High Levels of Fear Argue for a Limited Decline Before a Big Move Higher
This week's sell-off has been pretty scary. However, it has not yet ruptured the primary uptrend that began in March. In that respect, Chart 1 shows that the PPO for the S&P Composite, using 6- and 15-month EMAs as parameters, remains well above its equilibrium level. Zero crossovers in both directions have traditionally signaled bull and bear markets. In that respect, previous bearish periods have been flagged with pink shadings. This approach is not perfect, as it sidestepped the 1987 crash and the sharp, but brief, decline that took place earlier this year. However, to its credit, it has warned us of every full-fledged bear market since the 1970s.
Another sign of a bull market top comes from a low and complacent reading in the VIX. The arrows in Chart 2 flag each of the important peaks that have developed since the late 1990s. Note from their tips that each top began when the month-end close for the VIX had fallen to or below the horizontal blue line, thereby reflecting complacency or a lack of fear by investors. That's not the same thing as saying every reading at or below the blue line was dangerous for equity prices - merely that no peak has yet formed in the absence of such a condition.
Indeed, as Chart 3 shows, the current VIX reading is closer to a major bottom than a top. At 39, it is already higher than it was at the 2002, 2010, 2011 and 2019 bottoms. Of course, it is possible for it to move much higher. That seems unlikely, though, as a substantial amount of concern has already been factored into prices. Consequently, we should be on the lookout, then, for a reversal, as a sign that the decline has run its course.
The relationship between high yield and treasury bonds, as monitored by the iBoxxx High Yield/iShares 7-10-year Treasury ETF ratio (_HYG:IEF), offers another indication that investor sentiment is more consistent with a major low than a high. It is represented in Chart 4, not by the ratio itself, but by its long-term KST. Rising momentum means that investors prefer the higher yield offered by junk at the expense of the risk-free and lower-yielding treasuries. That's because they are optimistic about the economy. Rising credit-spread momentum also implies higher profits and, therefore, elevated equity prices.
The chart reflects these swings in sentiment with a rising and falling KST. Notice how all the peaks (in confidence) were followed by a stock market decline or consolidation. This compares to upside reversals, which were associated with a stock market rally. The history of this relationship only goes back for 10 years, but a comparable one, between government 20-year and Moodys Corporate BAA yields, can be traced back to the 1920s with similar results. Right now, the KST is at a record low, thereby indicating that sentiment amongst credit market participants is quite negative and, therefore, ia more consistent with a long-term buying opportunity than a selling one.
That said, the short-term technical position of the ratio has reached a critical juncture point. Chart 5 indicates that it is trading right at the neckline of a potential upward-sloping head-and-shoulders pattern as well as its 200-day MA. Both KSTs are currently bullish, but it would not take much in the form of downside action to trigger a reversal. The other near-term worry comes from the fact that the ratio recently experienced an upside break above the dashed trendline. However, that break failed to hold. The rule is that, when a false break is confirmed, we should expect to see an above-average move in the opposite direction to the break. That confirmation would come from a decisive penetration of the 200-day MA and head-and-shoulders neckline.
Chart 6 also features the VIX, but this time I have plotted it inversely so that it corresponds with swings in the S&P Composite. The black line represents a 10-day MA and the red one 15 periods. As you can see, it has just completed an upward-sloping head-and-shoulders formation along with the Index itself. That suggests lower prices. The good news is that the latest breakdown in the inverted VIX has been triggered while it was already signaling a high level of fear. You can see this from the fact that the MA of the VIX is turning down from a much lower level than it did last February. That suggests to me that whilst we cannot rule out a sharp decline, in terms of duration, it is likely to be brief.
Finally, Chart 7 compares the Dow to a 10-day MA of its 12-day ROC. I find directional changes from at or below zero in this momentum indicator to offer fairly reliable indications of a short-term trend reversal. The chart demonstrates this technique from the buy side. It is certainly not a perfect indicator. However, it has only experienced two failures out of a total of sixteen signals the last two and a half years. It's currently bearish, but is one important indicator I'll be monitoring in my quest to identify the end of this short-term sell-off.
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 Groupof Walnut Creek or its affiliates.
