogies, investors should be asking themselves: Is this move more like 1982 or 1974?

Consider: 1982 marked the end of a 16 year, secular bear market, which saw the Dow finally get over 1,000 on a permanent basis. It kissed that level in 1966, and again a few more times prior to breaching that level for good in 1982. After 16 years, nominal returns were zero, but on a real (inflation adjusted) basis, buy & hold investors lost nearly 90% of the purchasing power.

At the beginning of that 18 year long Bull market, equities were despised, bond yields were high and P/E ratios were single digits. History does not repeat precisely, but there is usually a rhyme involved.

I have noted in the past that following major bull runs, markets often have a major refractory period, wherein it takes years to work off the excesses of the prior period. Even in that period, markets will get deeply oversold and rally, and deeply overbought and sell off.The current secular bear is no different.

This could be 1982, but I doubt it. Instead, consider the 1973-76 period as a analog: The 23 month, 45% sell off was followed by 22 month, 76% rally. I could live through that again, as long as disco doesn’t come back also . . .

I’ll see if I can dig up a few relevant charts later.

And, Corey Rosenbloom at GreenFaucet.com puts forward his argument, Are we Reliving the1982 Scenario?

Could history be repeating itself directly?  Might there be an exact roadmap to follow as it relates to the current stock market trajectory?  If only it were so easy, but I did want to highlight some eerie similarities in the charts you might want to as it relates to the end of the 1982 Bear Market in what was called the "Melt-Up" action.  Let's take a look and see if we might be reliving the "1982 Melt-Up Scenario".

First, let's take a look at our current market structure as of May 4th, 2009:

Taking a quick look, we see a negative volume divergence accompanying a negative momentum divergence (shown in the 3/10 Oscillator and in other momentum oscillators).  Divergences are non-confirmations of higher prices and hint that odds favor a reversal (or at least a retracement) rather than immediate continuation of the rising price action.

A geometric 'arc' has also formed, which hints at a gentle transfer between buyers and sellers (supply and demand) - also a reversal/retracement signal.

Next, let's look at an eerily similar pattern that formed as we hit the absolute lows of the 1982 Bear Market:

We can apply the same analysis - rounded arc, negative volume and momentum divergences.  In the case of September 1982, we did see a much larger volume and momentum spike than we're seeing now.  Price had broken down out of a rising trendline and beneath the 20 day exponential moving average (all charts are showing the 20 and 50 exponential average as well as the 200 day simple moving average).

Speaking in terms of visual charting or technical analysis, virtually any market forecast would have returned a bearish implication from the negative divergences combined with the trendline and moving average break, and the persistent downward trend in prices.

But what happened just after I captured this chart?

Finally, here is the resolution of the pattern and what happened afterwards.

Much to the surprise to both technical and fundamental analysts, investors, and traders, price completely  shrugged-off the negative technical and fundamental analyses and rallied quite sharply - most likely in response to the persistent negativity, as funds who were short were forced to cover and equity funds who were in cash rushed to chase alpha buy putting cash to work, not wanting to 'miss the boat.'

Price continued higher with nary a meaningful retracement at all (finding support each time at the rising 20 day EMA) despite further weakness in the momentum oscillator and in volume.

If I extended the chart further to the right, you would see price continue its steady trek higher, rising persistently into August 1983 before any meaningful pullback occurred.  We often refer to this period as the "Market Melt-Up" (as opposed to a melt-down) or as the "Creeping/Oozing Trend Up" that continued to defy the bears (sellers).

We'll need to do more analysis to draw further parallels, so one might do well to turn back your charts to 1982 and see if the current S&P 500 continues to behave in the manner it did almost 30 years ago.  It might be an eerie coincidence, but there may also be something deeper of value to consider in the price structure parallels of then and now.

Finally, after reading Corey Rosenbloom's discussion, one counterpoint arose to his argument, that being that the US prime lending rate in 1981 had topped at 20.5%, and in the period thereafter, interest rates began their return to normal levels over many years. Today, we are faced with an empty monetary tool box and trillions of dollars in Quantitative and Credit Easing - an altogether different set of circumstances, i.e. fully tightened in 1982 vs. fully eased in 2009. Today's pretext is deflationary, not inflationary. And, worse, there appears to be a lot of hope, for hope's sake, that the worst of the problems of the banking sector are behind us. Are they?

To wit, stocks are not yet quite among the despised of assets, they are not yet in the single digit P/Es yet, and government bond yields are at historic lows. Where is the rhyme with either of 1982 or 1973-74?

The charts sure are interesting, and perhaps in some cases they do rhyme, or show high correlation to past markets, however, they remain inconclusive.

To reiterate Barry Ritholtz, the jury is still out. You decide.