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Wednesday, May 02, 2012

So after a string of clearly weak economic data, yesterday we get a very strong ISM manufacturing report showing a big jump in domestic manufacturing activity. This is in contrast to the recent regional data and it did catch the market leaning bearish. Today in turn we get some indications that the jobs picture is weakening globally and some very weak PMI data from across Europe suggest a deeper recession ahead. This caught the market leaning a bit bullish even though yesterdays did suggest some skepticism of the strong ISM data. Mixed signals from the economy is par for the course these days! So can the U.S. economy decouple from Europe? From a general market fundamental point of view, this has to be the most important question for traders and investors. Last year the answer from most was that decoupling was not likely and what ailed Europe would affect the U.S. and would therefore be reflected in equity markets. This year following the actions of the ECB, the market seems to believe that they have done enough to contain any fallout and avert contagion to the broad Global economy. I dont believe that the 2 largest economies in the world can decouple to this extent. I would agree that the central banks have perhaps taken the worst case scenarios off the immediate horizon, but not that the U.S. economy can completely shed the effects of a worsening economic downturn in Europe. This disparity between European and American equity market performance will eventually narrow. Those who believe the decoupling theory will state that emerging markets will make up for the weaker demand from established markets. While I agree this makes for a compelling long term argument for equities, I dont see the BRICs being able to provide sufficient near term growth to dampen the short term effects of the slowdown in Europe and the U.S. China seems to be slowing down with its own issues and so is Brazil. The debate most short term participants are having today is whether or not the correction is completed. From a true broad market overbought/oversold point of view which, in my estimation, is the percentage of NYSE stocks above or below 2 standard deviations from their 40 day moving averages respectively, we are about at the middle of the range. At the moment we are at about 15% of NYSE stocks trading two standard deviation or more above their 40 day MA. Historically, figures above 35% are considered overbought and extremely overbought conditions at levels above 40%. As a point of reference in late October of last year the NYSE had 50% of its stocks trading at or above 2 standard deviations from their 40 day moving averages! Strong bottoms usually come in when these same indicators show readings below 3%. So from this perspective, markets seem to be fairly balanced, not really overbought or oversold. These are very important indicators for index/sector traders as it gives us a indication of true overbought/oversold conditions from the perspective of the actual components of an index, the meat and potatos, rather than just a perspective from the day to day price action of the ETF. Again these are not necessarily to be used for entry and exit signals but they do make a world of difference when trying to make sense of stochastic readings. Looking at the stochastic chart to the right, we can see the differences in overbought readings from both late October 11 and from the recent peaks. Note that the peak in late March into overbought has come with a substantially lower number of stocks trading 2 standard deviations above their 40 day MAs. The most recent peak which we are seeing at the moment to the far right of the chart is even narrower with yet a lower number of stocks trading 2 standard deviations above their 40 day MAs. So bottomline is that we should be seeing around twice the number of stocks trading stocks trading 2 standard deviations above their 40 day MAs at this point. The fact that it is contracting instead is a strong indication that the most probable direction for the near term is lower. Obviously these are fluid readings and a spike in the breadth charts could quickly take this from a bad over bought to a good overbought, but as of now, that is not the case.

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