Part 2: Short Term Inflection Point

Chart 1: Volume spikes during intermediate low as retail investors panic

SPY Volume Source: Short Side of Long

  • Volume has spiked on various ETFs, including one of the most traded: iShares SPDR SPY. Usually, a spike in volume is a signal of retail investor (dumb money) liquidation and tends to signal kind of an intermediate bottom.

Chart 2: Volatility has tripled over the last few weeks… too far too fast!

Volatility Index Source: Stock Charts

  • The same is true for the volatility index, which has tripled since middle of September. During mid week, VIX index was almost 100% above both the 50 day and 200 day moving average. Historically, this has signalled some sort of capitulation (however, sometimes only for a brief rebound).

Chart 3: High low ratio has become oversold & should signal a bounce

S&P 500 High Low Ratio Source: Short Side of Long

  • Bears have been in control of the current price trend, with some foreign markets under pressure since June. All of this has pushed breadth into oversold territory and the HL Ratio has now officially turned oversold for the first time since August 2011. Even during downtrends like 2008, this indicator does a great job of signalling a potential relief rally.

Chart 4: Percentage of stocks above 50 MA is also quite oversold now

Stocks Above 50 MA Source: Short Side of Long

  • Same can be said about the other breadth indicator I frequently use – percentage of stocks above a certain moving average. In this case, we look at the percentage of S&P 500 stocks trading above the 50 day moving average and come to a conclusion that we are most oversold since May of 2012 (last time we saw a 10% correction).

Chart 5: Stocks are deeply oversold relative to bonds over the short term

Stock Bond Ratio Source: SentimenTrader (edited by Short Side of Long)

  • The Stock vs Bond Ratio indicator is very interesting (and comes to us from SentimenTrader website). While US stocks have fallen only a little bit in recent weeks, US bonds have rallied all year long and recently gone vertical. This makes stocks very attractive on relative basis. SentimenTrader reported that the last weeks Wednesday intraday movement betweens stocks and bonds got to almost 5 standard deviations oversold. Chart above shows what happens when stock bond ratio got to minus 3 standard deviations.

Chart 6: Some surveys have now entered fear levels & signal a rebound!

NAAIM Survey Source: Short Side of Long

  • There is no real capitulation or panic yet, that is obvious. Various sentiment indicators are still either complacent or neutral. Investor Intelligence bears remain stubbornly low. However, a few indicators have entered fear levels and one of those is NAAIM. Currently, managers hold under 10% net long exposure to US equities. Last instance we saw this was around August to October 2011.

Ok that was a quick indicator recap. We discussed the short term inflection point last Wednesday, so I am not lagging here. I was very quick to point this out in real time. In the short term, bears have been squeezed a bit, with S&P 500 futures rebounding close to 1900. Still, I do not think the volatility is over and by no means has the US stock market seen a major capitulation like we went through in early 2009 and late 2011.

Now, there is no rule book to say that we have to go through something as dramatic as the repeat of those two recent crashes. On the other hand, it might even be worse this time around. The key question here is connected to underlaying conditions and fundamental developments. How well can you read them…

Has the market just overreacted to Fed ending the QE program or is there a real slowdown occurring that could drag the global economy into another recession?

If you believe that the economy is starting to slow properly and earnings to be impacted on the downside, you are probably betting on the start of a new bear market and the indicators above won’t concern you much. On the other hand, if you believe this is just a short term panic, some of the indicators here are signalling oversold conditions right now. Maybe the correction could get a bit worse (10 percent plus), but you might be willing to be a contrarian soon enough.

We will continue with Part 3 coming up next…

Global Macro Update

Chart 1: The most volatile week since the Eurozone Crisis during 2011!

