Most of the time, this indicator is brought up because there is a “negative divergence” which then is used to argue that the market is floating on air and will come crashing (or correcting) down because not enough constituents are supporting its rise.

As I mentioned, the problem with this logic is that for the most part, the Nasdaq cumulative breadth has been in perpetual free fall:

The only time this indicator was able to mount a feeble come back was in 2003. And even then, it didn’t last long. While the market continued to rise, the cumulative breadth soon fell and broke through the low set in early 2003.

To see the recent graph of Nasdaq cumulative breadth, check out the link above.

The long term chart of the NYSE cumulative breadth is even more enigmatic. From 1995 to 1998 it rose along with the S&P 500. Then it decoupled and became it’s mirror opposite until the bear market bottom in 2003. And since then it has again, walked in agreement with the market index.

To anyone who proposes the theory of “negative/positive divergence”, I would ask, when should I have bought or sold? and why?

For example, should I have sold in the spring of 1998? and missed the massive run up to 2000? should I have bought in early 2000 because cumulative breadth was turning up and breaking the downtrend? wouldn’t that have resulted in massive losses?

Cumulative breadth simply doesn’t provide any sort of actionable insight. Unless I’m missing something huge. In which case, someone please forgive my elephantine ignorance and rescue me from myself.

After all, companies don’t go public as a gesture of charity. They do so because they think that they will gain something by exchanging their shares for your money. A transaction occurs when the two sides agree on the price but disagree on the value of the asset in play.

But there is an inherent asymmetry when it comes to IPOs. Although we have put in place measures to protect the public (through circulars, public disclosures, etc.) the insiders still know much more about their company and its merit as an investment than the general public who are taking the other side of the deal.

So obviously when we have an avalanche of insiders wanting to sell to the public, they aren’t doing so because they want to hand over their hard earned capital out of the goodness of their hearts. You know that valuations are so out of whack that they are about to soon regress to the mean. This is what happened in early 2000 - when you had people taking everything short of their daughter’s lemonade stand public.

The current market environment is very different from then. That is why I’m just not persuaded by the dire predictions of mass market meltdown or financial armageddon. We are actually enduring a severe IPO drought.

To play Devil’s advocate, today’s lack of IPOs may be partially explained by the low interest rate environment. Financially strong companies can turn to the fixed income market to find funding at lower cost of capital than equity markets. But I don’t think that explains it completely.

After the jump there is a great article written by Mark Hulbert for the NY Times which goes into more detail about several research studies which look at the predictive characteristics of the IPO market:

Strategies
A Sign of Hope for Stocks
By Mark Hulbert

FROM at least one perspective, the stock market peak of last October was not accompanied by the speculative excesses found at the height of previous bull markets. This raises hope that the market decline that began in the fall may not turn out to be severe — and that it may have already run its course.

The indicator in question focuses on corporate money-raising. Considerable research has shown that when companies turn aggressively to the equity market for their financing needs, through new issues or secondary offerings, it is a sign that the stock market is overvalued. Though there is no easy way to interpret the data, current trends in corporate finance appear no worse than neutral for the stock market’s intermediate-term prospects. And the data may actually be painting a bullish picture.

Owen A. Lamont, a former finance professor at Yale and now a fellow at its International Center for Finance, has studied shifts in companies’ use of the equity market to raise money. He has constructed a gauge, which some have called the new-list indicator, based on the percentage of all publicly traded shares that began trading in the trailing 36 months. This proportion increases as new companies go public or already-public companies issue more shares, and decreases as companies engage in stock repurchases or mergers and acquisitions.

Professor Lamont, who is also a portfolio manager at DKR Capital, a hedge fund in Stamford, Conn., has calculated the new-list percentage back to 1929. Its all-time high was nearly 15 percent, at the beginning of the Depression. Its second-highest level, almost 11 percent, was in March 2000, just before the Internet bubble burst. (He published these results in 2002 in an academic working paper.) [ You can find the paper in the free trading resource section, under Reports & Articles: “Corporate Events and Market Timing”]

Where does the new-list percentage stand now? In an interview, Professor Lamont said it was at 5.1 percent, or right in line with its long-term average. When the market hit its high in October, he said, his indicator stood at just 5.6 percent. That was only marginally higher than where it finished the year, and about half its level at the market top in March 2000. By this measure of speculative activity, the current market is markedly less overheated than it was before the bursting of the Internet bubble.

