E A Storm Is About To Hit Markets

If you were asked to do nothing as an investor for the week to come, could you do it? Sometimes the simplest and most appropriate measure to take is the most difficult for investors and traders alike. We think this is an appropriate manner in which to contextualize markets near-term and with respect to growing macro-uncertainties caused by COVID-19. Having achieved 13 new closing highs on the S&P 500 (SPX) already in 2020, investors and traders alike can rebalance or hedge YTD positions/gains against the backdrop of uncertainty and what that uncertainty may produce near-term. Keep in mind, there is still another 10 months and 1 week left in the year. Don't forsake future, potential gains with impetuous portfolio management today. Sometimes, indeed, doing nothing today results in greater achievements tomorrow. 

The following report is a redacted version of Finom Group's (for who I am employed) full-scale weekly Research Report

All Things S&P 500

Over the last several weeks, Finom Group has outlined that the market was likely offering market participants an opportunity. That opportunity was likely directed at active portfolio managers who aim to rebalance their portfolios periodically and in accordance with market conditions associated with breadth indicators, trends, sentiment and broad macro-fundamentals. For the week to come, markets may come under increasing pressure and present a selling storm if COVID-19 headlines worsen. Remember, it never just starts raining; clouds gather, skies darken, wind speeds pick up, and barometric pressures decline. When you have a consensus of the evidence, you typically carry an umbrella. That umbrella had already been offered to traders in the form of rebalancing opportunities in previous weeks. If we look back over the last month and with rebalancing reiteration rhetoric in my delivered weekly Research Reports, we also come to find that the S&P 500 has done very little over this time period.

While it may seem as though the market has endlessly climbed higher, and in some respects it has, when we brush aside the trees of daily candle sticks we come to find that the S&P 500 has done very little over the last month. A series of new highs and closing highs just this past week, also meant very little in the grand scheme of things. For the week, the S&P 500 achieved a new record high level just above 3,393. From that point, the S&P 500 finished the week in the red, down 1.25 percent. The Nasdaq (NDX) led the major indices lower with a loss of 1.59% for the week, also after achieving a new record high of 9,838 during the week.

I've discussed, in the past, that I was of the opinion the market was overbought and/or overextended.  The key technical premise for this opinion was and remains driven by the S&P 500 trending 3 standard deviations above it's 200-DMA. With this past week's 1%+ decline, the benchmark index remains in overbought territory and with a bullish trend. Nonetheless, while I've stressed the opportunity to rebalance portfolio positioning during such overbought conditions, I bring this up within the context of the last 30 years and secular bull markets. In the last secular bull market during the 1990s, the S&P 500 was routinely more than 10% above the 200-DMA. By mid-1995, the S&P 500 was 14% above that trend line. All of these instances led to consolidation periods followed by even higher new highs. This simply reinforces that overbought conditions are rebalancing opportunities that when met with a drawdown should be found as buying opportunities. Some still can't see the similarities between "then" and "now". That is often the case as new worries of the day are met with the human emotion of fear and capital preservation.

The S&P 500 is still up 3.3% year-to-date and hasn't hit its 50-DMA since October of 2019. Breadth weakened in the past trading week as one would expect with the broader indices taking losses for the week. Currently, the S&P 500 moving averages are outlined in the chart above and represented as follows:

  • 20-DMA =3,323
  • 50-DMA = 3,279
  • 100-DMA = 3,159
  • 200-DMA = 3,041
  • Let's do math: S&P 500 is 3,337-3,041 = 296 points to achieve the 200-DMA. The S&P 500 would decline almost 10% from peak to trough if it achieves the 200-DMA in the coming weeks or months.

The aforementioned bullet points are not a forecast, but to be used as reference points, as technical trends tend to seek out support and resistance levels. What is probably of greatest importance going forward and technically speaking, is the bearish MACD crossover that occurred late last week.

As shown in the chart above, the slower moving momentum line has crossed above the faster moving momentum line as of Friday last week. The bearish crossover is being realized at a level lower than January’s sell trigger, confirming a negative divergence compared to price. Accompanying this market internal development is continued relative strength weakness in the S&P 500. We've seen this before and in the past such bearish signals proved short-lived. All major moving averages remain curled up, which may need to flatten and turn lower in the coming week if the MACD signal is to be confirmed. Nonetheless, it may also prove relevant going forward to understand where open gaps in the S&P 500 remain unfilled.

So here's where it might get a little tricky in terms of separating technicals. That which was identified to this point are daily features of the S&P 500, and are increasingly bearish, but not yet demanding of greater risk control. In a long-term bullish trend, there should be a litany of time periods for which the daily technicals weaken and appear bearish, but remain within a bullish long-term trend. But now let's also look at the S&P 500 in terms of weekly moving averages.

On the weekly chart, the 20-week moving average at 3,184 remains a likely target for algorithms, especially if they can crack the 50-DMA with a weekly close below the 50-DMA.  The 20-WMA level would represent a pullback of approximately 6% from peak to trough, a typical gyration in any intermediate to long-term bull market trend. 

The 20-week moving average has frequently supported the long-term bull market trend through the past many years. Seasonally, the next period of strong buying demand for stocks is typically realized in March and April, suggesting an enticing window to buy should stocks pullback further.