Global Macro Assets Source: Short Side of Long

Very volatile week, so let us look at a basic grid of the most important Global Macro asset classes. Here are some interesting developments to note:

  • For the most part, Developed Markets stocks have under-performed Emerging Market stocks in the last few weeks. MSCI World Index, together with S&P 500 and DAX 30, have all broken below their recent multi-year uptrends. Broad Chinese stocks have outperformed recently, as correctly predicted almost three months ago.
  • Money continues to flow from the rest of the world towards United States – a reversal of the carry trade. All currencies have been under pressure as of late. Euro has failed to hold its support, while Yen and Aussie are trying to get a bounce of their respective support levels. If the Fed backs away from rate hikes, US Dollar could be in correction mode for awhile.
  • We are going through a bit of a deflation scare once again. Crude Oil has been under major pressure, while Treasury Bonds have gone through an amazing rally in 2014, and recently rising almost vertically. To me, this looks like a major shake out of market participants that were betting on inflation and interest rate rises.

Chart 2: Global stock and commodity markets under pressure this week

Global Macro Source: Short Side of Long

While the ever-popular US large caps and the more neglected Emerging Market stocks looked like they were going to gift investors some decent returns this year (20% plus on annualised basis), it seems that 2014 is all about Treasury Bonds. Starting the year as one of the most hated asset classes, Treasuries have outperformed just about everything this year. Furthermore, on the total return basis, Treasury Long Bond is currently making record highs.

The other hated asset was Gold. However, I believe the yellow metal continues to look weak despite still holding on its major support around $1185 per ounce. A breakdown is most likely coming before a major bottom occurs, as Silver continues to lead the whole sector lower.

A lot of readers have asked me: what will it take for the US Dollar to finally top out?

As long as US Dollar remains strong, commodities & emerging market stocks might continue to under-perform. A crescendo would occur as a major deflation shock runs through global financial markets, making the US Dollar go vertical at which point the Federal Reserve would most likely reverse its current view of monetary policy by 180 degrees.

Chart 3: Annualised returns show Treasuries outperforming other assets

Global Macro Annual Returns Source: Short Side of Long

Federal Reserve Has The Market Addicted

Chart 1: Federal Reserve has proven that we are now going to QE99… 

 Source: Internet / Unknown

Well… somebody has to tell the truth once in awhile, because you are not going to get it on CNBC or Bloomberg. This post has nothing to do with prices, fundamentals, trading, entry points, economic or technical indicators – all of which are commonly found on this blog. This post has to do with a basic observation of what is clearly happening today.

As soon as the Federal Reserve even attempted to take away the QE punch bowl, markets turned down very quickly and volatility spiked almost instantly. We can clearly see how addicted investors are to QE and how disconnected stock prices are to economic activity.

Now, keep in mind that the S&P 500 has declined between 7% to 9%, depending on the way one measures it. Unless you are a short term trader, this is nothing to even worry about. However, the Federal Reserve is already sending out signals that the QE exit might now be extended. This is just ridiculous!

And if the market goes through a short term bounce and decided to turn back down again in coming weeks or months, Federal Reserve will probably extended QE and scrap the whole plan of tightening.

Chart 2: S&P barley corrected & some of FOMC academics are in panic!

S&P 500 Source: Fin Viz

I am not saying without QE program S&P 500 would return back to March 2009 lows of 666 points, but what I am saying is that all the markets (including bond interest rates) need to be left alone, without constant intervention by central banks, to clear themselves and find fair and true value based on what the market deems to be current fundamentals.

We all understand markets aren’t perfect. But we should all also know that trillions of dollars by the private sector (billions of individuals who don’t work for the government), is a better decision making process then ten people locked up in a private room pulling levers on lagging economic data.

If I worked for the Federal Reserve, I would be ashamed of the policies that are currently in progress. I would also be embarrassed at the way FOMC caves in as soon as financial markets fall a little bit. This is not helping the local or global economy and the more juiced up & depended the system becomes, the larger the troubles will eventually be as Fed becomes forced to tighten. After all, you cannot stay at 0% interest rates forever…

Disclosure: I’m currently long US Dollars, short Australian Dollars and Gold, and fully hedged in Silver. The US Dollar bull market might go on for awhile longer, but it won’t last. At that point, you better own some Precious Metals in your portfolio.

