Is Our Simple Rule about to Reverse?

February 25, 2019

In a remarkable series of events, the S&P500 continues to power higher, almost continuously, since the beginning of this year. Last week, the S&P closed up 0.6%, and that’s on top of the prior week’s massive 2.5% gain. Volume unfortunately is not jumping higher along with the price gains; instead it’s lagging badly. This suggests that new investor money is not pouring into the stock market, and that much of the recent gains have occurred due to short-covering and corporate buybacks. Meanwhile, volatility continues to creep lower, and this is consistent with the recent price increases in the stock market indices.

So is the US economic data consistent with the big stock market recovery? In other words, are US economic reports surprising to the upside? Interestingly, the answer is no. In fact, recent US economic data—as well as recent corporate earnings results—have been mostly disappointing.  Retail sales, for example, missed badly. Industrial production also missed. These two reports are very important…..and they both disappointed. In addition, core durable goods orders missed.

At the same time, for the first time since 2016, US corporate earnings growth is slowing substantially. Back then, the S&P500 followed the corporate earnings slowdown and also declined notably. This time, the S&P500 is ignoring the earnings slowdown, at least for now. The question is will this divergence continue? Historically, stock prices and corporate earnings track each other.

Another interesting development is that our Simple Rule is now approaching a reversal point. Our rule has two major components—a fundamental economic piece and a technical market component. And over the last couple of months, both components turned bearish. Today, the fundamental component (US economic results) remains bearish. But the technical component is on the verge of turning bullish, primarily due to the massive stock market recovery over the last two months. This upcoming week, at the close of February, we will test the technical signal and if the S&P500 closes where it is today, then our Simple Rule will flip from bearish to bullish.

The S&P500 Stalls at Overhead Resistance

February 11, 2019

For the first time in many weeks, the S&P500 failed to rise. Sure it moved up a tiny bit—0.05%—but for all intents and purposes this was a zero gain week. Volatility didn’t change much: the VIX index ended the week roughly where it started, in the mid teens. And trading volume was light.

So what happened to the S&P last week? As mentioned here many times over the last month, the S&P500 finally ran into overhead resistance, coming from the 200 day moving average which acted as a ceiling on the index, helping to keep the index from rising beyond the ceiling. Many traders and investors look at the 200 day moving average as a signal of the general direction of the stock markets. When the 200 day is rising and prices are generally above it, then traders treat the stock market as a bull market and buy more stocks whenever prices dip close to the 200 day, because they know that the 200 day will provide support—making further price drops more difficult to stick, and making the likelihood of bounces up from the 200 day greater. On the other hand, when the stock market prices finally crash below the 200 day moving average….and stay there (as they have since October 2018)….then these same traders will treat the stock market as a bear market and sell stocks whenever prices rise up to (from beneath) the 200 day moving average, because the know that the 200 day will provide overhead resistance.

This is precisely what happened last week in the S&P500.  Not only did the S&P touch the 200 day moving average from underneath, it promptly started dropping after touching it. And this is what traders would expect—as we’ve discussed over the last month here—to happen. And the fact that it actually did happen will strengthen the conviction of traders who use technical analysis to trade the stock markets.

The next test is clear—the S&P500 must continue to sell off from beneath the 200 day moving average. If this happens in the next week or so, then many more traders will jump embrace the bear market hypothesis, and this will act to reinforce the sell off.

Last Stand for the Bears

February 4, 2019

The S&P500 continued its remarkable early winter run. Last week it climbed another 1.6%, even after stumbling earlier in the week. Volume was moderate, and volatility slid further–the VIX index closed down into the teens, for the first time since early December.

Among the numerous economic reports released last week, the most important was the January payrolls report. On the one hand, many more jobs were created (304,000) compared to the number expected (158,000). On the other hand, the unemployment rate rose once again, this time up to 4.0%. And average hourly earnings missed expectations by a large amount—earnings rose only 0.1% (month over month) not the 0.3% predicted by economists. More importantly for us, the jobs report data confirmed the bearish signal that our Simple Rule generated last month. In other words, the data showed no signs that the bearish signal was about to be reversed.

So this sets up a dilemma. While our Simple Rule is signalling that investors should be out of the S&P500 index, as whole (not any one particular security), traders are still pointing to the 200 day moving average which, at Friday’s close, has still not been crossed from below. In other words, until this 200 day moving average is tested, the bulls will not have a strong argument for the continuation of this current bounce. It will take another 35 to 40 S&P points of gains for this test to take place. If the bears are correct, then this will be their last stand—the 200 day must act as firm resistance at which the S&P turns back down. If the bulls want to argue that the bull market has resumed, then the S&P will not only have to cross above the 200 day moving average, but it will have to stay above the 200 day and climb higher from there. In other words, the overhead resistance provided by the 200 day will have to be smashed.