Bad Breadth - or is it? Fear overblown...

As TraderMike noted, many of the indices have yet to reach short term oversold levels on full stochastics which suggests any rally from here will likely get sold off. Mike also reported on the capitulation spike in the VIX and the T2108 indicator, the latter broke the '20' barrier typical of bottoms.

Also contributing to the malaise is some lackluster breadth levels. iBankCoin reported on the relatively high value in the number of S&P stocks above their 50-day and 200-day MAs - the latter in particular. The shift in character of these indicators from 2006/07 to late 2007/08 reflects the move from bull to bear market; in bull markets fewer stocks break these moving averages before buyers get antsy about missing the next leg of the rally - in bear markets there is no such willingness to jump in so greater number of stocks give up these key moving averages.

There is no shortage of warnings about Wednesday not been a bottom; InvestorPlaceBlogs were unconvinced even with the high VIX and a iBankCoin wrote a mea cupla on his bottom call. Wall St. Warrior is waiting for a capitulation (and is looking at tech for trading it out). However, Bill at VixandMore has an excellent Volatility Catastrophe Graphic showing the level of panic in the market, and another showing the relationship between the S&P and VIX (which would suggest a bottom in place). He explained the VIX spike very neatly here:

Regarding fear and large VIX spikes, my thinking is that the setup for a big VIX spike comes only after market participants begin to believe that a bottom is in and a sharp move downward suddenly causes them to change their mind. The mind set switches from something like "it's finally safe to be long again" to something along the lines of "oh no, this is much worse than I though...and I am caught on the wrong side of it."

As for my thoughts on this. The breadth indicators are a concern but we (including myself in the Royal 'we') may be placing too much emphasis on them. Bullish Percents could best be described as neutral; obviously, most people are looking at the downside and how this may be reflected in the indices - but there is room for a rally to the upside; it's just any rally will likely be shortlived.

Amazingly - there was a Bullish Percent 'Buy' in the Dow...

Summation Indices are similarly closer to overbought than oversold, but can go higher.

So upside can't be ruled out. The next chart shows how the cyclical bull market occurred on the back of a declining Summation Index. This negative divergence eventually caught up with the index as it converted higher highs and higher lows into lower highs and lower lows. But one can see the potential upside that can catch the sideline money out and force shorts to scramble for cover. A push to resistance around '0' would make things very interesting.

What are the chances? Probably higher than most are willing to admit. The last leg of the 2007 rally was kicked off by the NASI at -219, when the Nasdaq was trading at lows of 2,340. It then spent the next 8 months posting a 500+ point gain. If a rally was to occur here it would kick off the mother of all bullish divergences in the Summation Index; there is nothing that couldn't see a push to 600-700 as happened after the last cyclical bear market ended in 2003.

In addition, this scenario ignores the fact the VXN is likely to close the highest it has ever been in 5 years and notably higher than it was in any previous Nasdaq bottom over this period. Or that the Call-Put ratio is at levels last seen during the major bottom in 2004 and 2005, in addition to the aforementioned 2007 bottom. Ignore this information at your peril - particularly if you are short or are thinking of going short. The next rally may be short in duration, but it could pack quite a punch.

Dr. Declan Fallon, Senior Market Technician, the free stock alerts, market alerts and stock charts website

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