A RELATED and even more encouraging indicator focuses on the relative proportion of new corporate cash that comes from equity as opposed to debt. Researchers have found that in past periods when stocks were overvalued, companies greatly preferred equity over debt. The opposite tended to be the case when stocks were undervalued.

Two researchers who have studied these patterns are Malcolm P. Baker, a finance professor at Harvard Business School, and Jeffrey Wurgler, a finance professor at New York University. For each year from 1927 through 1996, the professors calculated the share of total capital raised by publicly traded corporations that came from issuing stock — what they call the equity share.

Over the 12 months after the quartile of years with the lowest equity shares (when this proportion was no higher than 14 percent) the stock market returned an average of 14 percent, according to the professors. In contrast, the market had an average net loss of 6 percent following the quartile of years with the highest equity shares (when this proportion was no lower than 27 percent). Their results were published in the October 2000 issue of the Journal of Finance. [ You can find the paper in the free trading resource section, under Reports & Articles: “Equity Share in New Issues”]
and Aggregate Stock Returns

Where does the equity share stand now? In an e-mail message, Professor Wurgler said it was 6.1 percent for 2007 through September, the latest date for which data are available. Because this puts the current market solidly in the quartile of past years that were followed by above-average returns, he says the data are sending “a bullish stock market signal.”

In separate interviews, he and Professor Baker hastened to add that this bullish signal by no means justifies throwing caution to the wind. They pointed out that companies have had far easier access to cheap debt financing in recent years than they did in earlier decades. As a result, they argued, the current low equity share may not be strictly comparable with similarly low previous readings — and thus may not be as bullish as it otherwise would appear.

But judging from how companies have been raising new money, Professor Baker said, there was little evidence of extreme levels of speculation at the recent stock market high. At least to this extent, he said, this means that “there is less downside risk in the market today than there was in March 2000.”

The energy sector managed to push a little bit higher in July 2007 but it then succumbed to the general market weakness. So since I wrote about my apprehension it didn’t go anywhere really for the next two months:

The strength of this sector was undeniable in 2007. In fact, last year it bucked negative seasonality to deliver one of the best sector returns. Usually, from the beginning of June to the beginning of December energy stumbles. In fact, in the past decade only 3 years have bucked this negative seasonality. On the other hand, once December rolls around, things do tend to rock and roll.

Seasonality
The logic behind the seasonal influence is the seasonal weakness in the commodities themselves. Natural gas and oil are weakest in the summer (May to July) and strongest in winter. So right now we are just about to enter the worst time of the year to be long oil and gas stocks.

On top of that 82% of stocks in the Energy Select SPDR (XLE) are trading above their 100 day moving average. That’s not the maximum but it is high. As well, the bullish percent for the sector is a bit “toppy”, hovering below 80%:

The smart thing to do was buy in January and March 2008 when the bullish percent spiked down to 20% (and less). But you already knew that because you know how to time the market using bullish percent charts, don’t you?

On Wall Street it depends who you listen to. Goldman Sachs is hyper-bullish on oil awaiting $150-200 a barrel oil while Lehman Bros. thinks that prices will fall to $83 a barrel in 2009 and $70 by 2010.

What about Peak Oil?
I don’t buy into “Peak Oil”. We will either discover more oil, better extraction methods for existing reserves or move to alternative energy sources. Take new discoveries for example: Thanks to the Tupi discovery, Brazil will become a major oil player - probably joining OPEC as a result. But that is years in the future, assuming all goes according to plan. Petrobras will have to drill more than 16,000 feet under the seabed, itself under 10,000 feet of water. The reward though is tantalizing: 5-8 billion barrels of oil and natural gas.

The reason why I bring it up is not because of Sprott’s size or significance to the market. It is after all tiny, managing only $7 Billion - in the world of asset management that doesn’t even register as a blip on the radar.

Rather, it is that Sprott has been at the forefront of the commodity boom, riding the rise of oil, gas, and even obscure natural resources like molybdenum to earn management fees. The owner and main portfolio manager, Eric Sprott, is an unapologetic believer in “peak oil” and a huge gold bug.

