Catch A Falling Knife?

• The Market Remains Oversold
• More Trend Damage Triggered
• Key Ratios Have Just Broken to New Lows

As a kid, I used to love building sand castles and defending them against the ensuing wave action. If the tide was coming in, however, it always proved to be a fool’s errand as the castle was instantly washed away. Last week, I raised the question of a year-end rally, based on a downside whipsaw, bullish seasonals, a deeply oversold short-term condition and some positive divergences. That seemed to be a likely possibility, especially after it was followed by a 2 ½-day rally, but, much like those sand castles, all those temporary gains away and then some were washed away by the bear market. It underscores the famous observation made by the late, great Richard Russell that surprises typically develop in the direction of the main or primary trend.

The Market Remains Oversold

The indicators I cited last week remain in an oversold mode, so a rally could develop at any time. The problem with bear market rallies, as I pointed out in previous recent articles, is that they are typically highly deceptive and usually sub-par in magnitude and duration. What the action of the last few sessions has taught us is that there is new evidence to add to the primary bear market case. That evidence comes both in terms of additional trend deterioration and the dramatic way in which prices have failed to respond to the kind of internal measurements that should have provided a strong launching pad for the elusive year-end rally.

Chart 1, for instance, plots my Dow diffusion indicator, a series that monitors the percentage of Dow stocks in a positive trend. Last week, it was rising from a relatively subdued reading, but the action of the previous two sessions has reversed it to the downside. In a normal bull market, this would have been sufficient to trigger a nice rally lasting at least several weeks. However, December’s action is more reminiscent of July 2015 at the beginning of the 2015-16 mini-bear market.

Chart 1

Chart 2 shows a 30-day MA of the put/call ratio. The green arrows show that most of the time reversals from above the green dashed line are followed by strong rallies. The most recent signal has been unreliable in that respect and, again, is more akin to those weak bullish signals generated in the 2007-08 bear market. That period has been highlighted with pink shading.

Chart 2

More Trend Damage Triggered

Chart 3 shows that the recent drop to new lows has taken a couple of breadth indicators with it. Not only has the daily NYSE A/D line violated a key uptrend line, but this action has also been confirmed by the A/D line calculated from common stocks.

Chart 3

In the case of the S&P itself, this week’s action has resulted in the completion of a major top. A similar breakdown process occurred earlier in October for the NYSE Composite.

Chart 4

Recent weakness has also reinforced the violation of an even more important line, that marking the S&P uptrend that started way back in 2009.

Chart 5

Finally, Chart 6 tells us that the Global A/D Line has also completed a top, an event that confirms what has also happened to the Index itself.

Chart 6

Key Ratios Have Just Broken to New Lows

Advances and declines in bond spreads and other measures of confidence have been deteriorating for some time, as pointed out in a recent article. However, in the last few sessions, some see them as beginning to pick up sharply on the downside, pointing to an expected rise in defaults down the road. Chart 7 features one of these credit spreads in the form of the ratio between the iBoxx High Yield and Barclays 7- to 10-year ETF. Junk versus treasuries, if you will. That ratio, along with many other similar measures, started to break down some time ago, but has now been joined by most equity indexes. None of this is bullish for equities.

Chart 7

Finally, the ratio between stocks and bonds is a fairly cyclical one, as shown by the fluctuations in the Special K indicator (SPK). Chart 8 shows that trend line violations in the SPK, along with signal line crossovers, have offered fairly reliable reversals in trend for both the indicator and the stock/bond relationship. These signals have an effect that is usually greater than a year. In the last few sessions, the SPK has crossed its signal line and 2016-18 uptrend line as it completed a small top. The ratio itself was a bit slow to get underway on the downside, but has now violated two key trend lines. This relationship has now reached support in the form of the April low and could potentially pause for some time. However, there can be little doubt that the main trend favors bonds over stocks.

Chart 8

The market is obviously very oversold and could put on a seasonal rally at any point. However, it’s wise to remember that nearly all of the longer-term indicators are pointing to a bear market. Until they show some signs of stabilizing or even turning to the upside, the price action of the last couple of weeks reminds us that being cautious is not a bad idea - just remember those sand castles!

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.