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posted on 18 September 2016

Walking A Fine Trend Line

by Lance Roberts, Clarity Financial

In last week's missive I noted:

"While it seemed for a while that volatility had been completely eliminated from the market by an ever present Fed, I warned this was a dangerous assumption to make.

On Friday, volatility returned with a vengeance."

Not only did volatility pick up on Friday, it remained present all week with the market swinging wildly between positive and negative days as shown in the chart below.

sp500-chart1-091616

Analysts, the media, and Wall Street talking heads rushed to grab every excuse available to explain the sudden sell-off this past week from the Fed, poor economic data, election rancor. It really was not a surprise as I have been warning about a pending correction over the last month as market extensions had reached extremes.

However, while the sell-off certainly woke investors from their complacent slumber, let's step back from the ledge for a moment and analyze what has happened. As I wrote three weeks ago:

"As shown, a reversion to the current bullish trend line, which coincides with the market's recent breakout levels, is a likely target in the short-term.

However, there is a more than reasonable chance, as I laid out two weeks ago for a deeper correction in the next 60-days. The chart below shows the potential drawdowns from current levels."

The chart has been updated through Friday afternoon.

sp500-chart2-091616

Despite all of the hand-wringing from the mainstream media this week, the markets have only experienced a very slight 3% correction to date.

But it is in the chart above the most important questions reside. Let's take a closer look.

sp500-chart3-091616

Notice the bottom indicator suggests the market is now short-term oversold. With the top indicator only about half-way through its resolution process. In late June, the oversold condition marked the bottom of the Brexit sell off.

Of course, this was at a time the Federal Reserve, and global Central Banks, rushed to the rescue with liquidity programs and verbal easing to reignite the bulls.

"So we should buy now, right?"

Maybe not.

The same conditions also existed back in the December of last year. The correction, and oversold condition did lead to a subsequent bounce which only lured unwitting investors into the subsequent January-February swoon.

"So, you are saying we should sell? "

Here is the honest answer to both of those questions: "I. Don't. Know."

I realize, of course, such a statement is of little help or comfort. But it is simply the case with which we are confronted with currently. Let's review the "Bull" and "Bear" case from last week.


The Bull Case (Buy The Dip)

There is little reason to believe, at the moment, the current bull market has ended. I say this for the following reasons:

  1. Central Banks are still engaged globally which continue to provide liquidity support for the markets.

  2. The Federal Reserve is unlikely to tighten monetary policy in September.

  3. Overall investor sentiment is still in "greed mode."

  4. Intermediate-term "buy" signals remain intact currently.

  5. Bullish trend lines remain supportive.

  6. Short-term oversold conditions have been achieved.

sp500-chart4-091616


The Bear Case (Deeper Correction)

The problem is despite the bullish supports that currently remain, the list of bearish detractions has grown markedly in recent months.

  1. Economic data continues to deteriorate. (See here)

  2. Fundamentals remain detached from prices. (See here)

  3. Current oversold condition is in conjunction with momentum "sell signal" (see chart above.)

  4. Intermediate-term "buy signals" are close to being reversed from high levels (see first chart below.)

  5. Long-term "sell signals" have been triggered (see second chart below)

sp500-chart5-091616

sp500-chart6-091616

If the market fails to hold short-term support, a deeper correction could begin to develop. A violation of the long-term bullish trend from the 2009 lows would be a key indication of a trend change in the market. Currently, that level is around 2050.

I said last week:

"I want to give this current market action a few days to play itself out. As shown in the chart below, the oversold condition of the market (green dots on bottom) suggest a very likely bounce next week. However, as I have highlighted (blue boxes) bounces near market tops have generally preceded eventual deeper declines."

sp500-chart7-091616

The action this past week was both good and bad.

The good: The market held support at the previous breakout highs.

The not-so-bad: The market remains below the 50-dma but is oversold which is providing some short-term price support.

The bad: There was very little improvement from last week which would suggest the "bulls" have regained charge of the market.

Importantly, the longer-term "buy signals" are still intact, along with the long-term bullish trend, which maintains the cyclical bull market currently. This means that one should NOT become overly defensive in portfolio postures as of yet.

