S&P500 Still at Resistance

January 28, 2019

As expected, the S&P500 hit and reacted to resistance last week. The large cap index closed down a small amount, only 0.2%, but it was down nevertheless. Volume was moderate, and volatility was almost unchanged–the VIX index dipped a tiny bit by Friday’s close.

Due to the government shutdown, many important economic reports continue to be withheld; when they get released, we will return to them. Meanwhile, last week’s releases saw existing home sales miss consensus expectations. On the bright side, the FHFA house price index exceeded expectations, as did PMI composite flash and leading indicators.

In terms of technical analysis, our expectation that the S&P would hit resistance at or around the 50 and 200 day moving averages worked. As of Friday’s close, the S&P was slightly above the 50 day moving average, but it never quite reached the 200 day moving average. And since the 200 day moving average, in the eyes of most traders and investors, is a stronger technical indicator compared to the 50 day moving average, then the S&P500 can still rise some more this week or next before arriving at its ultimate test—the 200 day. But after the 200 day is hit….assuming that happens…..then the S&P500 must turn down if a new bear market cycle has arrived, as our Simple Rule has signaled (based on one of four critical economic tests) has happened already.

That said, it’s important to remember that our Simple Rule can generate a false signal. This happened in mid-2015, when it signaled that S&P500 investors should exit the index. But it took only six months for the Simple Rule to reverse itself and generate a re-entry signal, and as a result, the Simple Rule would have captured almost all of the in the S&P500 from early 2016 through the end of 2018.

So today, we are not only looking closely at the S&P500 to see how it reacts to the overhead resistance offered by the 200 day moving average, but we’re also looking for additional (delayed) economic reports to confirm our recent Simple Rule signal to exit the S&P500 index.

S&P 500 is Now Hitting Resistance

January 22, 2019

After rallying another 2.9% last week, the S&P has completed a fast and furious bounce in the first three weeks of January. Volume was light, and volatility crept down further. That said, the VIX is still almost twice as high as it was during the complacent summer months in 2018.

Building on the arguments presented here last week, the S&P500 has now bounced so strongly that it’s reclaimed the 50 day moving average. And while it’s still below the 200 day moving average, Friday’s closing level puts it just about at the downtrend line that was created after the dramatic October sell off began. Now this downtrend line should act as overhead resistance to further gains. And the yet to be reached 200 day moving average should act as the strongest and final resistance to further gains (this would be only 40 S&P points above Friday’s close).

All this means that if we’re actually in a new bear market cycle that the S&P must now start to show weakness by turning down in the upcoming weeks. If this happens then, the possibility of retesting the lows from December will grow. Also, if this happens then many more traders and investors will begin to believe that the downtrend line has been confirmed. And this will make the resistance of this downtrend even stronger in future tests, when the S&P approaches the line from underneath.

On the other hand, if this downtrend line does not hold (ie. the S&P 500 closes above it and continues to climb higher) then the bears may admit defeat; they may no longer argue that a new bear market cycle has begun.  And the bull market cycle may resume.

All of this should be resolved in the very short term—only a few days, perhaps a week at most. And certainly not a few months.

S&P 500 Approaches Critical Test

January 14, 2019

As fully anticipated here, the S&P500 continued to bounce from a deeply oversold condition (reached a couple of weeks ago). Last week, the index rallied about 2.5% on moderate volume. Volatility in the S&P naturally declined to echo the rise in price in the index; the VIX fell back all the way to 18, but this is still a long way from the super complacent levels associated with new highs in the S&P.

There is one hugely important development, from a technical analysis point of view, that traders are focusing on with respect to the recent bounce in the S&P500. Since the uptrend line, a line that had been in effect for many years, was broken to the downside over the last few months, traders are now looking for confirmation that the new downtrend line is working. And for this downtrend line to work, it must effectively provide resistance to price rises whenever the index approaches the line from beneath. Now that the S&P500 has rallied back up to about 2,600 the area of resistance from the new downtrend line should start asserting itself at around 2,650.

If the S&P500 fails to jump through this level….and more importantly, if the S&P500 turns back down when this level is approached….then the new downtrend line will gain even more strength and support from the technical trading community. And as a result, the strategy of “selling the rallies” will become more popular and will act as negative feedback to any strong bullish arguments for the S&P.

Also, if this were to occur, traders will hone their buying and selling points—selling on bounces up to the 200 day moving average, and buying (if they even want to get long at all) on major drops below the 200 day. Many traders will start using this technical strategy to make bearish bets; specifically, they will go short at or near the 200 day, and then cover their short positions (profitably) on major drops below the 200 day.

Finally, if this downtrend line continues to hold (ie. work) then US stock market sentiment will become more pessimistic. While at first (ie. early in the downtrend) this will typically not affect the general retail investing population, over time it will spill over to Main Street investors who will unfortunately start selling well after additional stock market declines have already been booked.

On the other hand, if the S&P500 rallied well above the 200 day moving average….and stays there….then the damage from the past 3-4 months may begin to be erased and the bull market cycle would resume.

These next two weeks—-literally—-may determine for certain if we’re actually in the beginning phases of a new bear market cycle, or not.