What makes me question the IPO is its potential significance as a market tell for the whole commodity boom. There is no question that Sprott is an astute manager and market timer. The track record of his various funds attests to that. The natural corollary is then, why is he selling now?

If he thought that the commodity boom would be continuing or even accelerating, wouldn’t he want to keep aas much of the company and the profits for himself?

The only logical reason to sell is if the commodity boom is about to come to an end.

Consider these other examples:

Sam Zell, probably the keenest real estate investor today, sold Equity Office Properties in February 2007 to Blackstone after a protracted bidding war between the winner and Vornado REIT. You get one guess on when the REITs in the US topped out.

Or take the June 2007 IPO of Blackstone Group (BX), one of the largest private capital managers in the US. Timing when to take companies public, when to take them private, and valuation is their bread and butter. Do you think they might know something you don’t?

Blackstone’s IPO marked not only its own share price but also the top for private equity deals:

For more examples, check out: Don’t buy what Wall St. sells

Of course that doesn’t mean that by default all IPOs are to be shunned. But in the case of Sprott there is a more fundamental reason. It is extremely expensive! The IPO values Sprott Asset Management at $1.5 Billion - twice as much as other Canadian boutique asset managers. Finally, Sprott is selling right at the top. The TSX is at a triple high above 14,500 and the energy sector is rather stretched to the upside as well.

Given the cyclical nature of the natural resource sector, my hunch is that sooner rather than later this sector will revert to the mean. Peak oil is a meaningless concept that has been bandied about for the past 50 years. Every time oil prices go up it finds a new following and every time oil prices return to earth the peak oilers somehow melt into the scenery quietly. The reason why Hubbert’s theory has been proven wrong again and again is that new advances in science and engineering processes move the line in the sand. In effect making it an anachronism.

In any case, for those interested, watch for Sprott’s IPO on May 15th. It will trade under the symbol SII on the Toronto Stock Exchange.

Sentiment Surveys
The AAII sentiment survey came in this week at 53% bulls - unchanged from last week. Not only is this a very high bullish reading for this indicator, it is the level at which the market topped out last October. Furthermore, the fact that it has remained firm in the light of this past week’s market performance should be sending chills down the spines of bulls.

From a contrarian point of view, I want to see the retail investors (AAII respondents) become fearful as the market is falling and remain so even as it rises. The fact that they have now quickly shuffled over from extreme bearishness to bullishness and maintained it for two weeks, even as the market fell, reinforces my belief that we are in for some trouble.

In contrast, the Investor’s Intelligence survey is showing 44.4% bears and 32.3% bulls. There was a slight increase in the bullish numbers and an even larger increase in the bearish camp. Still, according to the current II we aren’t anywhere near bullish extremes. Take for example that the bull/bear ratio is 1.37 - it was more than 3.0 when the market topped last October.

Rydex Nova/Ursa Ratio

In case you’re not familiar with this indicator: before the onslaught of ETFs, Rydex’s Ursa and Nova were the ticket if you wanted to time the market. The are mutual funds but they settled twice daily (I don’t think they do anymore) and you could switch assets between them or other Rydex funds with no penalty. Like other contrarian indicators, when the fast money crowds to one side, the smart thing to do is to jump to the other side.

Right now the ratio is showing an abundance of optimism from the Rydex fund timers. Something which makes me wary. On its own this wouldn’t be enough to really concern me but it is just one more in an ever growing list of short term indicators which suggest some sort of correction or pause at best.

Fund Flows
The only bright spot, from a contrarian perspective, in the sentiment overview is the mutual fund money flows. According to AMG Data, one of the largest and most accurate providers of this sort of data: domestic (US) mutual funds reported net redemptions (outflows) of $8.6 Billion. This dovetails with the panicky behavior we’re seeing in Canada.

With interest rates so low, and cash being basically a negative return investment, you won’t be surprised to learn that money market funds had the largest monthly outflow in April ever on record: $78.7 Billion. Some of the cash flowed into municipal bond funds ($4 B), no doubt in search of a higher yield. But I suspect much of it, perhaps even the vast majority, was the US consumer’s retrenchment.

Finally, among the sectors, real estate funds received the largest inflow of money since February 2007 - which was exactly the worst time to buy REITs or anything else real estate related in the stock market.

