Our Simple Rule Flips Again — Back to Bullish

March 18, 2019

Amazingly, the S&P500 roared back up last week, this time by almost 2.9%. Volume was light however; this suggests once again that the sudden spike in prices did not occur as a result of a big inrush of investor capital. According to many market experts, short-covering and the steady stream of corporate buyback activity pushed the large cap market higher. At the same time, volatility did climb down; the VIX index fell all the way back to a 12 handle.

So what happened with the US economy during the big move upward in stock prices? Ironically, the majority of the data released last week was a disappointment. Retail sales absolutely collapsed in December (report delayed due to the government shutdown), even though sales did inch higher in January. Durable goods orders, ex-transportation, also missed badly. New home sales, jobless claims, the Empire State manufacturing index, and industrial production all missed as well. On the positive side, construction spending, consumer sentiment, and the JOLTS survey beat their respective estimates. So the stock market rally had very little to do with good news from the economy, which continues to limp along.

Also, in the background, the Federal Reserve balance sheet continues to shrink at roughly a $50 billion per month rate. As of last week, the Fed’s balance sheet has fallen by almost $500 billion from peak. Clearly, this balance sheet reduction is also not contributing to the recent jump in US equity prices.

Finally, our Simple Rule—due to the sudden surge in equity prices—has flipped back to being bullish. While the fundamental components of our rule are bearish, the technical, and in this case, deciding, components are implying that investors should — for now — go long the S&P500 stock index.

Our Simple Rule Goes Bullish but only Temporarily

March 11, 2019

Last week, and for the first time in all of 2019, the S&P500 gave back a material amount of gains. The index closed down almost 2.2%. Volume was light, so there was no rush for the exits. But volatility jumped: the VIX index moved from about 13 to about 16, after temporarily moving above 18.

Once again, the S&P failed to break above—and stay above–the 2,800 level. Something similar happened in both November and December 2018. This is concerning because for the bulls to successfully argue that the bull market is still in effect, not only does this 2,800 level need to be reclaimed, but the index must advance back to the old highs (close to 2,950) set October 2018 and then set new highs. But now that investors have tried—and failed—to do this three times over the last six months, many experts are getting concerned, and rightfully so, that further gains are limited. What’s worse: the argument that the all-time highs, in this bull market cycle, are behind us becomes stronger.

On Friday February 19th, our Simple Rule, interestingly, changed from being bearish back to being bullish. Keeping in mind that our rule has two major parts, a fundamental part and a technical part, it’s important to note that the fundamental part of the rule did not flip from being bearish to bullish; instead it remained bearish. What changed on February 19th was the technical component, which flipped to bullish on February 19.  And based on the way the Simple Rule is designed, this conflicting set of signals is resolved in favor of the technical component, meaning that the overall signal became bullish again.

But as of Friday, March 8—after the material loss in the S&P500—the technical component of our Simple Rule flipped back to being bearish. So now, combined with the unchanged bearish fundamental signal, our overall signal returned to being bearish.

Given that our Simple Rule is extremely slow moving, this whiplash is very unusual. So let’s see how the US equity markets behave over the next several weeks; specifically, let’s see if they act in accordance with our signal.

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.


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.