 

Short Term Inflection Point

Chart 1: VIX tripled in the last few weeks & is extremely far from its mean

VIX Index vs 200 MA Source: Short Side of Long

Huge price action last night during the US market. I will do a proper write up soon, but here is a quick update since I am out of the office:

  • US equities declined sharply on very high selling volume (SPY ETF), most likely indicating a short term wash out. VIX has tripled in the last few weeks and now stands over 70% above the 200 day moving average, usually a sign of an intermediate or major bottom. Crude Oil volatility spiked much faster then it did during the 2008 crash, signalling panic in the energy markets!
  • Breadth is oversold in the US, and extremely oversold in Eurozone with only 6% of stocks trading above the 200 MA in the MSCI EU Index (similar to August & October 2011). Throughout the session some indicators would have made extreme oversold levels, but then we saw positive reversals in US small caps, US junk bonds, US energy & material sectors, US transport stocks, MSCI China & Russia indices, MSCI Germany and so forth. At the same time VIX put in a negative reversal too.

Chart 2: Could Treasury Bonds be forming an important top right now?

TLT Treasury Long Bond ETF Source: Stock Charts

  • Major moves occurred in safe haven assets such as Treasury Bonds, Gold and Japanese Yen. During the early stages of the US session, as the volatility spiked, Treasury Bonds went through the roof (yields dropped like a rock). A friend of mine told me that at first he thought a 10 Year Note at 1.87% was a misprint. There are 96% bulls on bonds and the asset class could be making a very important top right here, right now (more on that later)!
  • Portfolio changes: Since Russell 2000 has been outperforming over the last few days, I decided to close my highly leveraged short positions early in the session. I have also closed my Japanese Yen long last night as well. I’ve now added to a Gold short with a stop above $1,250 (previous support could be resistance now). I expect Gold to break below $1185 support zone eventually.
  • Portfolio recommendations: Apart from US small caps, I also recommended shorting MSCI Germany via EWG in the middle of September. This index is now extremely oversold and with a positive reversal last night, I recommend closing this trade. On the bullish side, MSCI China hasn’t dropped below the 200 day MA throughout the whole correction and could be a buy at a double bottom – I’m looking into it! I’m also thinking about buying more MSCI Russia positions too.

Crude Signalling Weak Economy

Price of oil around the world has been dropping fast. I believe that short term oversupply is not the only cause here, as the drop is also accompanied by a global stock markets slide as well. This indicates that the demand side might also be very weak and global economic activity is suffering yet another slowdown.

In my opinion, Crude prices are a great barometer of the global economy. As a keen market observer you might notice that prices fell significantly during late 1990s, early 2000s and in 2008 (refer to Chart 2). In late 1990s Asia went through a Financial Crisis, in early 2000s US suffered a post “Tech Bubble” recession and in 2008 the whole world went through a Global Financial Crisis and a depression-scare. Even the mini-crash in Brent Crude during 2012 occurred as Eurozone entered a recession and China slowed down meaningfully.

Chart 1: Brent Crude Oil is in a mini crash over the last several weeks…

Brent Crude COT Source: Short Side of Long

As already discussed on the blog, Crude prices have been in a prolonged consolidation pattern since the early parts of 2011 and a major move was about to occur in early 2014. Volatility continued to remain very compressed until June and unlike many other commodities that have been falling since 2011, Crude prices managed to hold its own. That is… until now!

The initial breakout on the upside turned into a bull trap and the reversal that followed in the opposite direction has been incredible to watch (I wish I was smart enough to trade it). After peaking close to $116 per barrel during June of this year, Brent Crude currently trades at around $85… a drop of 26% in just four months.

Chart 2 shows that maybe prices have fallen down too far too fast, but please keep in mind that this is not a complete capitulation like we saw in 1998, 2001 and 2008. Various sentiment indicators that I track Crude are also not close to the panic levels just yet.

