S&P 500 suffers “Death Cross”

August 31, 2015

Being in US stock markets last week felt like riding on a roller coaster.  At the beginning of the week, stocks fell again and fell hard.  The S&P was down another 5% or so on Monday. Then on Tuesday it began to bounce, a bounce that would very much be normal and expected when stocks were so deeply oversold—on the daily charts—on Monday. The bounce continued for the remainder of the week, and the S&P500 actually finished up on the week….rising by about 0.9%.

Volume, as one can imagine when stocks were initially down about 5%, exploded to the upside. More impressively, volatility also exploded higher. The VIX index surged above 50 on Monday, a level last seen only in the 2008-2009 meltdown. But then, as prices bounced for the rest of the week, volatility dropped but nowhere near the super low levels of the summer. By Friday, the VIX retreated only to the upper 20’s, which meant that traders were still very nervous despite the big bounce in prices.

The big new for the S&P500 is the technically important “Death Cross”. Most bear markets (defined as a drop from peak of at least 20%) don’t happen unless the Death Cross occurs. What is it?  It’s when the 50 day moving average of the S&P crosses below the 200 day moving average. And it hasn’t happened to the S&P since mid-2011 when the S&P did actually retreat by about 20%. Back then, on the back of the various QE programs initiated by the Federal Reserve, the S&P recovered fairly quickly after initially dropping about 20%. And not only were all the losses recovered,  but the S&P went on to hit new highs for the next three and a half years, until finally cracking earlier this year.

So does this mean that we should prepare for a certain 20% drop in the S&P?  While the drop so far was only 10% (intra-day and quickly erased by the end of the week), the probability of a 20% total drop has gone up. That said, it is by no means certain to happen. There have been times in the past when markets have recovered from an initial Death Cross.

Still, all bear markets are preceded by a Death Cross, and while not always, most Death Crosses are followed by 20+% total losses.

At the very least, this is another serious warning sign that the 3+ year old bull market run is nearing an end. And that if investors are not prepared to ride out some major price swings over the next several months, then now—after a nice bounce—may be a good time to pull back exposure to US large cap stocks.

US Equities Approaching Panic Zone?

August 24, 2015

Something very different happened in the US equity markets last week. While stocks fell, they didn’t fall by their usual 0.5% or slightly more severe 1% margins…..as we’ve seen them do over the last three to four years whenever they’ve sold off. Instead, the S&P500 plunged almost 6%.  And this happened to be the biggest loss, in percentage terms, since 2011….or four years.  Volatility exploded, but surprisingly volume did not jump all that much, which suggests that average investors were not running for the exits. At least not yet.

But the massive jump in volatility does suggest that there was some panic in the markets. Instead, it appears that most of this panic was felt by professional investors and traders. And that’s a problem, because significant—or tradable—bottoms in stock markets usually occur when retail investors start to panic and sell in large numbers, booking losses, just to get out at any price and prevent further losses.

This is called a capitulation bottom, and it most certainly has not happened. So what? Well that means that there’s a big risk that additional, future selling may add to the already painful losses suffered last  week. And typically, such follow-on selling occurs fairly quickly after the initial lurch downward.

Could we see a knee-jerk bounce this week?  Of course. But many pros will use this bounce to get out, and if retail investors do the buying, as they often do, they will be the ones left holding the bag when this additional, follow-on selling occurs.

We’ll know which way the stock markets turn within a week or two.

In the meantime, the technical picture has suddenly changed dramatically. From a slowing eroding, distribution pattern, a lot of technical damage has just been registered. First, Friday’s close left the S&P well  below the 200 day moving average. That said, the 50 day moving average has still not crossed below the 200 day. Unfortunately for technical bulls, the magnitude of last week’s drop means that even if the S&P does nothing this week, the 50 day will continue to converge with the 200 day and is very likely to cross below anyway.

So as the retail world suddenly begins to follow the US stock market more closely through front-page stories around the country, the professional technical traders will also begin to dust off their sell buttons, something most of these traders have used only sparingly over the last four years. If the Death Cross does happen, then even more technical selling will be sure to follow.

High Yield Diverging from US Stocks

August 17, 2015

The S&P500 inched up another 0.67% last week. Volatility slipped a little, which is what one would expect in an up week.

The technical picture became more bleak, especially for the Dow Jones Industrials.  For the first time since 2011, the Dow experienced a “Death Cross” where the 50 day moving average crossed below the 200 day moving average. Back in 2011 this led to a total loss of about 20% and in 2008, this led to a total loss of over 50%. The key point is that this development almost always suggests that a bear market correction will follow.

At the same time, the Death Cross has not yet happened in the S&P500, and until it does, most market analysts will not declare an end to the bull market. Why? Because the S&P500 is far more important to market experts that the Dow Jones Industrial Average. That said, the 50 day moving average in the S&P is still converging ominously to the 200 day, and the Death Cross looks like an imminent and strong possibility.

While we’ve highlighted some key market divergences lately (eg. oil, copper, and other commodities), and while these bearish divergences have continued to worsen (ie. oil and copper have continued to fall while the S&P500 has continued to hold up), another very interesting divergence has been occurring in the high yield market.  Back in July, tracking funds such as HYG experienced a Death Cross of their own.  HYG’s 50 day is now below its 200 day moving average.  And this development is extremely ominous for equities. Almost every time in the past when HYG (or its equivalent) diverged bearishly from US equities, the divergence resolved itself with equities falling to match the drop in high yield credit. In other words, the smarter money seems to be in high yield bonds, and it “gets out” of its positions well before the dumber money in stocks gets out.