I suggest keeping these charts and momentum indicators handy over the coming weeks. Know market gap zones and support levels should they be tested, as they can provide for a tradable bounce. Moreover, recognize any near-term turbulence and volatility in the market as forward-looking opportunity. I also remain constructive on markets in 2020, despite near-term headwinds, which I also recognize may become increasingly heady/troubling, but prove transient.

My cautiously optimistic tone is held within the long-term context. In Finom Group's private Twitter feed, here is what I offered after the closing bell on Friday.

It's with this tweet in mind that we are starting to see the signs of improved risk/reward potential. Sentiment on Friday, as gauged by the options put-call ratio, ended bearish at 1.15.  This is the highest put-call ratio since November 21st, indicating that the complacency that has been excessive in the market is being greatly challenged.  The more investors hedge their portfolios by way of puts, the better the risk-reward of the market becomes. This is, of course, with respect to the longer-term picture for S&P 500 returns.

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Speaking of longer-term, let's take a look at some longer-term potential market breadth signals historically and juxtaposed with the same signals in the present. For this exercise, we are going to rely on the ADX. What is the ADX? The average directional index (ADX) is a technical analysis indicator used by some traders to determine the strength of a trend. The trend can be either up or down, and this is shown by two accompanying indicators, the Negative Directional Indicator (-DI) and the Positive Directional Indicator (+DI). Therefore, ADX commonly includes three separate lines. These are used to help assess whether a trade should be taken long or short, or if a trade should be taken at all. Now that we know what the ADX is and what it is used for, let's look at some setups care of Chris Ciovacco's latest video analysis. 

That doesn't mean a whole lot to us, of course, without knowing how the S&P 500 performed with the trend lines setup. The following table identifies these 6 ADX trend setups and how the S&P 500 performed going forward.

Clearly, the market performed quite well for each given sleepy ADX signal going forward and over the next 8 years on average. Of course, there were hiccups along the way, but the ADX should be used with such context that it is not a timing signal. Having said that and recognizing that tech stocks have largely been driving the latest leg of the market rally, I also recognize that Friday's losses were most heavily felt in the Nasdaq Composite and tech sectors of the market.

Recall chart's of the tech sector that I've offered in past reports and as follows:

Seeing how this ratio was so extreme in the recent past, it should serve to figure that the tech sector was the most heavily hit sector on a weighted average basis on Friday. The ETF that tracks the space (XLK) fell by 2.24%, breaking below its rising 20-day moving average at the lows of the session.

Speaking of 20-DMA's and technology stocks, the Nasdaq 100's 20-DMA had gone up 88 days in a row. This was the most extreme trend in history for the Nasdaq 100. Similar streaks always ended with SHARP corrections over the next month, according to the SentimenTrader.

While the SentimenTrader's depiction of the Nasdaq 100's momentum captured in the chart above is notably bearish, here is another FUN fact! In 1995, the Nasdaq composite 20-day simple moving average was up for 175 days in a row. So while the present streak is notably extended, history says streaks can go on much longer than we would like to believe they can.

In speaking about the Nasdaq more broadly, we can utilize another market internal indicator known as CCI. Developed by Donald Lambert and featured in Commodities magazine in 1980, the Commodity Channel Index (CCI) is a versatile indicator that can be used to identify a new trend or warn of extreme conditions. In general, CCI measures the current price level relative to an average price level over a given period of time. The following chart of CCI dates back to 1970. (Charts from Chris Ciovacco)

As we can see from the chart above, the CURRENT setup is similar to that which had occurred on 5 previous occasions, including the famed 1995 date, which we previously mentioned. What we aim to better understand is, of course, how did the market perform going forward, based on the market internal reading in the CCI? (Tables from Chris Ciovacco)

It would appear that across all time frames out some 5 years, the stock market performed very well with an 80% probability of positive returns across all time frames. Naturally, the 1999 dotcom crash was the exception, which drew the average down during all time periods. But in speaking of the dotcom bubble, as I recognize that many aim to compares price to sales ratio of today with that of the dotcom era, here are some pertinent facts that display the current market paradigm is not like the dotcom era at all.

Robert Buckland, a global strategist at Citi, studied stock market distributions to show the market now is not really that similar to that of the dot-com days. He looked at the components of the MSCI World stock market index over 12 months and weighted returns by average market capitalization, both now and when the market peaked in 2000. In our first chart below, we have only a couple of stocks that have more than doubled in value.

The dot-com era had many Tesla-like big performers. In March 2000, there were a number of companies that had tripled over 12 months. The dot-com era also had a more extreme distribution of under-performers. (See chart below)

If you weren't convinced about the secular bull market, perhaps you are now open to the idea for why this uptrend has a chance to go on for a lot longer than you might think. It's why I often suggest that weakening breadth is not a sell signal. Rebalancing is always a preferred practice of a sound portfolio manager. We sell when the macro-backdrop shifts decisively negative. Even in Q4 2018 the macro-backdrop, and after a 20.28% peak-to-trough decline in the S&P 500 occurred, did not shift decisively negative. It is why during that time period, I continued to accumulate short-VOL exposure and anticipated a market bounce with a VIX crush.

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