posted on 16 October 2016
by Lance Roberts, Clarity Financial
Over the last couple of months, I have been discussing the importance of the bullish trend line that began this past February.
As I stated just this past Tuesday:
Chart Updated Through Friday Morning
Importantly, the market broke that bullish trend line this past week with the market remaining overbought and on a "sell signal." These combined events put further downside pressure on the markets into next week.
If we zoom in we can get a little clearer picture about the breakdown.
The two dashed red lines show the tightening consolidation pattern more clearly. As I stated on Tuesday:
Currently, the market has been able to defend crucial support at the level where the markets broke out to new highs earlier this year. However, the market now finds itself "trapped" between that very crucial support and a now declining 50-dma and the previous bull trend support line.
David Larew (@ThinkTankCharts) had a very good chart on this on Friday. This down trending top, combined with falling moving averages, provide significant overhead resistance keeping downward pressure on stock prices.
It is important, as an investor, is not to "panic" and make emotionally driven decisions in the short-term. All that has happened currently is a "warning" you should start paying attention to your investments.
As I have written many times in the past, by the time an event occurs where a potential signal is issued, the market is generally either overbought or oversold. Rather than immediately acting on the signal when it occurs, it is often better to wait for some correction of that overbought or oversold condition before taking action.
The chart below shows this a bit more clearly.
As shown the number of stocks trading below their 50-dma is pushing levels more normally associated with short-term trading bottoms. This does NOT MEAN it is a "BTFD" (Buy The F***ing Dip) moment.
What it does suggest is the market is oversold enough on the short-term for a trading bounce back towards previously broken support which now acts as new resistance. Such a reflexive bounce will provide investors the opportunity to proactively rebalance portfolio risk and raise some cash.
As noted in David's chart above, it is very likely we will get a small reprieve in selling pressure temporarily allowing for a bounce next week to rebalance risk into. However, as shown in the WEEKLY chart below, there is ample evidence we are currently working through a bigger correction process that is not yet complete. This should keep portfolio allocations tilted to a more conservative posture.
This is particularly the case given the two confirming "sell signals" in the lower part of the chart. While it is currently very early, previously when both signals have been triggered further corrective action followed. Given the high levels at which both signals are currently triggered, it pushes the risk of a deeper correction higher than many would likely suspect.
For now, particularly as we enter into earnings season, caution is advised.
Dollar Rallies As Expected
Back in July of this year, I began writing about how the dollar will likely continue to strengthen in the months ahead. To wit:
Here is an updated version of that chart.
As mentioned...the earnings outlook could be in jeopardy. The chart below compares recent months to where estimates stood in January of this year. As of October 1st, forward estimates are at their lowest levels yet. (Let the "beat the earnings" game begin.)
The dollar rally could be a real problem with respect to the earnings recovery story going into the end of the year. With an already weak economy, a stronger dollar means weaker exports for companies and a drag on corporate profitability.
Michael Pento noted this problem in his article this past week:
Let's take Michael at his word about historically high valuations. Heading into the turn of the century valuations spiked to an astronomically high level driven at first by irrational exuberance and then collapsing earnings. However, prior to that period, every bull market in history ended when valuations approached 23-25x earnings.
The chart below is a thought experiment which compares the inflation adjusted S&P 500 index with Robert Shiller's CAPE which has been capped at 25x trailing earnings. By stripping out the one anomaly, we can find a potentially more realistic view about current valuations and as it relates to expected forward returns.
Given the current level of valuations, if there is a failure of earnings to rebound going into the 4th quarter, the justification of higher valuations is going to become much more difficult to support.
This is particularly the case if interest rates rise further, which will become to crimp further demand for credit, along with a stronger dollar impacting exports.
By the way, don't expect for a moment the Fed will actually hike rates in December. That particular window has been closed, boarded up and cemented over.
Earnings Already Set To Disappoint
Speaking of earnings set to disappoint, Jeffrey Snider made a good note of this possibility.
So, technically the set up is poor. The fundamentals support the technicals. But what you need is a complacent market to create the opportunity for a "panic selling" environment.
Hibernating Bears And Market Tops
Dana Lyons had a very interesting piece out last week that also provides support for a deeper correction process in the works.
The whole piece is well worth reading but you get the point. High levels of complacency are important when something causes them to reverse sharply. The problem is that we never know what the event, or catalyst, will be that causes the flight to safety.
The overall backdrop for investors is not currently favorable for excessive equity exposure. However, technically, the market has not broken which would require a significant reduction in portfolios currently.
As stated previously, this is not a market to become overly complacent with. While this may turn out to be another "buy the dip" opportunity, there are enough warning signs that suggest the reward is not currently worth the risk.
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