Contrarian Thinking Says The Equity, Oil And Junk Bonds Rally Is Over

• Inflection point for junk bonds?
• Fake out rally a la 2008?
• Short-term oil rally over?

Inflection point for junk bonds?

It has been a feature of this bear market that stocks sell off in concert with junk bonds and oil prices as investors fret over potential energy company defaults.  Not all Junk bonds are issued by energy companies of course, but there are enough, about 20%, to cause a ripple effect in the Junk market when oil prices slip. Both oil and junk have been spearheading the February/March equity rally, so imagine my surprise this morning when I woke up to see the following Journal article  prominently featured on my iPad WSJ app “Junk-Bond Rebound Signals Easing Fear”. Remember, junk is not often featured so prominently in the Journal. When it is, this reflects excitement on the trading floors. Extremes in excitement typically forms around a turning point. The last time I saw something like this was at the bottom of a junk bond sell-off, where the article was citing fear and concern. From a contrary point of view the appearance of this story suggests that the junk/oil/equity rally may have ended or at least is close to its termination.

Let’s consider the junk bond market first, through the SPDR High Yield ETF, the JNK. It’s featured in Chart 1. The lower panels show the PVO and the PPO, volume and price momentum respectively. When the PVO is overbought and the PPO oversold, as was the case in October and December, that represents a selling climax, which is of course bullish. On the other hand, when both are overbought, as was the case last week, that indicates that buyers are exhausted, which is bearish. Note also that the price is now running into resistance in the form of the green trendline. Moreover, the rally has retraced approximately 61.8% of the previous decline. Typically bear market counter-trend moves will retrace 50% or 61.8% of the previous decline, so it’s certainly an intelligent place for anticipating a turn to the downside.

Chart 1

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Fake out rally a la 2008?

We could well be at a critical point as Chart 2 shows that the recent advance could turn out to be offering a false sense of security on the lines of the summer 2008 advance. This, like the current advance, developed after the completion of a head and shoulders top, and which took prices back above the extended neckline. It’s certainly a possibility to be on the lookout for, but what of the supporting facts?

Chart 2

Whipsaw upside breakout for some US equities?

In this respect, Chart 3 shows that the S&P ran up to resistance earlier in the week in the form of its red 200-day MA. It also rallied above the green trendline that was really the extended neckline of a head and shoulders top. However, it failed to hold above it and is now in danger of violating the red up trendline.

Chart 3

Chart  4 features the Dow, and here you can see that the 200-day MA and trendline are literally at the same level as the Tuesday closing price. Any additional weakness will confirm the false breakout as it will cause the price to violate the steep up trendline.  The two series in the bottom of the chart  show us that the rising prices (PPO) have been accompanied by shrinking volume (PVO), a typical bear market characteristic. Note that the PVO is now very oversold, meaning that the next move is likely to be one of rising volume. If prices do as well that would be bullish. However, if the overbought PPO starts to peak that would suggest declining prices and declining prices and expanding volume are ingredients for a sharp decline.

Chart 4

Lack of volume is also a problem on the NASDAQ as you can see from the rising red arrow against the price and the falling one just above the PVO. A break above the green line at $106 would be bullish, but a more likely scenario is a penetration of the red up trendline just above $104. If that happens, and given the oversold PVO, such a move would likely be accompanied by expanding volume.

Chart 5

Stocks versus bonds

Chart 6 shows that the stock/bond ratio ($NYA/TLT) recently completed a head and shoulders top, the recent rally merely representing a normal retracement move. Chances are that bonds will continue to out-perform stocks for a while yet.

Chart 6

Oil and a bearish two-bar reversal

Chart 7 features the US Oil ETF, the USO, together with volume (PVO) and price ) PPO) momentum. I have noticed that false upside breakouts are often accompanied by above average moves on the downside. This is especially true when the false move consists of a bearish two-bar reversal.

That’s exactly what happened this week as the price broke above the green trendline but was unable to hold that position by Tuesday’s close. A two-bar reversal develops after a rally, where the first day, a wide bar, opens near its low and closes near its high. The second bar opens near the previous close but ends the session near the previous open. Thus, pretty well all traders who went long during this two day period, come home with a loss. These are potential sellers who are likely to weigh on the market. Bottom line, I am expecting to see a test of the February low.

Chart 7

Metals and Mining

The SPDR Metals and Mining ETF, the XME, has also experienced a false break above its green resistance trendline. It does, however, still remain above the 200-day MA and the KST is continues to rise. Nevertheless, that KST is extremely overstretched at present, which suggests that buyers may have taken this thing as far as they can for the time being.

Chart 8

I say the time being because Chart 9 is both bullish and bearish. The bearish part refers to the fact that the XME has retraced 50% of its recent decline, a perfectly normal bear market phenomenon, and likely rally peaking point. However, that KST reading is on par to the one that developed at the start of the previous bull market. In other words, the recent KST strength means it is acting more as it might in a bull market than a bear trend. This is only anecdotal evidence that the tide has turned, but means that we cannot rule out that the recent bottom was a bear market low. Thus any decline from here could represent a successful test. The blue arrow in early 2009 shows where we could be in the cycle.

Chart 9

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.