REASONS WHY THIS MARKET CORRECTION MAY BE BIGGER THAN PREVIOUS ONES
FIRST A SURVEY OF THE WEEK'S DAMAGE... It was the market's worst week since the bull market began more than four years ago -- both in terms of percentage losses, downside volume, and bad breadth. All market sectors and industry groups fell. Every single market index closed below its 50-day average in decisive fashion. The Russell 2000 Small Cap Index broke its 200-day line. The market sectors that fell the hardest were basic materials (-7%), utilities (-6.8%), consumer discretionary (-6.7%), and energy (-6.6%). The consumer discretionary sector broke its 200-day line as did the Dow Utilities. Although consumer staples and healthcare suffered the week's smallest percentage losses (-3.8% and -3.7%) respectively, both sectors closed below their 200-day lines. That negates their smaller percentage losses and rules them out as potential safe havens. The week's two weakest groups were REITs and homebuilders with losses of -9% and -10% respectively. Financials fell 6%. There were only three markets that rose this week -- the U.S. Dollar, oil prices, and Treasury Bonds. The Dollar bounced from an oversold condition and long-term chart support at 80. That pushed gold prices -3.5% lower and contributed to an -8.5% loss in precious metal stocks. The week's biggest winner by far was Treasury Bonds which surged more than 1% on the week. That was the result of a huge flight to safety. Chart 1 shows the week's biggest winner among Exchange Traded Funds. The 20-Year Treasury Bond Fund (TLT) gained +1.5% to close at the highest level in two months. And it did so on rising volume.
Chart 1
JUNK AND EMERGING MARKET YIELDS ARE RISING... Although this is a little beyond my normal range, I thought I'd address a question that may have occurred to some of you. Shouldn't falling interest rates be good for stocks? The problem is that while Treasury yields are falling, yields on junk bonds and bonds of lesser quality are surging. The spread between junk bonds and Treasuries has been surging as well. That means that bond traders are turned more risk averse by switching out of higher-yielding (but less secure) debt into the safety of Treasuries. The same thing is happening with the yield on emerging market bonds which have been rising as their prices have been falling. Don't assume, therefore, that just because Treasury yields are falling, all interest rates are falling as well. That's just not the case. More evidence of markets turning risk averse was clearly evident in this week's plunge in emerging market stocks. Chart 2 compares the percentage drops in the S&P 500 (black line), EAFE iShares (blue line) and Emerging Market iShares (red line) during the past week. The chart shows emerging markets hit much harder than the U.S. market and developed foreign markets. That's a switch from what we've seen over the most of the last year.
Chart 2
EMERGING MARKETS HAVE LED GLOBAL RALLY ... Chart 3 shows the juxtaposition of emerging market stocks (red line), foreign developed stock markets (blue line), and the S&P 500 (black line) over the last eighteen months. The chart clearly shows emerging markets leading, followed by foreign developed stocks and the U.S. market lagging behind. That's been the case since the spring of 2003 when the global bull run started. The charts shows the last two market corrections that took place in the spring of 2006 and the first quarter of 2007. In both cases, emerging markets fell much harder than developed markets. That makes sense since investors normally turn more risk averse during market downturns, which means that they sell riskier assets like emerging markets first.[That also explains why small cap stocks have fallen much harder than large caps over the last week]. While the drops in riskier bonds and stocks this past week tell us that global investors have turned more risk averse, it doesn't tell us how serious the downturn is. For that, we have to consult our longer-term charts and some technical indicators.
Chart 3
WEEKLY MACD LINES TURN DOWN ... We all know the market has entered into a downside correction. The question is whether or not this downturn is the same, or different, than previous downturns over the last four years' bull run. To determine that, we have to consult weekly and monthly charts. Let's start with a weekly. Chart 4 plots the weekly MACD lines for the S&P 500. [I've blocked out the S&P to concentrate on the indicator]. The chart shows that the MACD indicator has turned negative (which is an intermediate-term sell signal). That in itself isn't terribly enlightening. The chart shows at least four similar downturns over the last three years. The bigger question is whether this downturn is different. Let's take a longer term look.
Chart 4
Chart 5
WEEKLY MACD MAY SHOW BEARISH DIVERGENCE... Chart 5 plots the same indicator for seven years. There are two points of relevance to the present environment. The first is the MACD bottom in the second half of 2002 (green circle). Although the market hit a new bear market low during 2002, the weekly MACD bounced off its 2001 low to create a major "positive divergence". That paved the way for the ensuing bull market. We may now have the reverse situation. On the top right, the weekly MACD is meeting resistance at its early 2004 peak (yellow circle). That raises the possility that the MACD may be forming a major "negative divergence" for the first time in four years. That suggests that the current sell signal may be more important than the previous five that have taken place during market uptrend.