Our Simple Rule Flashes RED

January 7, 2019

Once again, the S&P500 had a volatile week of trading activity…also holiday shortened…and once again, the S&P managed to bounce a bit. This time it rose just about 1.9%. Volume was light, but that was largely due to the short week. And eased back down to the low 20’s, which would be expected in a week when prices closed higher.

In US macro news, the biggest number of the week was the US payrolls report. In it, the number of new jobs created exceeded expectations, and so did the average hourly earnings. On the other hand, the headline unemployment rate missed badly–it rose from 3.7% to 3.9% on expectations of remaining at 3.7%. Outside of payrolls, the Dallas Fed manufacturing survey missed, as did PMI manufacturing, ISM manufacturing and initial jobless claims (much higher than expected). On the positive side, PMI services beat consensus expectations.

In terms of technical analysis, the two weeks of consecutive bounces has done nothing to repair the longer term (weekly and monthly) technical damage. In fact, it would have been more surprising than not if we had not seen at least a couple of weeks of bounces. Because these bounces have not taken the S&P back up to the 50 day or 200 day moving average, we should expect the bounce to continue until one or both of these moving averages are touched. At that point, the real test will begin—if a bear market mentality has kicked in, then traders and investors will use these technical levels to sell. In other words, these would be the natural levels at which technical traders would sell the rallies…..the opposite of what they did for many years in a bull market cycle (when the bought the dips back down to the 50 and 200 day moving averages).

But the big news for us is that for the first time in many years, our Simple Rule has flipped from being bullish to being bearish. The key US economic indicators that we follow are no longer unanimously positive, and that means that the likelihood of a US recession has risen dramatically. When this happens (and specifically, this happened last week), we turn to our long-term technical system for the S&P500 and it is also flashing a red, or exit, signal. This means that we should use any bounces….such as the ones we’ve been experiencing lately….to sell out of any index funds mirroring the S&P500. And the proceeds of these funds should be redeployed into short-term US Treasury bills and notes, until our system tells us to get back into the S&P500 index.

As a reminder, our Simple Rule keeps us invested in the S&P500 index for about 85% of the time in any given ten year period. So it’s not a common occurrence for the system to tell us to exit. That said, if these signals hold, it’s not unusual to have to stay out of the S&P500 index for at least 12 months.

There is no guarantee that this system works perfectly to forecast an imminent recession and a related bear market cycle, but the number of false positives over the last 50 years of data is extremely low. In other words, it usually works.

Some key problems in adhering to this type of system include: 1) it means that investors may need to sit on their hands for 12+ months and hold mostly US Treasury paper. This is far from exciting and most investors cannot accept such long periods of “doing nothing”, and 2) it means that investors may still incur some drawdowns before the system tells them to exit. No successful system (no matter how success is defined) can eliminate all temporary drawdowns. Some investors cannot stomach temporary drawdowns, and if so, they should stay away from equity investing entirely.

Finally, a Small Bounce

January 2, 2019

After several weeks of massive selling, the S&P500 managed to bounce back a bit, during the holiday shortened week. The large cap index closed about 2.9% higher, but on very light volume so not much should be read into the meaning of this bounce. Naturally, as the selling subsided, the VIX index also backed off, ending the week in the mid-20’s.

Given the holidays at the end of the year, the number of US economic reports was light. On the bright side, the Chicago Fed national activity index beat expectations, as did initial jobless claims, the FHFA house price index, and the Chicago PMI result. On the downside, the Richmond Fed manufacturing index missed badly. Consumer confidence also missed, and pending home sales were a disaster. The Fed continued….without much press coverage….the unwinding of its balance sheet: as of the end of December, the Fed has shed 385 billion dollars in assets, since it began quantitative tightening back in October 2017.

With respect to technical analysis, last week’s modest bounce is barely visible on the weekly charts. In fact, the damage since the sell-off began (at the beginning of October) is so severe, that it would take many more weeks of 3% jumps to even begin to repair the current technical damage. What this means is that any minor bounces, such as the one registered last week, are perfectly normal bounces within larger bear market downturns…..and that traders who are bearish will simply look for such bounces (in fact, they will hope for such bounces) in order to get better, ie safer, entry points from which to short the stock market again.

In other words, many traders in the US stock markets have already abandoned the “buy the dip” strategy and have fully embraced the “sell the rally” strategy, a strategy that helps define the presence of a true bear market.

Meanwhile, the S&P500 in the month of December is on track for being the worst December since 1931. And for the year 2018, the S&P500 is on track for losing the most, in percentage terms, since 2008. Needless to say, there was no Santa Clause rally this year, and this left many experts on the wrong side of the market.

Finally, our Simple Rule has moved into a cautionary, or warning, zone, a zone that is very close to signaling for us to exit the S&P500 index, and move all proceeds to short term US Treasuries. As a reminder, our Simple Rule keeps us in the S&P500 over 80% of the time in most historical 10 year periods. So if this exit were to actually occur, it would be a highly unusual event. Hopefully, we’ll be able to make this call more definitively over the next couple of weeks.