What Is Not Seen

On March 10, major U.S. stock market indices like S&P 500, Dow Jones Industrial Average, and Nasdaq, all reached there respective lows after the last stock market sell off. Since then, stocks have rallied, with S&P 500 up 11.94 %, Dow Jones up 10.62 % and Nasdaq up 16.57 % .

While some people seem to believe that we now are “out of the woods”, I strongly think that the economic troubles so far are only getting started.

For the stock market, we should expect a correction soon. For guidance, I turn to my favorite contrarian indicator, the Bullish Percent indicator. This indicator tells us how many percent of the underlying stocks of an index that are showing there first Point & Figures buy signal. At present, this gives us a way of gauging if stocks at given prices are over bought, and hence are likely to correct.

A reading above 70 is red alert for stocks, should they start declining. A reading below 30 in the Bullish percent is a good opportunity to buy, as only a small amount of additional money entering the market will push up prices.

Since the stock market started to increase, investors and asset managers have successively increased their exposure to stocks. This was captured by the bullish percent. Looking at Bullish percent for New York Stock Exchange, and for S&P 500, we see that the index reversed up into a column of X’s in the final weeks of March.

Now 40 days into the bear market rally, the Bullish percent indicators have all begun reaching higher levels. NYSE Bullish percent are currently showing that 58 % of the index stocks are displaying buy signals, and are still rising. S&P 500 shows that 62 % of the stocks are experiencing positive demand. Dow Jones on the other hand have recently reversed down from 66 % to 60 %. Suffice to say, current levels should start to raise some concern.

Given the present economic conditions, many managers and investors are still cautious. This can be interpreted that a Bullish percent reversal at present levels could be as serious as a reversal above 70 in the past when over all economic conditions were better.

When it comes to the Bullish percent indicators i don’t like trying to predict the predictors. As likely as a reversal, more capital may enter the stock market pushing prices and Bullish percent even higher. Personally I look at the indicator, and only afterwards take the apropriate action.

Although, should we see further gain, let say NYSE Bullish percent goes to 65 or even 70, we can expect the correction to be more severe and longer lasting, when it eventually comes.

The goal for most investors is to stay ahead of the curve. Regardless of what ever asset class in mind, fixed income, equity, commodities or currencies the ultimate goal is to be well positioned, and in line with the market. This can be a tedious task especially when market movements go the opposite direction from economic indicators and the overall economy. I can’t remember how many times I have seen magazines, cover stories, etc. proclaiming, either the “The end of equities”, as did News Weak 1982 or “The end of the oil age”, as did The Economist 2003, just to see markets take off in the opposite direction almost the exact same date.

There is no doubt that markets tune in to fundamentals over the long turn. Just like a rock getting thrown up in the air under the act of gravity, markets that rise without fundamental support will eventually return to the ground or for equities to the historical average growth rate. Take a look at total return for GDP and S&P 500 since 1960. During this period, growth rates have varied, but total return is not surprisingly the same. During negative years for stocks, GDP sometimes had a positive return. This is one example when a belief in following the underlying economy can get you side stepped.

The search for economic indicators able to warn investors of such diverging tendencies made me think about the Bullish Percent Indicator. This indicator is a contrarian indicator constructed for the sole purpose of gauging the likelihood of a shift in market behavior. The Bullish Percent is based on the number of buy signals given from Point & Figure charts. The most interesting one is the NYSE Bullish Percent Indicator that shows the number of stock on the New York Stock Exchange currently in a buy signal. The logic behind this goes back to supply and demand, and the fact that changes in these dictates market movements. On Stockcharts.com you can find the index by the ticker name $BPNYA.

A low reading, below 30, indicates that less than 30% of the total 2500 stocks in the index are experiencing buying pressure. This situation is synonymous with one where most investors that don’t have an interest in stocks at the moment is outside the market. The lower this index drops the smaller amount of demand is needed to have a positive affect on market prices, making it a good time to get in the market.

Had you only looked at the underlying economy for guidance or the currant negative trend of historical equity prices, the likelihood is high that you would have missed a potential shift. Historically Bullish Percent has been a good contrarian indicator as it warned us prior to both the crisis around 9/11, and last year of the subprime crises that got to Wall Street in august.

As we have seen stock markets and fundamentals tend to diverge from time to time, making it even harder to get a good read of where the market is heading than usual. Bullish Percent is one of many contrarian indicators, grounded in economic theory that can assist investors in foreseeing possible bottoms and tops in asset prices.

Finally, I would like to clear up one misunderstanding with regards to the Bullish Percent. Most investors have herd the expression that “the trend is your friend”, even Point and Figure analysis is centered on this concept. This idea implies that a stock experiencing upwards- or downwards pressure is likely to continue in the same direction. The obvious question whit regards to Bullish Percent is: What if every stock – let say in the broad NYSE index – had signaled buying opportunities, would not that contradict the logic of Bullish Percent and trending prices? Absolutely not!

If one stock rises, it doesn’t say anything of the overall market demand. Market demand may be slowing, but some stocks always go the opposite direction. Let’s say for the sake of argument that every stock is signaling buying opportunities. This has almost certainly resulted in surging prices as every available demand has entered into the market. With every one willing to participate in buying stocks already owning stocks, there is extremely little demand left to continue acting as upward pressure on prices. This is a situation where a marginal increase of supply will have a significantly large impact on market prices when there is no longer any counteracting force holding prices up.