Is it Time for a Digestion of Recent Equity Gains?

• The 8/16 PPO for the SPX is overbought
• Nasdaq is running into major resistance
• The HYG experiences a false upside breakout and a bearish shooting star

The week before last, I drew your attention to the fact that since the August sell-off recent market gyrations had been truncated in terms of their duration. That suggested that we should lower the parameters of momentum indicators such as the Percentage Price Oscillator (PPO) in an attempt to more accurately capture reversal points. I used the PPO with 8/16 parameters as one piece of evidence that a successful test of the August 24 low had just taken place. In the meantime, prices have risen sharply, far more than I would have expected. Now, this indicator and others suggest that this leg of the rally may be in the process of topping out.

The PPO using 8/16 parameters

For instance, Chart 1 tells us that the PPO has already reached its .75 overbought zone. The solid red arrows point out that previously overextended readings have successfully warned of an impending short-term correction. The two dashed arrows indicate failures, but it’s important to remember that they developed under the context of a primary bull market. In other words, they were counter-cyclical in nature. If the assumption that we are in a primary bear market is wrong, then it’s quite within the realm of possibilities that the PPO could go on to register a really strong overbought condition without doing much harm. The sell signals at A and B on Chart 1 are the kind of thing I have in mind.

However, markets are far more sensitive to overbought conditions when the trend is down, just as they are far more sensitive to oversold conditions when rising. Witness the green arrows and the sharp rallies that followed. The point I am making then, is that if the long-term trend is bearish the market will be very sensitive to an overbought condition, so an overstretched PPO at this time is likely to result in a decline of some kind or at best a digestion of recent gains.

Chart 1

Chart 2 compares the NYSE Composite ($NYA) to a 10- and 20-day EMA of the McClellan Volume Oscillator(!VMCOSINYC). Sell signals are generated when the (black) 10-day EMA crosses below its red counterpart. However, I have lined the arrows up with the actual peaks to make this technique more sensitive. Right now the 10-day EMA is still rising. However, it is at a pretty overextended level and is certainly vulnerable to some downside gravitational pull.

Chart 2

The same can be said for Chart 3, which compares the S&P Composite ($SPX) with the 10-day ratio of NYSE advances to declines ($SPXADP).

Chart 3

Chart 4 features the TRIN, otherwise known as the Arms Index after its inventor Richard Arms. It has been plotted inversely to correspond with price movements in the S&P 500 ($SPX) and smoothed with a 5-day (blue) SMA. The arrows show that reversals from an overextended reading have been reasonably accurate in calling declines. The dashed arrow tells us that this is not a perfect record. The peaking action of the last couple of days further suggests that some form of a digestion of recent gains is likely to take place.

Chart 4

The NASDAQ

The NASDAQ is also overbought and running into resistance. This applies to both the NASDAQ Composite ($COMPQ) and the NASDAQ 100 (QQQ) as shown in charts 5 and 6. In Chart 5 the McClellan volume indicator (!VMCOSINAS) has reached an overstretched level. It’s true that the 10-day EMA (black) is still rising and that it has not yet triggered a sell signal. However, the price itself is right at key resistance in the form of the two converging trendlines. There is nothing in the rule book that says it cannot push through even with an overbought reading. However, if our bear market scenario is to play out this is the kind of set up that will halt a counter-cyclical rally.

Chart 5

Chart 6 features the QQQ. In this instance, the negative reading in the Percentage Volume Oscillator (PVO) tells us that so far the rally has lacked volume. This, combined with the speed of the advance, suggests that recent strength is more a function of short covering than new money coming in. Note also that the QQQ has run into a very formidable resistance barrier as flagged by the two converging trendlines.

Chart 6

Junk Bonds

Chart 7 shows that the most of the time junk bond prices move in tandem with the S&P Composite 500 ($SPX), but at other times provide a leading role. On Friday the iBoxx High Yield ETF (HYG), experienced a false breakout above its 2015 down trendline. Chart 8 indicates that Friday’s action resulted in a type of candlestick shooting star. The whipsaw and the candlestick in and of themselves only indicate short-term weakness, say 5-10 sessions. However, Chart 8 also indicates that two gaps lie below current prices. Since it is normal for gaps to be closed or at least an attempt is made to close them I would expect to see lower prices develop in the period ahead.

From a longer-term perspective, Chart 7 also informs us that the HYG touched a post-August 24 low unlike the S&P 500 ($SPX). The ensuing rally has also left the bond ETF below its previous high, again failing to confirm the equity market which did. This discrepancy has been flagged by the two dashed red arrows. Although there are precedents in which high yield prices lag equity market turning points, that usually represents the exception rather than the rule. This relative HYG weakness, therefore, is a cause for concern.

At this point, it would seem that the HYG is poised to at least make an attempt at closing at least one of the gaps. One reason that a new bear market low in junk bond prices may be problematic comes from the fact that a number of articles pointing out junk bond weakness have recently been published in the Wall St. Journal and other popular publications. This suggests that from a contrarian aspect most of the selling may already be over as market participants have already factored in all of the foreseeable problems.

Chart 7

Chart 8

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.