Is it Time to Pull the Plug?

• NASDAQ, IWM and NYSE Composite face key tests early next week.
• Confidence in the bond market about to snap?
• Dow violates key bull market trendline.

Market tops are not usually straight up and down affairs but typically experience a trading range separating the primary bull from the bear. During that topping out process, the internal technicals slowly but surely deteriorate. That’s because fewer and fewer issues participate in the uptrend  whilst a growing number start to move lower.  If we use a broad measure of capitalization, such as the Wilshire 5000 as shown in Chart 1, or the NYSE Composite, it is evident that the market has been range bound for the last year. The pattern is not that dissimilar to the 2000 and 2007 tops. Note also, that the long-term KST, while certainly not perfect in its predictions, is currently in a bearish mode.

Chart 1

The red rectangle in Chart 2 encompasses trading during the last year for the NYSE Composite ($NYA). In this instance prices are actually lower than they were at July opening in 2014. One of the keys to spotting ranging actions at market tops as opposed to consolidations during an on-going uptrend is to observe a deterioration in breadth. That’s because the equity market reflects the broad sectors of the economy. If a particular sector is not performing, this will be reflected by lower prices of these equities, whereas a broad economic advance is reflected in a more widely based equity move. Also, as the economic recovery matures, pressure begins to build for higher rates and this too affects market breadth in an adverse way as interest sensitive sectors such as utilities and REITS begin to sell-off. We can observe the manifestation of breadth from several angles. The middle panel of Chart 2, for instance, shows a cumulative line calculated from the daily plurality of net new 52-week highs ($NYHL). It goes bearish when it drops below its 50-day MA. This series moved into negative territory a couple of weeks ago. What we do not know is how long it will remain in a negative mode. Last October it only remained there for a brief period. However, as long as it continues to deteriorate it is a negative factor.  Note also that the upside/downside volume line for the NYSE ($NYUD) in the bottom window of the chart is already well below its 200-day MA and the solid red breakdown trend line.  It is now resting just below the neckline of a potential head and shoulders pattern. Any additional weakness will complete it. The equivalent level for the NYSE Composite is 10,600.

Chart 2

Chart 3 contains two broad measures of participation. The first calculates the number of Dow Jones industry groups on a short-term buy signal (!TPMMBDJS). The second is the more familiar bullish percentage indicator ($BPNYA). Both series offer warnings of impending weakness when they diverge negatively with the averages and vice versa. Recently we have seen two huge divergences as these breadth series peaked a couple of years ago. That’s bearish of course, but by the same token the very low current observation does set up the possibility of a very oversold reading with just a relatively small market decline. I wouldn’t count on that just yet until we are in a better position to judge the decline.

Chart 3

Chart 4 shows another discrepancy whereby the S&P was within a whisker of its all-time high yet more NYSE stocks were at 52-week lows than at highs ($NYHL). Note how the net new low series has already moved below its late June bottom unlike the S&P. Looks like the soldiers are leading the generals!

Chart 4

Confidence Indicators

The relative performance of high yield to good quality bonds often gives us a useful pointer as to forthcoming equity market moves. Such a ratio is featured in Chart 5 between the iBoxx High Yield (HYG) to the Barclays 20-year Trust (TLT). Divergences in both directions between the ratio and the market offer useful signs of strength or weakness. As you can see from the red dashed arrows there has been a large negative discrepancy building up in the last couple of years. However, since early this year a counter-trend rally in confidence developed. Now this formerly promising inverse head and shoulders base has been invalidated and the ratio looks headed lower. Remember, false breaks such as this are often but not always followed by above average moves. In this case that would involve a sharp loss of confidence. Given the weakening breadth discussed above, that may translate into an attention getting decline in equities.

Chart 5

Just to emphasize the point we see the two components compared in Chart 6. Note that the high yield ETF (HYG) has completed a head and shoulders top whereas its government counterpart has broken out from a base. This places extremely high odds on the ratio between them collapsing.

Chart 6

Short-term Indicators

Earlier in the week I laid out the case for a short-term rally, albeit a selective one. A few days later some of the indicators that gave me some optimism are either reversing or in the process of doing so. One of my favorite techniques is to compare the 10-day to the 20-day EMA of the McClellan volume oscillator (!VMCOSINAS). Crossovers provide us with bullish and bearish signals. We see an example for the NASDAQ in Chart 7. First, it's important to note that a sell signal has not yet been given. However, the rolling over action offers a warning that one is likely early next week. Also, the price experienced a false upside breakout a few sessions ago and that also hints at exhaustion.

Chart 7

The NYSE Composite ($NYA) is much closer to a sell signal. Note the series of declining peaks and troughs since the false upside move in May. It looks as though we may find out soon because the Index is rapidly approaching the neckline of a second head and shoulders (the first was at the dashed red line). If this potential, and I really want to emphasize the word potential pattern is completed with a daily close much below 10,600 we could see things unfold quite quickly.

Chart 8

Finally, we see that the Russell 2000 ETF, the IWM recently broke to the upside i.e. above the green trend line, but has been unable to hold that breakout this week. Now it is resting on key support in the form of another potential head and shoulders neckline. Note that the relative strength line has already broken down and the KST for relative action is still falling. Any upside momentum that appeared to be present earlier in the week is now greatly diminished.

Chart 9

The Dow versus the Short-term KST

Finally, Chart 10 compares the Dow to a weekly short-term KST. Note how the KST peaked in 2009 and has been declining on an irregular basis ever since. This week the Index broke below a key up trend line and looks as though it has confirmed these multiple divergences. I would still like to see some more confirmation such as the NYSE dropping below 10,600 on a daily close basis and the S&P falling below its previous daily closing low of 2050, but it seems to me that the die has probably been cast.

Chart 10

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group or its affiliates.