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Thursday, August 22, 2013

Dangerous divergences unseen since 2007


Aug. 21, 2013, 8:31 a.m. EDT

By Mark Hulbert, MarketWatch

CHAPEL HILL, N.C. (MarketWatch) — You can’t say that the stock market isn’t giving us plenty of warning that downside risk is both high and rising.                                        
The latest big warning comes from the failure in late July/early August of the NYSE Advance/Decline line to confirm the stock market’s new highs. This non-confirmation is potentially quite worrisome, according to several of the market technicians I monitor, because it means that an unexpectedly few stocks were participating in the broad market’s march into new-high territory.

From the perspective of this non-confirmation, the stock market’s decline over the last couple of weeks is therefore not a surprise.

The NYSE Advance/Decline line is calculated by taking the number of issues that rise in price on a given day, and subtracting the number that fall. This net number is added to the cumulative total of prior days’ readings, resulting in a historical data series.

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This series topped out in May, according to several of the technical analysts whose services I monitor. When the broad market averages rose to new highs in July and early August, in contrast, the A/D line apparently failed to join in.

(I say “apparently,” because Jim Stack, another of the analysts I monitor, calculates that the NYSE A/D line actually did hit a marginal new high on July 23. However, he added in an interview that he nevertheless thinks it’s worrisome that it hit only a marginal new high in the face of much higher new highs by the major market averages.)

The warning that comes from the A/D line joins another indicator that captures many of these same market cross-currents: The High-Low Logic Index. As I pointed out a month ago when devoting a column on the subject, the High Low Logic Index in June issued its first sell signal in years—the first, in fact, since late 2007, well in advance of the stock market’s terrible losses in 2008 and early 2009.

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The High Low Logic Index was created by Norm Fosback in 1979, then the President of the Institute for Econometric Research, and currently editor of Fosback’s Fund Forecaster. It represents the lesser of two numbers: New 52-week highs and new 52-week lows (both expressed as a percentage of total issues traded). High readings are bearish, while low levels are bullish.

In its own way, therefore, the High Low Logic Index captures the same underlying divergences also reflected by the A/D line.

The index’s latest reading is 5.9%, even higher than the 5.1% reading registered in June. According to Ned Davis Research, which has studied the index’s long-term track record, sell signals are generated whenever it rises above 4.4%. In fact, the index’s latest reading is even higher than its highest level from late 2007, the previous sell signal.

To be sure, neither the A/D line nor the High Low Logic Index is a short-term indicator, typically issuing signals months before eventual market carnage — if not years. As Dan Sullivan, editor of The Chartist, recently pointed out, the A/D line in 2007 hit its peak on June 1, more than four months prior to the bull market peak in October of that year. Prior to the October 1987 stock market crash, the A/D line’s peak came in March. And prior to the bursting of the Internet bubble, the indicator’s peak was “years early.”

For the moment, Sullivan remains bullish — but worried, acknowledging that the A/D line’s recent behavior is a “longer term” concern. Stack is even more worried, having decided this week to reduce the equity exposure in his managed accounts and build up cash.

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