Chart 2: …however prices are not yet at extreme oversold levels to buy!

Brent Crude Performance Source: Short Side of Long

S&P 500 vs 200 Day MA

Chart 1: S&P 500 is below the 200 day MA after a 98 week unbroken run!

S&P 500 vs 200 MA Source: Short Side of Long

After one hell of a run up since November 2012, S&P 500 has finally closed below the 200 day moving average. This one was for the history books, as we traded above the long term trend for 98 weeks. After such a powerful rally, the question now is whether or not the correction will also be one for the history books?

Are We Going To Rally Soon?

Chart 1: Short term breadth continues to signal oversold conditions… 

Market Breadth Source: Short Side of Long

A quick update on the previous post over the weekend. Various US stock markets have finally dropped below 200 day moving average. It has been almost two years since this condition was last seen, in November 2012. Over the near term perspective, markets are becoming more and more oversold as each day passes. S&P 500 failed to hold the 1,900 support, but US futures are attempting to bounce as I write this.

Usually a loss of a critical support level means more downside, but the question is will be bounce or rally first? Various indicators are suggesting differing levels of oversold conditions, but none are yet at ultimate extremes suggesting a complete washout.

For example, we currently have 16% of stocks with the S&P above the 50 day moving average. This is quite oversold, while below 10% would be very rare and extreme. The weekly HL Low ratio seen in Chart 1, has collapsed towards 10%, which usually signals a bounce is close. Finally, Chart 1 also shows that 21 Day (or one month) Advance Decline Line and Down Volume is now very much stretched on the downside.

Chart 2: Measures indicate differing levels of oversold market conditions

Oversold Breadth Source: Index Indicators, Bespoke & StockCharts

Adding to this evidence is a few other indicators seen in Chart 2. Firstly, S&P Bullish Percent Index currently stands at 49%. This is a mild oversold zone, while readings of 30% or lower would be very oversold. Furthermore, as of last night’s close there are now 40.5% of stocks with the S&P index that are trading at daily RSI reading of 30 or below (an oversold technical condition). As we can see in the chart above, we reached 46% in May of 2012 when we went through a last 10% correction. However, this indicator went well above 90% during the August 2011 mini-crash. Finally, BeSpoke states that 63% of the stocks within the S&P 500 are trading 2 standard deviations below the 50 day mean, also known as another technical oversold condition.

All of these indicators suggest that a bounce is imminent. However, markets don’t always work like that. The same way uptrends can remain overbought for a prolonged period of time, so too downtrends can remain oversold for a prolonged period of time.

October Market Breadth

There has been quite a lot of market action in stocks as of late, so it is time for another Market Breadth Summary. Most market participants would look at the chart of S&P 500 and conclude that some kind of trouble only started several days ago as selling intensified and the volatility index jumped. However, the internal market breadth for the US equities has been deteriorating since at least June of this year. Let us look at a few charts.

Chart 1: Market conditions are changing as bears take control from bulls

S&P 500 vs Volatility Index Source: Short Side of Long

Before I start, there is an important point I would like to make. According to the price behaviour and various indicators I track, market conditions are changing as bulls lose control to the bears. In other words, probability is quite high that the central bank sponsored rally, which has lasted for the better part of two years, has probably come to an end and the prevailing trend right now is bearish.

Why is this important? Because a lot of market participants fail to trade with the trend. Since I’m not that smart nor experienced, I will quote Jesse Livermore on this subject:

I was utterly free from speculative prejudices. The bear side doesnt appeal any more than the bull side, or vice versa. My one steadfast prejudice is against being wrong. When I am long of stocks it is because my reading of conditions has made me bullish. But you find many people, reputed to be intelligent, who are bullish because they have stocks. I do not allow my possessions, or my prepossessions either to do any thinking for me. That is why I repeat that I never argue with the tape. Obviously the thing to do was to be bullish in a bull market and bearish in a bear market.

