I haven’t written anything in over a month but now feels like a good time to provide an update of what I’m seeing and expecting.
Investment markets in general, and stocks especially, typically act in one of two frames of mind. When investors are comfortable taking on risk virtually all bad news is ignored and asset prices tend to climb higher. However, whenever we flip to a “risk off” mood, generally all news is viewed as a reason to sell, regardless of whether or not it’s actually bad. We’re pretty much in the latter right now. Markets move in an ebb and flow process and once sentiment becomes stretched, investors become complacent, and everyone is leaning too far to one side of the boat, the unwind begins and it tends to occur much quicker than the build.
So why now? I see two main reasons: 1) we hit the blackout window for share buybacks. Companies aren’t allowed to buy (back) their stock a couple of weeks leading up to their earnings announcement so that massive bid was pulled. And 2) the drop earlier this year in February broke the momentum of the rally and this whole move higher has been a retest on negative divergence. This is a big sell signal and was one of the key reasons I’ve been lightening up on US stocks over the past couple of months.
So let’s take a look at where things stand from a short- and long-term perspective with some charts.
Short-Term Charts
Just as a market can get ahead of itself on the upside, it also happens on the downside. In the short-term, the stock market has become very stretched from a technical, sentiment and breadth perspective, and I’m expecting to see a fairly strong bounce in the very near future. We’re also entering the period where stocks tend to rise the most from a seasonality perspective. If we do not see a strong rally soon, then it’s a sign of more serious, longer-term concern. We saw a similar setup two years ago leading into the presidential election where oversold conditions led to a strong rally that began the day after the election into the new year. We could see a similar situation here, regardless of the outcome, simply because markets don’t like uncertainty. Just knowing the results adds a calm and allows participants to reposition based on their view of the results.
I’m seeing exhaustion type signals and a positive divergence on the RSI despite prices making a new low today – this is a positive sign that we should see a bounce.
S&P 500 – 1 year, daily
We’re also approaching levels of support from the lows earlier this year just below. Markets are always very technically driven in the short-term. You can see how it respected the trend lines earlier and then the selling accelerated once we broke through. I would expect to see some decent support just below.
S&P 500 – 1 year, daily
Long-Term Charts
Last month I wrote about the dynamic between interest rates, yield curves and the economy, and said that a slow-down is pretty much baked in the cake. This has been evident in stock markets across the world, but is finally showing up here in the US and we’re playing “catch down” pretty quickly to get back in synch. The charts are flashing some serious warnings present at past bull market highs but interestingly I’m not yet seeing any confirmations across rates or spreads. All in all, I’m not completely convinced the bull market is over yet but I do have to respect the price action I’m seeing in the US stock market right now.
The S&P 500 has put in a pretty serious negative divergence on the RSI and other momentum indicators, similar to the past 2 market tops. However, as you can see in the late 90’s, these can be drawn out for a couple of years so there’s nothing that says we still can’t see another new high in 2019.
S&P 500 – 25 years, monthly
We can see this in a similar manner by looking at momentum – my preferred method. I’ve broken this down into 4 parts, each one numbered:
- Break of trend in momentum (green line)
- New price high on a negative divergence, meaning weaker momentum (red line)
- Break of support structure in momentum (horizontal blue line)
- Momentum goes negative (red vertical line)
This same process plays out across different asset classes and across various time frames. It all happened back in 2015 when half of the economy went through a recession (energy, industrials, manufacturing, transports) but half did not (consumer spending, tech, healthcare, etc.) which allowed the market as a whole to hold on and momentum never went negative. We’ll see if things play out in a different manner this time.
Seeing how the market drops has some information but seeing how the market responds is the info with real value. If the bounce is strong with broad participation and is able to recapture broken momentum levels, then the uptrend can continue. However, if the bounce is weak with lackluster breadth and momentum is unable to rise above that blue horizontal line, then I will be fading the bounce by further reducing exposure and hedging risk.
One Final Thought
One of my bigger concerns overall is the amount of money that has moved into systematic strategies (CTA’s, computer algorithms, risk-parity, etc.) and indexes over the last decade. This money does not think; it moves based on calculations and it often invests in a leveraged manner. The “sell points” for these strategies are below the market so on days the market is down a good bit and volatility is up, when they recalculate you often see really big liquidations in the last 30 to 60 minutes of the day. This is why we’re seeing very hard sell-offs late in the day lately on the big down days. There’s no thinking behind it. Your typical value investor likes to “buy low” and “sell high.” These programs are the exact opposite. This is great if you’re a value investor because indiscriminate selling of everything, even things that should not be going down, creates opportunities. The negative aspect is that it makes markets go from a state of a very calm, slow grind up which often sucks in a lot of people at the highs, to a sharp unwind down. That’s the leverage at play. My concern is that we eventually see a day where the unwind gets out of hand and the selling accelerates. This is what happened during Black Monday back in 1987. We have circuit breakers now but all that will do is spread it out into a multi-day event. I don’t mean to scare you but just understand that the markets are dominated by computers these days and computers don’t think or act like a rational, value investor so you just have to expect and embrace the volatility to use it as an opportunity.
I made a few new buys last week so I’ll detail some of those holdings soon. I just wanted to get this bigger picture update out first. Let’s see how things play out through the rest of the year.
Thanks for following!
-Nick