Monday, October 26, 2015

Not Out Of The Woods Yet

Since the swift and dramatic correction in August, equities have put in an impressive rally off of what appears to be a double-bottom.

The S&P 500 has climbed about 11% from its August low and on Friday successfully broke through key resistance at 2050, the breached support level that led to the plunge in August. It will be important for the index to experience carry though this week, to rise clearly beyond the resistance area and towards prior highs of 2100.

It is a bit concerning to see the flatter Russell 2000 Index performing less well.

Whereas the S&P 500 has achieved reaching the low levels of August, the Russell 2000 has yet to get there (2000 level). In fact, the 1170 area looks to be serving as resistance thus far. Also note that the Russell 2000 peaked in June compared to the S&P 500 peaking a month later in July -- a bearish divergence as the R2000 Index made a lower high in July and continues to underperform the S&P 500.

On a longer-term monthly basis, I keep an eye on the following S&P 500 chart:

The chart shows four things that I have tracked over time: 1) the 6-month moving average (MA) vs. 12-month MA, 2) Unemployment rate, 3) stochastic, and 4) MACD histogram. This 4-item checklist has helped to serve as a reliable longer-term barometer for the stock market. Currently, the picture is somewhat worrisome. To run through the list:
  1. The 6-month MA has pierced down through the 12-month MA, indicating a possible negative trend change. This occurrence does not always result in a trend change (see late 2010 and 2011) and it's more valid when there's greater daylight between the two MAs. However, it gave plenty of heads-up notice in 2000-2001 and 2007-2008 (blue circles). BEARISH
  2. The unemployment rate (black line) remains in a downward trend, bullish. Note in 2000 and 2007 it broke downward trend pre-market corrections. But for now: BULLISH
  3. The stochastic indicator (STO) has declined from above 80, but remains above 50, another good sign. Note in 1998, 2010 and 2011 the stochastic similarly eroded to near 50 but did not break down through that key level. For now: BULLISH
  4. The MACD histogram is concerning. Currently the monthly reading is -25.4, well below -10 (blue line) indicating momentum thrust, if you will, has decidedly turned negative. Whereas the market corrections in 1998 and 2011 did not result in the MACD histogram submerging below -10, it clearly did so for 2000-2001 and 2008. My fear is when momentum turns negative this abruptly and strongly, it can tend to have legs or carry through going forward. BEARISH
To sum up, the weight of the evidence in the above chart is mixed with a 50/50 bull/bear split. However, given the MACD histogram in particular, I continue to lean on the cautious side.

Another indicator I follow that suggests we're not out of the woods yet is the percentage of NYSE stocks above their 200-day MA.

As shown in the weekly chart above, during the August correction, most stocks could not avoid the carnage. Only 20% of NYSE equities were able to remain above their 200-day MA. With the recent rally this indicator has improved to nearly 35%, however it remains far below the key level of 75% that I prefer to see for an all-systems-go signal.

For stocks to get below the 30% level (blue horizontal line), it means that most stocks have experienced significant technical damage and typically it takes some time for healing to occur in the form of widespread price recovery (breadth). Note in the chart that after declining below 30% in 2002, 2008 and 2011, this indicator eventually returned to the 75% or higher level in less than 12 months time, i.e. relatively soon, inferring a higher probability for an ensuing secular bull market. Yet a glaring exception is 2008, when early in that year this indicator dipped below 20%, then rose to as high as 60% before rolling over.

Does a reading below 30% suggest a very oversold condition for equities? Yes. In the long-term scheme of things (20+ years), do such extreme oversold readings make for good entry points? Arguably yes, they often do. HOWEVER, as I illustrated with 2008, there could be more ugliness to come and some may wish to exercise patience, waiting for the 75% threshold to be obtained.

I'll finish by showing one more chart:

S&P 500 trailing 4-quarter EPS (Y/Y %) is fast approaching the 0% level (orange line). Net profit margins remain at record levels, but typically when 4-quarter earnings get this low, net profit margins have reversed trend, heading lower. Worse yet, note the grey-shaded vertical bars indicating recessions and how the red line is often at 0% or lower before recessions take hold. Yes, this time may be different (as it was in 1985 and 1998), but the above chart remains another item of concern.

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