Positioned for a Rally From Here

A few interesting things happened this week. This tweet came out just before the open on Tuesday.

The market opened higher then immediately started to sell-off. Then around mid-day we saw that spectacle out of the Oval Office between President Trump, House Democratic Leader Nancy Pelosi and Senate Democrat Leader Charles Schumer.

The market continued to sell-off. It later reversed to close flat on the day. On Monday the market did something similar. On Monday we saw what Martin Pring from Stockcharts.com classifies as a bullish Pinocchio bar. He notes, “Monday’s action was what I call “scary bullish.” First, we saw prices sell-off sharply, only to then rebound as if nothing had happened. Well, something did happen - the formation of a bullish Pinocchio bar on several Indexes. Chart 1 shows this for the S&P, where the open and close developed above the red trend line, but the intraday action pushed it temporarily below, resulting in a false downside break at the end of the session.”

“Officially, Pinocchios only have a short-term effect, lasting for roughly 5-10 sessions. However, some are so strategically placed that, in retrospect, it can be seen that they actually developed at major turning points. The vast majority of my long-term indicators remain in the bearish camp; since a lot of them are slow to turn, my belief that a primary bear market is underway remains unaltered. That said, there are a number of intermediate indicators that are bullish, so we may well see a nice rally develop from current levels. Add to that the bullish seasonals, the post mid-term election rally tendencies and a Chinese trade/Brexit/Fed wall of worry and it’s possible that we will see an extension of the trading range that has been building since late January. If my suspicion of a bear market is correct, that trading range will turn out to be a top.”

I believe the market has found a trading range that is becoming increasingly immune from the Washington DC circus theater.

I have deployed the remainder of our capital and am expecting the S&P 500 to make an attempt towards the top of the range – somewhere near 2800. For full disclosure, we deployed much of our capital near the lows on Monday (this seemed like a strong support level and will ultimately be my stop loss if I am incorrect about the year-end rally). See Looking For The "Throttle-Up" Trade.

Tom Bowley pointed out in Stockcharts.com, “Yesterday was significant for one very important technical development. The February 2018 low close of 2582 was within a whisker on Monday as the S&P 500 hit an intraday low of 2583 before rallying strongly. Technology (XLK, +1.38%) led the rebound, followed by communication services (XLC, +0.76%) and healthcare (XLV, +0.39%). Energy (XLE, -1.56%) lagged badly, as did financials (XLF, -1.39%). Let's look at that key price support test on the S&P 500”

“Two things stand out to me. First, the green arrows clearly mark a MAJOR price support level. That horizontal line at 2582 marks the primary difference between a bear market and a correction, in my opinion. You cannot have a bear market without that breakdown. If the breakdown occurs, I'd expect to see a very swift move lower, accompanied by the highest Volatility Index ($VIX) reading of 2018.”

Seasonality may also support our tactical trading thesis. From Almanac Trader, “Historically December has opened with strength and gains over its first five trading days before beginning to drift. By mid-month all five indices have surrendered any early-month gains, but shortly thereafter Santa usually visits sending the market higher until the last day of the month and the year.”

This seasonality is no guarantee of a successful outcome, especially in light of our erratic fiscal policies out of Washington. Jason Goepfert from Sentiment Trader noted, “Over the past six months, there has been a dramatic decrease in the probability that buyers will step in after weakness. After reaching a 20-year high earlier this year, the probably that investors will buy the drip has dropped below 50% for the first time in two years.”

“When the probably is above 50%, the S&P’s annualized return since 1928 has been 13.1%. When it’s below 50%, that drops to -1.5%. It’s not necessarily just a feature of bear markets, but stocks generally do better when investors are willing to step in after weakness (of course).”

That said, he did go on to note December seasonality. “The S&P 500 formed a hammer by falling to a new low then reversing by the close. These look nice but have been poor signals in the short-term. A better sign is that stocks have dropped so much in December, which has a strong tendency to reverse in the month ahead, with a 90% win rate since 1950.”

As I wrote in previous posts, I am seeing bullish divergences everywhere on the daily S&P 500 chart. This has enticed me to trade the SPX with a 2800 target area in the near-term.

Sentiment

The sentiment picture has deteriorated enough for me to be short-term bullish. From Stockcharts.com, “Chart 4 features a 30-day MA of the CBOE Total Put/Call Ratio. High levels tell us when traders are excessively pessimistic. Since pessimism can morph into greater pessimism, it is when this indicator reverses trend that it triggers buy signals. Bearing this in mind, the green arrows show those periods when the oscillator reverses from, at or above the dashed green horizontal line. The most recent indication was given a couple of weeks ago. The pink-shaded area covers the most recent full-fledged primary bear market. You can see that the indicator still worked during this period, but the rallies it triggered were far more subdued than those generated in the bullish parts of the chart.”

“In Chart 5, the VIX is plotted inversely to correspond with price movements in the S&P. The black line represents a 10-day MA, while the red one represents a 15-day MA. Timely buy signals are triggered when these two series reverse direction from below the lower dashed horizontal line. The indicator is currently oversold but is still declining. However, if those Pinocchios are going to have their usual bullish effect, it’s a small leap to conclude that the VIX MA’s will soon reverse to the upside.”