As I continue to reiterate, I remain on the lookout for an opportunity to "SAFELY" increase equity exposure in portfolios. That opportunity has not yet presented itself as of yet.

There is also, at this late stage of the bull market cycle, a chance it may not.


I Don't Like My Gut

One of the biggest mistakes that investors consistently make is allowing "emotions" to drive investment decisions. This is why a do my best to remain focused on my discipline and the 15-trading rules that drive the overall process.

Currently, while the markets are holding their current bullish trend lines from February, there is a nagging voice that suggests something has changed.

Call it a "shift in the wind."

Or a "change in the temperature."

Whatever it is, it is nagging me the current correction may not be over as of yet.

Michael Kahn wrote an interesting piece for Barron's suggesting the same:

"There are certain days in the market when change is palpable. Many times, they originate with proclamations by governments or major corporations. On Friday, the sell off was triggered by talk of interest-rate hikes by the Federal Reserve. Yet rather than registering as a non-important technical move on the chart - as was the Brexit vote in June - last week's decline created a very important pattern breakout (see Chart 1) that suggests the 'fun' is far from over."

on-bu451_gtcht1_ns_20160912162735

"With the market on edge about the timing of the Fed's next move, any clarity, whether real or imagined, has the ability to change the market's mood instantly. Just look at the reaction of interest-rate-sensitive areas such as utilities, real estate, and high-yielding consumer-staples stocks. These groups actually foreshadowed recent events with their market-lagging performance last month."

on-bu452_gtcht2_ns_20160912162509

"As we can see in the chart, the Russell's weekly range opened above and closed below the range of the week before, in a fairly textbook version of the pattern. Unless the bulls retake control immediately with a rebound of at least half to two-thirds of Friday's loss, we have to assume that the new trend to the downside is already in place."

Tom McClellan's view also noted an interesting point last week that only adds to the current conundrum of whether, or not, investors should be "buying the dip."

"This particular version of the McClellan Oscillator for High Yield Bonds is calculated the same way as for the NYSE A-D data. But because the number of issues traded are different for each market, the raw scaling is therefore necessarily going to be different."

corp-bonds-mc-osc-sep-2016

"Once we get past that notion of scaling, and just focus on the chart itself, we can pretty easily see where 'high' and 'low' readings are. I drew a horizontal line at the arbitrarily chosen level of -75 to help focus the eye on the situation we see right now. Very low readings below that line tend to reliably be associated with meaningful bottoms for the SP500. I should caution that the notion of 'meaningful' bottoms does not mean the same thing as 'final" bottoms.

But such bottoms are usually followed by meaningful bounces, if not outright up moves. That is the important message. What we are seeing with this very low reading is a message that the stock market is at a meaningful bottom and ought to see a brief pop, at a minimum. What happens after that is a more difficult question to address.

It is not only the McClellan Oscillator for these data which has merit. A raw Advance-Decline Line (A-D Line) can have value on its own, when it signals a trend change."

corp-bonds-a-d-line-sep-2016

"When the High Yield Corporate Bond A-D Line crosses through a long trendline, it is a pretty darned good signal of a trend change. Some examples are shown in this second chart.

This is important now because we have just seen such a crossing, this time below the rising bottoms line that dates back to the Feb. 2016 low. That line has been fairly authoritatively broken, and now this A-D Line is also threatening to close below its own 5% Trend (AKA 39-day EMA), an act which would add further confirmation of a trend change.

High yield bonds had come back into fashion in 2016, as the central banks' policies of zero or negative interest rate policy has pushed investors into more risky assets. The pendulum appears to be swinging back again, although it has swung really far already on the first push, as evidenced by the extremely negative McClellan Oscillator reading shown above. That says the initial down leg may have gone too far too fast all at once.

But the broken uptrend lines says we are seeing a significant trend change getting started right now. Both messages are worth acknowledging."

Still confused. Me too.

I am going to sit tight for now and wait and see what Monday brings us.

If you subscribe to the website and I will email you the technical update on Tuesday which will note any changes to allocations.

For now, we wait.

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