So while this beleaguered sector has valiantly fought back from the January 2008 lows, it may be about to top out (again). Look alive out there.

Sponsor: Free Trading Resources : eBooks, articles, and more

Being a contrarian isn’t as easy as simply doing the opposite of what the non-professional investors are doing though. The key is to pick your moment. You want to do the opposite of what they are doing only at extreme inflection points.

Escape to Cash
Take for example the current state of Canadian investors. In spite of seeing the market recover, they are so traumatized that cash holdings in Canadian households has climbed 15%. According to the investment banking arm of CIBC, this is the fastest pace since… c’mon now, this shouldn’t be difficult… 2002.

So Canadians are basically rocking back and forth in the fetal position. Just as they were at the bottom of a brutal bear market which cut the Nasdaq in half and decimated investment accounts everywhere.

They have cashed out $35 B of equity mutual funds in the past 6 months. And on a rolling 3 month basis, net sales of mutual funds is in negative territory (in other words, net redemptions). That is the worst state of the mutual fund industry since they have been keeping records.

Double Whammy
So on the one hand we have investors who don’t see the market correction coming, get excited and buy mutual funds. And when the market does correct, and they lose money, they are so shell shocked that they just sit there on a pile of cash while the market moves on.

The 1987 stock market crash lasted two months and panicked investors towards the safety of cash. The problem was that, according to the CIBC report, they stayed there for 16 months afterwards, missing out on an amazing run as the market recovered.

This is the sort of thing that drives regular people absolutely bonkers! The give up saying that the market is “rigged”. Truth is that money flows inevitably from weak hands to strong hands.

The good news in all of this is that with a bit of effort you can learn to zag when everyone else is zigging. This is not as simple as it sounds though. There is something innate within us that draws us to the safety of the crowd. So standing apart is excruciatingly difficult from a mental and emotional basis.

Caution, Caution, Caution
While this level of fear usually marks major market bottoms, it doesn’t mean that the stock market will go up without pause or retracement. In fact, from the percentage of TSX stocks trading above their 50 day moving average, it looks like this is just the right time to lighten up:

The fact that the market is now probably topping here does not negate the contrarian significance of the regular Canadian investor hording cash. Note that the market topped out in July 2007 and again in October 2007 without whipping the masses into a frenzy of stock buying. That is, they weren’t mortgaging their homes to buy stocks like the bubble years gone by.

And when the market bottomed in the summer of 2006 and 2007 it wasn’t enough to cause people to become shell shocked. For some reason it took the market correction in early 2008 for that. I have no idea why. Maybe it was the confluence of the housing market, the price of oil marching higher, the credit crunch, etc. All I know is that right now we have market sentiment so bearish it only appeared last in 2002.

On a related note, if you are interested in mutual fund cash levels and their significance for the stock market, check out Jason Goepfert’s award winning paper: “Mutual Fund Cash Reserves” located in the Charles H. Dow Awards folder of my free trading resource area.

• Cake Financial
• MarketGuru
• Mint
• Wikinvest

Is this completely new to you? Then you are in for a treat! Think of it as facebook meets Wall St.

If you are already familiar with one or two, or even be a member of a site… it’s worth looking over the list because you might find a more interesting community that offers you more: Guide to Social Investing Websites

You are either a novice, hungry to learn more about investing or trading for yourself. Or an experienced trader or investor, interested to enter a community that will allow you to continue learning or maybe even profit from your knowledge. Which ever you are, you’ll find just the right community for you.

Oh and by the way, Mint’s new investment feature is in beta but you’ll find a link to an invite if you follow above link!

Starting from April 18th, I noticed a change in the market tone. Whereas pretty much every single indicator had been flashing buy in January, February and March, one by one, they started to point to caution:

• too many stocks above their 10 day moving average
• a fourth attempt at the 1400 level
• AAII sentiment back to October 2007 bullishness and the ISE call put ratio too high
• trading volume low enough to cause concern
• 78% of S&P 500 stocks above their 50 day moving average
• “Sell in May and go away!”
• market stretched above its 50 day moving average
• AAII sentiment inches even more to bullish excitement
• number of S&P 500 52 week highs compared to 52 week lows signals caution

The best scenario for the bulls would be for the market to pause here and digest this overbought condition and then continue to move higher, breaking above the flag or pennant formation.