And this historical relationship is so strong, that it’s highly likely that the same thing will happen again this time. Of course, this doesn’t mean that stocks must crash to resolve the divergence. But they will need to fall far more than the 2-3% that they’ve fallen this year, whenever they’ve dipped. Instead, a drop of at least 10% and possibly 20% would correct the divergence.

For so long, over the past two to three years, US stocks have magically held onto big gains, and have even piled more gains on top of their prior gains. At the same time, almost all other risk asset classes have broken down and have suffered meaningful corrections. However, stocks’ magical price gains will not last forever.


Crash Prone US Stock Market

August 10, 2015

The S&P500 resumed its recent decline by dropping almost 1.3% last week. While still fairly light, volume was notably higher during this down week compared to weeks when the S&P rose. And as expected, volatility crept up somewhat; that said, it’s still very close to the lows of the summer and the year.

The technical distribution pattern continues to gather strength. For the year, the S&P is virtually unchanged through the first week of August. And the 50 day moving average is clearly starting to converge with, or “pinch”, the 200 day moving average. Ultimately, when this happens, a “death cross” will have formed (the opposite of the “golden cross” that formed in mid-2009 and again in early 2012) and a lot of traders will start to sell, or at the very least reduce their buying of, US stocks. Of course this hasn’t happened yet. And the 200 day moving average is still comfortably sloping upward, so the current bull market run has not ended.

Also, the market internals have not improved. While index prices have remained stuck near all-time highs, many measures of market breadth are sending extremely bearish signals. This divergence, historically, has never lasted very long.

In US macro news, last week’s reports were fairly weak. Construction spending came in well below expectations. ISM manufacturing also disappointed. Factory orders were a disaster; orders ex-transportation were the weakest since 2009. International trade was bad—the trade deficit was worse than expected. July payrolls came in just about as expected, but the labor force participation rate was stuck at multi-decade lows. That means people who can’t get decent jobs simply stop looking for work, and are no longer counted as “unemployed”. On the positive side, only ISM services stood out with a meaningfully better than expected result.

Finally, it’s important to remind everyone that almost every time when US stock market crashes have occurred over the last 100 years or so, two conditions were in effect. First, valuations—as defined by long-term measures such as the Shiller PE ratio—were extremely stretched. Second, market internals—defined as measures of breadth such as New Highs minus New Lows—were diverging bearishly. This situation is presented in great detail by money manager John Hussman. But the bottom line is this—both of these conditions are in place right now. And so stock market investors ought to really assess their exposures to equity risk, and unless they’re fully prepared to ride out losses as potentially massive as the ones seen in 2000-2002 and 2009-2009, then they may wish to reconsider their conviction that this time nothing really bad will happen.

A market crash may not be around the corner, but if one were to occur now, it would be no surprise to anyone who’s studied history.

China and Commodities Collapsing Together?

August 3, 2015

Last week, in an unsurprising move, the S&P500 bounced back a little over one percent. It was unsurprising because the bounce happened just as the S&P touched the 200 day moving average. In other words, the 200 day did exactly as what most market technicians would expect it to do—provide support.  On the other hand, volume was very light and that means that this support was only technical, not some sign of new money rushing into US stocks. And volatility dropped back down to the lows of the calendar year.

So while one technical interpretation was bullish (the 200 day successfully provided price support), another interpretation is still bearish: the 5o day moving average is converging down towards the 200 day, and the slope of the 200 day moving average is flattening out. Now this doesn’t mean that the “Death Cross” (which typically marks the beginning of a bear market phase) is imminent, but it bears closer watching with these two hugely important moving averages start to pinch together.

On Main Street, the bad news returned. While durable goods orders and the Chicago PMI beat expectations, almost every other economic report last week as a disappointment. The Dallas Fed manufacturing survey missed. Consumer confidence collapsed. Pending home sales missed. GDP came in lower than expected. Consumer sentiment missed, and the employment cost index missed very badly. This report sent shock waves throughout the Treasury markets because investors had been bracing for higher wages (employment costs) which would make it more likely the Fed would begin to raise rates. But when the report showed negligible wage growth, Treasury bears had to run for cover and interest rates plunged back down to levels more consistent with weak wage growth.

Finally, it’s becoming clear that as China’s financial markets continue to crumble (and they are) and as its real economy continues to stumble (and it is…..even the positively manipulated numbers are coming in very weak), the collapse of the commodity complex—which began over a year ago—is related and will probably continue to collapse as long as China keeps failing to re-ignite strong growth.

What’s worse is that when one backs up and looks at broad commodity indices over the last 15-20 years, one sees a massive commodities bubble that coincided almost perfectly with China’s investment bubble. And since China’s retreat has only recently gotten underway, it’s realistic to assume that the downside to commodity prices may still be huge….even after the already massive pullback in prices.

Copper for example is down almost 50% from its 2011 highs, but it may fall an additional 40% just to return to the 2008 lows. To reach it 2002 lows—which is very possible if China’s bubble completely unwinds—then copper may fall an additional 75%….from where it already is today!

And similar outcomes may apply in oil, and other base metals, and all the currencies that benefited from the Chinese bubble (for example the Australian dollar).

So does this mean that commodities and energy are NOW good assets to buy?  Yes and no.  Yes, because many are already down well over 50% and if the holding period is long enough, then the upside should be high. No, because one of the major indicators of bear and bull markets—the 200 day moving average—is still solidly in bear more. So to improve the timing of the investment, it would be advisable to sit tight and wait for the 200 day moving average to first stop descending and even better to begin to turn up before putting a lot of money to work in these sectors.

The good news is that after 50% losses, the turn up in the 200 day moving average is that much closer, given that it first turned down in late 2011.  It could be another six months, or a year or even longer, but when it happens, you’ll be less likely to suffer subsequent, even if only temporary, drawdowns in your investment.