3 STRIKES AND A TREND CHANGE, S&P 500 FORMS BIG HAMMER, JUNK BONDS UNDERPERFORM INVESTMENT BONDS, STOCKS UNDERPERFORM BONDS, AVERAGE STOCKS UNDERPERFORMS LARGE CAP STOCKS, THE DAMAGE IS NOT UNDONE, MID-CAP AND SMALL-CAP AD LINES HIT NEW LOWS
3 STRIKES AND A TREND CHANGE... Link for today's video. There has certainly been a lot of noise the last two weeks and this makes it a good time to look at some weekly charts for a little perspective. We will start with the S&P 500 because it is probably the single most important major index. A downtrend in the S&P 500 means a downtrend for the broader stock market. A downtrend for the broader stock market means the majority of stocks are in downtrends and chartists should adopt a defensive posture. Chart 1 shows the index with the 5-week exponential moving average (pink), 52-week EMA (blue) and 26-week CCI. These three indicators can be combined to create a simple trend-following strategy. Each indicator signal represents a strike or hit and the trend changes with three strikes or hits. 3 strikes are bearish. 3 hits are bullish.
Moving averages smooth out the price data and help identify the overall trend or trajectory of prices. I am using 5 weeks because it represents around a month and 52 weeks because it is one year. The trend is down when the weekly price closes below the 52-week EMA and the 5-week EMA is below the 52-week EMA. The 26-week Commodity Channel Index (CCI) is used to identify emerging uptrends and downtrends. Donald Lambert, creator of CCI, suggested that moves above +100 show unusual strength that can signal the start of a new uptrend. Moves below -100 show unusual weakness that can signal the start of a new downtrend.
S&P 500 FORMS BIG HAMMER, BUT TREND REVERSAL REMAINS... Chart 1 uses the three signals described above to define trend changes. The trend is clearly up when all three are in bull mode (hits) and down when all three are in bear mode (strikes). There are three events marked on the chart, but only one trend change with three strikes. The S&P 500 dipped in 2012 and closed below its 52-week EMA, but the 5-week EMA held above the 52-week EMA and CCI held above -100 to remain net bullish. CCI dipped below -100 in October 2014, but the index did not close below the 52-week EMA and the 5-week EMA held above the 52-week EMA (still net bullish). Things changed on August 21st when the index closed below the 52-week EMA and CCI plunged below -100. Two of the three indicators were clearly bearish for a simple majority. The 5-week EMA moved below the 52-week EMA this week and all three indicators will be bearish if this holds into Friday's close. Note that these three bearish strikes reverse the three bullish hits from December 2011.
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Chart 1
So how long will this bearish signal last? Come on now, you know the answer to that question. At the very least, you know my answer and Charles Dow's answer. The trend is in force until proven otherwise, and neither the length nor the duration can be predicted. What would it take to reverse this signal? Twice in 2014, the S&P 500 declined sharply and then formed a hammer that setup an important low (green ovals). The hammer alone is not enough to signal a trend reversal. It simply signals an intraweek reversal off the lows. Follow through is required and some sort of breakout is needed for a meaningful reversal. In 2014, the index followed through on both hammers the very next week and then broke out a week or two later. I would like to see follow through and a close above 2110 before taking this hammer seriously. Chart 2 shows the Russell 2000 with the bearish strikes in red and bullish hits in green.
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Chart 2
JUNK BONDS UNDERPERFORM INVESTMENT GRADE BONDS... In addition to basic chart signals, we have also seen a clear decline in risk appetite over the last two months. Chartists can measure the appetite for risk by using ratio charts to compare the performance of one asset against another. The appetite for risk is healthy when the riskier asset (numerator) outperforms the less risky asset (denominator). This ratio chart is also known as the price relative or relative strength comparative.
Chart 3 shows the High-Yield Bond ETF (HYG) relative to the Investment Grade Bond ETF (LQD) using a ratio chart (HYG:LQD). I also added the 5-week EMA (pink) and 52-week EMA (blue) to help define the trend. Notice that HYG outperformed LQD from December 2012 until November 2013 and the ratio did not break down until July 2014. Even though junk bonds started seriously underperforming investment grade bonds in the summer of 2015, the stock market held relatively firm and the S&P 500 moved to new high in February. Junk bonds started outperforming investment grade bonds as oil bounced in March-April and held near $60 in May-June. Things fell apart again in July as oil plunged to new lows and junk bonds started underperforming investment grade bonds again. This risk indicator suggests "risk off" in the bond market right now and this is a potential negative for stocks.
