A Fake-Out Breakout

 | Jan 04, 2012 | 6:00 AM EST
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For anyone who believes we saw a high-quality rally on the first day of trading year, please step forward. Just so you know, the laundry list of what wasn't good about it is longer than the list of positives.

Let's begin with the number of stocks making new highs on the NYSE. The number came in at 202 Tuesday vs. last week's impressive 213, even as the S&P 500 jumped past its highs from last week. This is not to say 202 is a bad reading. But, on up days, we want to see new highs expand rather than contract.

Number of Stocks at New Highs -- NYSE

Also quite disconcerting was the breadth. It has been cruising along, keeping pace with the market. However, the readings from Tuesday's 20-point rally were lackluster, coming in worse than it did in last Thursday's 13-point rise.

What particularly surprised me Tuesday was the put-call ratio, which fell to levels not seen since July. With a total put-call ratio of 76%, I would not call it low, exactly, but consider that the market was near its high the last time we saw a put-call reading down here. The 10-day moving average of the ratio is also now at its lowest level since July.

While the equity put-call is not at its lowest level, its 10-day moving average is now in the area from which it has bottomed out in the past six months. It hasn't ticked up yet, so it's not giving any signals. However, considering the Investors Intelligence readings I discussed in Tuesday's column, which are showing more than 50% bulls, I would now say this indicator could flash a confirmation any day.

Put-Call Ratio

Then there are the charts of the major indices, themselves. I've had several folks ask about the breakout. We all have our own definitions what constitutes one, and there is no right or wrong answer. Robert Edwards and John Magee, for instance, say the breakout should go 3% past the in-focus level before you can trust it. I have never used that rule, though, as I tend to prefer anticipating a breakout rather than chasing one.

However, I do have an analogy. Think of a breakout as a kid who runs away from home. Do they get on the bus and leave town, or do they go to the neighbor's house and hide out? In the former case, the kid really means it -- they want to break away entirely. In the latter situation they're not so sure, and probably just want to scare the folks.

With that in mind, let's go back to the chart of the Russell 2000, which I highlighted as a potential breakout candidate a couple of weeks ago. Does that climb out of the head-and-shoulders bottom look more like the kid who left town, or the one who went to the neighbor's house? I believe it's the latter, and if the index retreats back under 750 and stays there, that would confirm my view.

Russell 2000

The good news is that the market is not yet overbought on an intermediate-term basis, which means the window is still open for improvement. The bad news is that the chop we've seen for the last few months looks to me to be very much alive and well.


Overbought/Oversold Oscillator -- NYSE

Overbought/Oversold Oscillator -- Nasdaq

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