“A favorite short/intermediate oscillator is my Dow Diffusion Indicator. It’s shown in Chart 6. This one monitors the Dow stocks that are classified as being in a positive trend. Once again, buy signals are generated from an oversold upside reversal, examples of which have been flagged by the green arrows. The dashed green arrows show that it has diverged positively with the Dow itself in the last few weeks, which means that it is situated to experience a positive take-off.”

“Another indicator that has been diverging positively with the S&P is the 10-day ratio of NYSE advancing versus declining issues. This discrepancy is not a signal to buy, but does argue for an improving under-the-surface technical structure.”

“The vertical green lines in Chart 8 show when the percentage of NYSE stocks above their 50-day MA initially touches the red horizontal oversold line. The pink shaded area represents the 2007-2009 primary bear market, where you can see that buy signals did not have a lot of upside power. As I said earlier, the market is likely in a primary bear phase. If that view is correct, I would not expect any of the oscillators described here to perform any better than they did in the 2007-2009 period and I am, at best, looking for a failed test of the old highs. If you are of a different persuasion and are expecting the bull market to resume, this could represent a buying opportunity commensurate to that which developed in the spring of 2016.”

“The NASDAQ was one of the strong downside leaders, but in the last couple of weeks it appears to have stabilized. Chart 9 shows us that, prior to the 2015 and 2018 tops, the number of 52-week new highs had been shrinking. In the last few weeks, though, the NASDAQ Composite has experienced lower lows, followed by a slightly higher one this week. However, the net new high data is sporting a positive divergence, as the 10-day MA bottomed in November, not unlike the positive divergence we saw in early 2016.”

The longer-term technical bear-case.

The market is acting as a market would during a topping process, in our opinion. So, while our tactical stance is bullish into the year-end, our strategic views are neutral-to-bearish. We are watching longer-term technicals along with select leading economic indicators to assist us in formulating our 2019 outlook.

This piece of research from Dana Lyons shows how excessive volatility can be found in both a market topping process and bottoms. I’d find it hard to imagine this is a cyclical bottom for the market so caution is warranted. He writes, “Volatility continues to be the theme on Wall Street as exemplified by yesterday’s action. The S&P 500, for example, plunged nearly 2% at one point during the day before rallying all the way back to close higher on the day. And, in fact, it was the 2nd such reversal in the past few days as last Thursday saw the index drop nearly 3% at one point before closing near the unchanged mark. Now while they do underscore the present volatility, these 2 recoveries perhaps mask a rare streak on selling pressure in the S&P 500.

Specifically, regardless of the closing performance, the past 4 days have seen the S&P 500 drop at least 1.89% each day on an intraday basis. That is just the 11th streak of such selling pressure in the S&P 500 going back to 1960, and the first since 2008.

If we relax the parameter a bit to 4 straight intraday drops of at least 1.7%, we observe 17 occurrences going back to 1960. Many of them occurred at interesting market junctures.”

“As the chart displays, several of these instances occurred in the direct vicinity of cyclical market bottoms, including 1974, 1982, 1987, 2002 and 2009. That might give bulls some hope that perhaps things have gotten so bad, i.e., rock bottom, that there’s nowhere to go but up. Although, it is probably a stretch to conclude that we are at a cyclical low right now since we were at all-time highs just about 10 weeks ago. And looking back at the chart, we see that some of the other historical events, e.g., 1974, 2001, 2008, occurred during the meat of a bear market and saw stocks just continue to fall further, going “subterranean” if you will.

So which one is it? Are stocks at rock bottom – or are they just getting rolling downhill within a larger bear market?”

Chris Kimble in See It Market wrote, “The stock market has been in a corrective sideways move for the better part of 2018. Is it ready to decline even lower? Well if the “average stock” is any indication, then investors should be concerned.

The “monthly” chart below is of the Value Line Geometric Index (INDEXNYSEGIS: VALUG), which plots the price of an average stock in today’s market. We can see that a bearish wedge pattern has developed in a similar fashion to 2007 and 1999.

It’s notable that in each of the past two breakdowns (1) and (2), the price broke below wedge support and its 10-month moving average. It appears to be doing the same thing today. Careful here!”

Using the monthly technical picture for the S&P 500, here is what I look for in a developing bear market. The monthly MACD line pierces the signal line to the downside. This happened in October. I then look for prices to breach the 20-month SMA to the downside. This has happened this month. I also look for the RSI(14) to break below 50. This hasn’t happened yet. The RSI(14) is at 53.88. Once those things happen I look for the 20-month SMA slope to go negative. This hasn’t happened yet.

If all those things were to happen, I would look for one last thrust attempt (the final bull run) and a failure at the 20-month SMA resistance and a RSI(14) failed attempt to get back above 50. I would be convinced technically that there is much more room for the market to drop from there. This would probably correspond with a piercing of the early 2018 lows in the S&P 500.

Near-term tactical bullish positioning – up to round 2800 on the SPX and re-evaluate if we get there. If we pierce the lows of early 2018 I’ll take my loss and sell (hedge) my positions.

Longer-term strategic neutral positioning – We’re not convinced a recession is coming but are watching for clues using technical analysis, yield spreads and key leading economic indicators.

Joseph S. Kalinowski, CFA