Sponsor: Free Trading Resources : eBooks, articles, and more

Or can we?

Every once in a while the bears point to the “negative divergence” in the Nasdaq index and the Nasdaq cumulative breadth. They get worked up over the fact that market breadth does not correspond to the market price. Here is the recent Nasdaq breadth, showing a waterfall decline, in contrast to the Nasdaq Composite index:

It sure looks ominous. Once you zoom out though, you realize that there’s something seriously wrong with this way of looking at the market.

NASDAQ Cumulative Breadth
Just for kicks, let’s go back to 1998. From there, the Nasdaq cumulative breadth fell consistently until October 2002. That’s right. Even though the Nasdaq was screaming higher, then topping out in early 2000, its breadth just barreled down paying it no attention.

Breadth continued falling until it made a sort of double bottom in early 2003, just as the Nasdaq was ending its bubble bear market. The recovery in breadth was short lived because it again started to fall in early 2004 and has been falling consistently since!

So it is obvious from this slice of history that Nasdaq breadth and the Nasdaq composite are completely decoupled. In fact, if we go back further in time we see that breadth has been falling continuously since, well, since I have data for it.

NYSE Cumulative Breadth
The other broad measure of breadth, for the securities on the NYSE, is not all that different. From a top in 1998 it fell continuously until early 2000. For the rest of the year it stabilized and in late 2000 started to rise. NYSE breadth found a top in May 2002. Yes, you read that right! As the market was going to hell in a hand basket, breadth was rising! For some reason, it decided to not rise in 2002 - I guess in sympathy to the stock market. But then in early 2003 as the market was rising, so did NYSE breadth. And it has continued to rise to this day.

My point is that we have so many positive and negative divergences between breadth and indices they purport to represent that cumulative breadth is basically useless.

I agree that a trend simply can not continue if less and less securities are participating in it. Eventually it exhausts itself and crumbles under its own weight as it becomes unsustainable.

The problem is that no one knows when, exactly, this will take place. And cumulative breadth certainly provides no insight whatsoever into this.

This is why I prefer taking a much simpler measure of breadth: the moving average of net advancers and decliners:

The above chart is the 30 day moving average but you can use any number you like, as long as it doesn’t introduce too much lag into the equation. It gives you not only timely signals, but it also pinpoints most, if not all, intermediate bottoms with ease.

I’ll show the long term charts of cumulative breadth for both Nasdaq and NYSE in an upcoming post. It really is eye opening.

All the smart and “hot” money has been trading it and riding it higher. And you can bet they will run for the exit at the first sign that the party is over. Which is why I watch Apple so closely. I’m seeing a confluence of things which gives me reason to believe that the ride may be over.

So how did I do?

Well, Apple thoroughly spanked me. The only tattered consolation I can cling to is after writing that, the rocket ride known as Apple paused for the rest of the month of June. The only thing that knocked it out of the sky was the general market tumble in mid July. It found footing where it had paused earlier and off it went again when the market recovered.

I’m bringing this up for two reasons. One to review a past call and award myself a meager C- and two, to talk about entry into momentum stocks. Most technical traders agree that momentum stocks provide a great opportunity. As the saying goes, “the trend is your best friend”. Or, bodies in motion tend to stay in motion.

This is especially true when the market has corrected and is about to find its footing again. It is a very rare momentum stock indeed that can completely buck the general market tone. Apple certainly didn’t and it was one of the best performers in 2007.

The general market is like the tide or the waves of the ocean. It is a background element common to all boats (stocks). But some boats have better hulls and more hydrodynamic shapes. So they will react differently to the same common element.

Apple carved out a rounded bottom at $120/share, just as the S&P 500 found its footing. For AAPL that level also coincides with previous important points of support. From there it launched into an astounding recovery which left other stocks in the dust. While it has now easily reached the heights it once claimed in late 2007, the S&P 500 is still more than 8% below its highs of October 2007.

Although most would agree that it is smart to ride the momentum of stock like Apple, but can’t agree when exactly they should enter it. I would suggest that the best time is when the market has exhausted itself within a correction and is about to bounce back. This allows you to define your risk and base it on support levels, removing guesswork.