I’m struggling what to write tonight, or even whether to write at all. When dealing with loss of life and tragedy, the markets really don’t matter all that much. Still, today’s action was somewhat historic, and so I struggle.

I’m going to try and find a balance by just posting a few graphs and making a few comments about the graphs and leaving it at that.

The graph above has 3 breadth indicators: one that is very short, one that covers a week or so, and one that covers an intermediate term.

The middle pane with the green line shows a percentage rank of the number of stocks that have declined. Note that it is at 100. Obviously it can’t get any higher. Readings above 90 are good for an immediate bounce.

In the lower pane, the red line shows the number of stocks trading above their 5 day moving averages. It closed at 319. A reading of this level is associated with a bounce that can be sustained over a period of days or even a week. Although this reading is very low, I’m not sure if I trust it since the influence of the Boston tragedy is hard to quantify.

Let’s look at another suite of breadth indicators.

These graphs are based on Stockbee’s Market Monitor. I’ve coded them over the past month or so in order to backtest them. I’m not going to write a great deal about them tonight, but I will highlight the big divergence in the first pane under the $SPY graph, which shows the number of stocks up more than 25% or down more than -25% a quarter. This divergence is a huge blinking yellow caution light.

Secondly, notice today’s first peek of yellow in the middle pane, which means there were more stocks today that were down more than 25% this month than up more than 25% this month. Another warning sign.

So what I am seeing is the likelihood of a short-term bounce, but I do believe the market is entering a corrective phase.

I offer my thoughts and prayers to those in Boston.

We are finally seeing a little pullback after a solid month of rallying. The pullback is still pretty cute and has not turned ugly, although it has one of my indicators flashing a rather extreme signal. The indicator of which I’m speaking is the Decliners indicator.

This indicator simply counts the number of declining stocks with a close greater than 1 buck, 50 day average volume greater than 100K shares, and a 50 day average dollar volume greater than $1,000,000. It then ranks this count against all the previous counts over the last 250 days.

The Decliners indicator is the middle pane, green line. It closed this evening at 94.8. Click on the chart to enlarge it.

So what happens when we buy $SPY the next morning on the open after the Decliners indicator registers a close above 90?

The $SPY After Setup next day return is more than 2x better than average and results improve going forward. We see that by the 10th day, the edge is wearing off and $SPY average performance is catching up.

One important caveat about the Decliners indicator is that the edge can come and go very quickly. One of the other breadth indicators I use tends to portend a bounce that lasts longer. This is the number of stocks above their 5 day moving average. It is the indicator in the lower pane, red line. It has not yet fallen far enough for me to expect this bounce to last awhile. What this tells me is to expect a bounce, but do not expect it to last a long time. We may be setting up for a test-the-recent-highs situation before embarking on a more meaningful pullback.

Two measures of breadth that I’ve been following for years are signaling that a bounce is likely. There are probably other measures that are confirming that market breadth is oversold, but I’m a believer in following and trusting in what you know and understand, and these indicators fit that description.

The two indicators are the number of stocks above their 5 day moving averages and a percent-rank of the number of declining stocks.

The Rules:

• Buy $SPY at the close when the number of stocks above their 5 day moving averages is < 650 and the percent-rank of declining stocks is > 89.
• Sell $SPY at the close X days later.
• No commissions or slippage included.
• All available $SPY history used.

The Results:

So yeah, oversold breadth tends to lead to a bounce. Duh.

Some Additional Stats:

Next Day Winning Percentage: 53.75%
5 Day Winning Percentage: 59.71%
Median Trade After 50 Days: 2.77%
Average Trade After 50 Day: 2.00%
Number of Setups: 160
Number of Trades Held 50 Days: 60

Belows is a chart showing the indicators…Click to enlarge…

I have included trading arrows to demonstrate when both indicators have triggered in tandem. The red down arrows show the sells 50 bars after the buy. There were other times the indicator triggered, but those are not reflected in the chart because it was already in a long trade from a previous trigger. In other words, the system can only be in one trade at a time.

Ignoring technical measures, I’m thinking that the recent selling is likely due to seasonal reasons plus the expectation of the increase in capital gains taxes. If this is true, the selling may continue despite market breadth being oversold.

I’m guessing that good news on the fecal cliff will yield a bounce that may be substantial initially, but may sell-off once the details are better understood.