MONTHLY RSI STARTS TO WEAKEN... Chart 6 is a monthly S&P 500 chart. There are two things worth noting on the chart -- and both are long-term caution signs. The first should be obvious to any chart reader. Every single major market index with one exception has exceeded its 2000 peak. Unfortunately, that one exception happens to be the S&P 500 which is the major benchmark for the U.S. market. Chart 6 shows that the S&P is on the verge of suffering a downside monthly reversal right at its 2000 peak. [A downside reversal occurs when a market starts the month strong and ends weak]. If that happens at an important previous peak (which this one has), the monthly reversal is more important. That's not all. The blue solid line is the 14-month RSI line. The RSI line oscillates between oversold territory below 30 to overbought territory over 70 (see lines). On a monthly chart, those signals take on major significance. The last major oversold reading (and major buy signal) took place in 2002 as the market hit a major bottom (green circle). The RSI line turned up ahead of the market in the spring of 2003, signalling that a major new uptrend was starting. We may now be getting a reverse picture. On the upper right, the RSI line has been in major overbought territory over 70 for about a year (red circle). After forming a second peak this year, however, the RSI has fallen below 70 for the first time since last summer. That's also the first major bear signal in four years.
Chart 6
TOO MANY NEW LOWS... Here's another disturbing indicator. It's the NYSE New Highs - New Lows Indicator (NYHL). It plots the difference between the number of NYSE stocks hitting 52-week highs and 52-week lows. I first showed this a week ago Friday when it was just starting to weaken. On Wednesday, Arthur Hill noted that indicator had fallen to the lowest level since October 2005. I'm showing a monthly version of the indicator here for longer-term analysis. [Monthly indicators become more relevant as we approach the end of a calender month as we are now]. The chart shows the NYHL line at the lowest level in nine years. The last time it ended a month at this low level was in 1998. More importantly, it's the lowest level near the end of a month since the last bull market began. Compare the falling NYHL line to the S&P 500 (green line) which has just hit a seven-year high and is just 5% below that high. Clearly, something is amiss here. How can the S&P (and other major stock indexes) keep rising when so many of its stocks are hitting new lows for the year. At the very least, I'd add this disburbing discrepancy to the reasons why I suspect that the market may be vulnerable to a more severe selloff.
Chart 7
UPSIDE VOLATILITY BREAKOUT ISN'T GOOD... My Friday evening message showed the CBOE Volatility (VIX) Index hitting a new five-year high. Chart 8 shows that major upside breakout in its point & figure version. I've suggested many times that rising volatility is usually bad for stocks. I've heard some market observers suggest that rising volatility can actually help stocks since it just implies more rapid price movement. That strikes me as disingenuous. The stock market has been rising for more than four years on low volatility. Why at this late stage of its advance should the market start rising on higher volatility? Although there was one period between 1996 and 1998 when rising volatility didn't hurt stocks, the long-term track record shows that the stock market and the VIX usually trend in opposite directions. Draw your own conclusions.
Chart 8
LOOKING AT PERCENTAGE RETRACEMENTS... The S&P 500 lost about 5% this week. That's well within the parameters set by previous downside corrections. I mentioned on Friday evening that the previous five S&P 500 corrections averaged losses of -7.4% with the largest (-8.8%) occurring during 2004 and the smallest (-6.1%) in the second half of 2005. The last correction in February/March of this year lost 6.7%. I also noted that the S&P hasn't had a double digit correction since the bull market began. That may be about to change. In keeping with the percentage retracement theme, I've applied Fibonacci retracement lines to the daily S&P 500 bars in Chart 9. In any pullback, the minimum retracement is usually 38%. A 50% pullback is the most normal. If that doesn't hold, the 62% line becomes a critical support point. If the market doesn't stop there, a drop all the way down to the 100% level (the March low) becomes likely. The percentages are measured from the last low (March) to the last peak (July). The S&P is now testing the 50% line as well as its February high near 1460. Just below that is the 200-day average near 1450 and the 62% line. Let's hope the lowest line at 62% holds. If it doesn't, the S&P may be in for its first double-digit correction (of at least 10%) and a possible drop to its March low near 1363.
Chart 9
WEEKLY RETRACEMENT LINES... Chart 10 applies Fibonacci retracement lines to a weekly S&P 500 chart. In this case, we measure from the last major bottom (June 2006) to the latest peak. The minimum retracement of 38% is at 1433 (which coincides with the 62% level on the daily chart). A 50% correction of the yearlong rally would take the S&P near 1393 (which would be a 10% correction). The 62% retracement line sits just below the March low. [When that happens, the previous low at 1363 takes precedence]. A drop to that level would amount to a 12% S&P correction. Those numbers suggest a possible S&P 500 correction in the 10-12% range without disturbing the market's long-term uptrend. The blue line is well worth watching as well. It's the 80-week moving average which has contained every market correction since the spring of 2003. It currently sits right in the middle of the 10-12% correction range. I suspect that's where we're headed between now and the autumn.
Chart 10