Chart 2: Percentage of stocks trading above 20 day moving average…

Stocks Above 20 MA Source: Index Indicators (edited by Short Side of Long)

With that in mind, let us now focus on the various internals and breadth readings. The recent sell off has pushed the S&P 500 broad index into a short term oversold condition. The percentage of stocks within the index that are trading above short term moving averages like 20 day and 50 day stands at 17% and 24% respectively (refer to charts above and below).

These are rather minimal numbers that usually indicate that some kind of a rebound could occur. But it is worth saying as a side note that just because the index is oversold, does not mean selling could not continue for awhile longer and become even more oversold. During an uptrend, we saw markets become overbought and yet they kept making higher highs for months on end. While I am not predicting this, there is no reason as to why something similar could not occur on the downside.

Chart 3: …as well as 50 day moving average has dropped into oversold!

Stocks Above 50 MA Source: Short Side of Long

If and when markets do decide to turn around for a rebound, the nature and strength of the rally should be judged with a microscope. Chart 3 clearly shows that the current price action signals technical damage in form of a breakdown from a recent two year uptrend. And while the index is oversold in the short term, keep in mind that the percentage of stocks trading above 200 day moving average is not yet oversold (longer term and more meaningful perspective).

Chart 4: New highs vs new lows ratio is most oversold since mid 2011!

High Low Ratio Source: Short Side of Long

With quite a number of stocks breaking down, it shouldn’t be a surprise that the NYSE new highs vs new lows ratio is now very close to oversold conditions as well (refer to Chart 4). We haven’t seen a condition like this occur since middle of 2011, when majority of the market participants panicked during the US Debt Ceiling saga. Whether we are in a bull market or a bear market, oversold conditions in this indicator usually produce some kind of a rebound or a relief rally. Therefore, a further fall towards 20% or lower in the HL Ratio could produce a rebound soon enough.

Chart 5: Advance decline line and down volume is becoming oversold!

Advance Decline Line & Volume Source: Short Side of Long

Furthermore, both the advance decline line and down volume averaged over 21 days (or one trading month) is now turning towards extremely oversold level as well. We have seen this type of a condition in May 2010 during the flash crash, in August 2011 during the US Debt Ceiling saga and in May 2012 during the last leg of the Eurozone Crisis, before Draghi’s “whatever it takes” speech. For more then two years, breadth in the US has not become extremely oversold, at least based on this indicator. But today we find ourselves with a condition where selling has turned a bit extreme, in particular with the down volume.

Chart 6: One third of the S&P is trading in short term oversold territory

Stocks Below RSI 30 Source: Index Indicators (edited by Short Side of Long)

So what is next for the stock market? I understand that most traders would claim that S&P 500 might find some support at its previous trough from early August at around 1900 level. So therefore, one might assume that a rebound could occur soon enough as the price sits at this important support.

However, instead of talking about how the market is oversold from the short term, I think the more important point to make here is the breadth deterioration between the August trough at 1900 and the current internals as S&P trades at 1900.

In August about 20% of S&P stocks became oversold with RSI below 30 and about 10% of S&P stocks traded at 6 month new lows. Fast forward to today and while S&P 500 finds itself at the same level of about 1900, we now have 30% of S&P stocks with RSI below 30 and 32% of stocks making new 6 month lows. So what does this mean?

Chart 7: One third of the S&P 500 is breaking down to 6 month new lows

Stocks At 6 Month Lows Source: Index Indicators (edited by Short Side of Long)

For me, it is plain and simple: a growing number of stocks are breaking down towards lower lows (definition of a downtrend), while the index itself gives the appearance of still respecting support. My view is that the market is trying to trick majority into buying this oversold dip, as if it is the same as every other dip since November 2012. However, with Federal Reserve changing its policy, the up-and-coming rebound from oversold cod notions discussed in this article could end up being a bull trap. Therefore, instead of buying a potential rebound, I would actually consider selling the coming rally.