What Are The Odds Of An October Surprise?

• Conditions that feed a crash
• Rising rates
• Emerging markets could be the triggering mechanism
• Market breadth not so hot
• Is the e-commerce bubble bursting?

Conditions that feed a crash

October started off as just a continuation of September’s dull price activity. However, knowing that the month of October has occasionally offered some nasty surprises for US equities, it is worth posing the question of whether we are likely to witness another sharp sell-off. First, it’s important to note that though September is statistically the weakest month, October gets the media attention because it has traditionally hosted some of the more dramatic sell-offs. In this respect, 1929, 1987 and 1998 come to mind. Second, because of the random nature of crashes, there are no known techniques for consistently forecasting them ahead of time. Quite often, though the conditions that trigger them are in place, nothing happens. At other times, only some of those conditions are present, yet a dramatic sell-off actually follows. It all depends on when confidence collapses. Sometimes the sell-off is over quickly, such as 1987 and 1998. At other times it forms part of a bear market (1929 and 2008). The point of this article is not to forecast a crash, because that’s a fool’s errand. Rather, it is to examine whether any of those pre-conditions exist today. Unfortunately, some of them do.

There are two of what we might call basic foundations. First, an unusually sharp sell-off typically follows a really strong and pervasive uptrend, which feeds a surge in confidence. Second, this leap in sentiment results in very careless investment decisions being made. Once the die has been cast, those positions are rendered vulnerable to unexpected changes in financial conditions. It could be something as basic as rising rates that trigger margin calls. Moreover, a currency crisis impeding normal capital flows often feeds back to countries other than the country initially in trouble. The list goes on. I am already 250 words into this article and we haven’t seen a chart yet, so I will belatedly introduce some that can help us navigate potential trouble spots.

Rising rates

Chart 1 shows a simple relationship between the S&P and the 5-year government yield. The joint trend line breaks flag when the yield experiences the violation of an uptrend line; this is later confirmed by an S&P decline. In other words, rates rise and stocks initially welcome such an environment, because it reflects a healthy economy, but, at some point, rates reverse to the downside. When stocks confirm with a break of their own, prices are vulnerable. Historically (i.e. prior to 2000) it was typical for rates to peak after equities, at the tail end of their bear market. In the last 18 years, however, it seems that the deflationary effect of an expanding debt overhang has altered this relationship. The bottom line, in the current situation, is that both series are rising. Until stocks violate their up trend line at 2800, rising rates are not a problem, so this chart will remain positive for stocks.

Chart 1

Emerging markets could be the triggering mechanism

Troubles in the emerging market sector have been problematic for US equities all the way back to the Mexican debt crisis in 1982. Chart 2 shows that the iShares MSCI Emerging Markets ETF (EEM) have under-performed the world since late 2010. That’s not surprising since many are commodity producers and commodity prices have been weak since that point. Moreover, these countries have accumulated trillions in US Dollar-denominated debt. Unfortunately for them, the Dollar has been rising during most of the intervening period, thereby raising servicing costs. Moreover, it seems that the Dollar is headed even higher, which can only exacerbate the situation.

Chart 2

I am not sure whether we can classify China under the emerging label, as it is the world’s number two economy. However, I do find Chart 3 to be compelling. That’s because the Shanghai Composite is trading just above its secular bull market trend line. During the October Market Roundup video, I discussed this chart and opined that the Index was likely to bounce from the line as it had started to break to the upside. Since then, Chinese equities have been unchanged and will remain that way until next Monday, when they re-open at the end of Golden Week. In the meantime, though, other Asian equity markets have sold off sharply; two Chinese ETFs, the ASHR and PEK, have dropped 3- 4%. That means that the potential secular uptrend line violation may be back in play again.

Chart 3

Chart 4 shows that the Bombay 30 is right at a secular trend line of its own. It has not broken down yet, so we should not jump the gun. The point I am trying to make is that emerging equities remain vulnerable and, at some point, could catch the attention of US investors in a negative way. Shanghai and Bombay are just two possible triggering points.

Chart 4

Market breadth not so hot

Throughout the bull market, the NYSE A/D Line has been more or less in sync with the NYSE Composite. Indeed, it reached a bull market high in late August when the NYA itself was unable to take out its January peak. Now, we can see that both A/D lines, along with the Index itself, have violated key short-term uptrend lines.

Chart 5

Breadth can also be monitored by examining net new high data, as shown in Chart 5. Here, too, we have a problem, as the S&P Composite registered a new high in late September, yet the net new high indicator in the bottom window was barely able to edge into positive territory. Clearly, the recent rally was supported by relatively few stocks, which is not a positive sign.

Chart 5

Chart 6 explores the breadth picture by considering the bullish percent for the NASDAQ. Note the series of negative divergences as the NASDAQ registered successive new highs between February and September. At the same time, the bullish percentage traced out a series of lower peaks and troughs. As a result, the Index is within a whisker of its record high, whereas the bullish percent is almost back to its February low, where barely 50% of NASDAQ stocks are currently in positive trends.

Chart 6

Is the e-commerce bubble bursting?

Bearing in mind the fact that careless decisions typically follow strong and pervasive price advances, our final two charts feature the Dow Jones E-commerce Index. This series doubled between its 2002 and 2008 lows, but increased by a factor of 20 between 2008 and its 2018 high ten years later. Altogether, they have experienced a 40-fold increase since their 2002 low. E-commerce stocks have really been the stars of the 2009-20?? bull market, as they have filled the leadership role of the 1990’s more generalized tech boom. When tech tanked, so did the market as a whole. It doesn’t seem to be a large leap to expect a general retreat in equities when e-commerce starts to unwind either.

Bearing that in mind, Chart 7 compares the $DJECOM to its RS line. With the RS, it is possible to construct two possible trend lines, if you are prepared to overlook the 2008 whipsaw. Both are in the same vicinity, along with the 65-week EMA for relative action. The price itself is within striking distance of its uptrend line and EMA (1168 versus 1090). No breaks yet, but they're getting pretty close.

Chart 7

Chart 8 looks at the more recent picture. In this instance, both the price and RS line have violated key chart points, which means that an attack on the longer-term line and 65-week EMA from Chart 7 is likely.

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 of Walnut Creek or its affiliates.