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Chart 3
STOCKS UNDERPERFORM BONDS... Stocks represent a clear risk asset and bonds represent a relative safe haven, and this makes the stock-bond ratio and good indicator of risk appetite. The risk appetite is strong when stocks outperform bonds and the risk appetite is weak when stocks underperform bonds (bonds outperform stocks). I chose the Equal-Weight S&P 500 ETF (RSP) because it represents the average stocks in the S&P 500 and the 7-10 YR T-Bond ETF (IEF) because it represents the belly of the yield curve.
Chart 4 shows the RSP:IEF ratio breaking its uptrend for the first time since August 2012. The pink dashed line is the 5-week EMA and the blue line is the 52-week EMA. Stocks are outperforming when the 5-week EMA is above the 52-week EMA. Note that RSP advanced over 60% from August 2012 to May 2015 as stocks outperformed bonds for over two and a half years. This outperformance is changing because the 5-week EMA moved below the 52-week EMA this week.
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Chart 4
AVERAGE STOCK UNDERPERFORMS LARGE CAP STOCKS... The third risk indicator is the ratio of the Equal-Weight S&P 500 ETF (RSP) to the S&P 500 SPDR (SPY). This measures the performance of the "average" stock in the S&P 500 relative to the large cap stocks in the S&P 500. Theoretically, the appetite for risk is healthy when the average stock outperforms the large-cap stocks. Relative strength in RSP points to broad strength in the stock market. Relative weakness in RSP indicates that participation is narrowing and this reflects a weakening risk appetite.
Chart 5 shows the RSP:SPY ratio with the 5-week EMA and 52-week EMA. The red shading marks the times when the 5-week EMA was below the 52-week EMA and RSP underperformed SPY. Notice that stocks do not always decline when the RSP:SPY ratio falls. This indicator just measures risk appetite and shows us where the money is flowing. Right now, the risk appetite for stocks is not strong because money is flowing into large-caps. The 5-day EMA of the RSP:SPY ratio broke below the 52-week EMA in early June and the ratio hit a 52-week low in July.
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Chart 5
THE DAMAGE IS DONE... and it has yet to be undone. Chart 6 shows the S&P 500 with the AD Line, AD Volume Line and 10-day EMA of High-Low Percent. Price action and indicator action are bearish and these bearish signals have yet to be proven otherwise. First and foremost, the S&P 500 broke below the March-July lows and hit a new (closing) low for 2015. This is a bearish development. Second, the AD Line peaked in May and broke its March low in June. A lower high formed in August and the AD Line plunged to its lowest level of the year this month. Third, the AD Volume Line peaked in May, broke the March low in mid June and broke to new lows for 2015. And finally, the 10-day EMA of High-Low Percent broke below -3% for the first time since October 2014. It will take more than just a one week bounce to undo these signals.
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Chart 6
The red rectangles mark the key levels for the S&P 500 and each indicator. The index, the AD Line and AD Volume Line got big bounces this week, but these bounces come after steep declines and these are just oversold bounces for now. As John Murphy noted this week, we saw a lot of technical damage in mid August and it will take some time for the market to regain its footing. I would not turn market bullish until all three break above their red zones.
MID-CAP AND SMALL-CAP AD LINES HIT NEW LOWS... Chart 7 shows the S&P MidCap 400 with the same indicators. Notice that the AD Line and AD Volume Line formed small bearish divergences in May-June. A bearish divergence forms when the security ($MID) records a higher high, but the indicator fails to confirm and forms a lower high. Overall, the three indicators, and the index, are in bear mode with the red zones marking the key levels to watch going forward. Chart 8 shows the S&P Small-Cap 600 and the corresponding indicators for reference.
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Chart 7
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Chart 8
Chart 9 shows the Nasdaq 100 with its breadth indicators. Notice that the AD Line and AD Volume Line formed large bearish divergences from late April to mid July and then moved to new lows for the year in August. The indicators are clearly bearish overall.
