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Short-Term Bottom Likely In, But Tread Carefully as Bearish Divergences Abound

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    October 1, 2014

    Last Friday you may have heard that both the Dow Jones Industrial Average and the S&P 500 hit new all-time record highs. The moment was short-lived however as both indexes sold off for the remainder of the day and then closed in the red. While the Dow and the S&P 500 have been rallying all month and would give the illusion that the stock market has a good run, we are actually seeing some serious subsurface deterioration in the market in which many stocks were not participating.

    Consequently, even though the Dow and S&P 500 have experienced only a mild 3-day decline, the bulk of the stock market has fared far worse as is in a more oversold position than what would appear by only looking at the major averages. The subsurface decline in the market has pushed my indicators (see image below) to levels that often mark short-term bottoms and suggests we should see some relief in the markets in the days ahead likely being led by small-cap issues.

    russell 3000 breadth
    Source: Bloomberg

    Further support for a near-term rally comes from the Russell 2000, which has been one of the weakest markets as small-cap stocks have not fared as well as their larger-cap brethren. The Russell 2000 has met the conditions for a Bloomberg TrendStall BUY setup and prior signals (see red circles) have done a good job at identifying prior bottoms and suggests another short-term bottom is likely in.

    russell 2000 buy signal
    Source: Bloomberg

    While the Dow, S&P 500, and NASDAQ may rally in the days ahead and retest their new highs made last week, I would treat any ensuing rally with a great deal of skepticism and caution given the number of bearish divergences currently present.

    Non-Confirmations & Bearish Divergences

    One very old and popular technical theory used in the market is Dow theory. A major component is that the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) should confirm each other by hitting new highs or new lows in concert. When they don’t, there is often a trend reversal. This is illustrated below from StockCharts.com between the two indices in 1998:

    How Averages Confirm

    Hamilton and Dow stressed that for a primary trend buy or sell signal to be valid, both the Industrial Average and the Rail Average must confirm each other. If one average records a new high or new low, then the other must soon follow for a Dow theory signal to be considered valid.

    dow theory
    Source: Stockcharts.com

    Shown above we can see the DJIA hit a new high in July while the DJTA did not, signaling a bearish trend change. Subsequently, a bullish trend change occurred in October 1998 when the DJTA hit a new low while the DJIA did not.

    Similar to a Dow theory confirmation I look for confirmation between the major market averages and the credit markets. When the two are not in sync, as we see now, we often see a market reversal.

    Shown below is the Bloomberg US Financial Conditions Index (BFCI), which is a composite of several credit spreads and is a good indication of the financial health of our credit markets. When we see new highs in the S&P 500 and failure for the BFCI to follow suit the S&P 500 is often pulled down and catches up to the weakness in the BFCI. We’ve seen this occur several times in the last year where the S&P 500 hit a new high in December of 2013 while the BFCI’s peak in December was lower than its November 2012 high and the markets sold off from January 2014 and into February before bottoming.

    Recently we saw the S&P 500 hit a new high in July while the BFCI did not and a July-August pullback occurred. We are continuing to see a failure by the BFCI to confirm the S&P 500’s move higher, which warns we could see a deeper pullback than what has been seen so far since last Friday’s highs.

    sp500 financial conditions
    Source: Bloomberg

    More signs of a lack of confirmation between the credit and equity markets comes from high yield spreads. The Barclays US High Yield OAS spread deteriorated in June and into July all the while the S&P 500 was marching higher and warned of a coming pullback. Similarly, the spread has been worsening all month and is almost back to where it was in early August while the S&P 500 rallied into last Friday’s high. The current deterioration in high yield spreads suggests we may have more to go in the current pullback after receiving a temporary oversold reprieve.

    sp500 high yield
    Source: Bloomberg

    We are seeing more bearish divergences when looking at the quality and safety spectrum of the market, which is shown in the multi-panel below. The top panel is the S&P 500 shown in black while the bottom panel shows three different quality relationships. The red line shows the relative performance of junk bonds versus investment grade bonds and the lower quality junk bonds have been underperforming the higher quality investment grade bonds since January and show a lower risk appetite by investors in the corporate bond space. Similarly, riskier small cap stocks (Russell 2000) have been underperforming mega cap stocks (S&P 100) since March, which also shows a preference for quality and safety by investors in the stock market. Finally, the S&P 500 Low Quality Index (stocks with lower credit ratings) has been underperforming the S&P 500 High Quality Index (stocks with higher credit ratings) all month and suggests investors′ moods are beginning to sour towards the riskier areas of the market and indicate we could be moving into a “risk-off” environment.

    sp500 risk off
    Source: Bloomberg

    Respecting the Message of Bob Farrell’s Rule # 7 (Again)

    Back on July 25th of this year I wrote an article with the above title (ex the “Again” verbage) highlighting the seventh rule of “Bob Farrell’s 10 Rules to Remember” shown below:

    Bob Farrell’s 10 Rules

    1. Markets tend to return to the mean over time.
    2. Excesses in one direction will lead to an opposite excess in the other direction.
    3. There are no new eras — excesses are never permanent.
    4. Exponential rising and falling markets usually go further than you think.
    5. The public buys the most at the top and the least at the bottom.
    6. Fear and greed are stronger than long-term resolve.
    7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chips.
    8. Bear markets have three stages.
    9. When all the experts and forecasts agree — something else is going to happen.
    10. Bull markets are more fun than bear markets.

    In hindsight we now know the article was written the day after the markets peaked and fell over 4% into August and illustrates the usefulness of monitoring market breadth. I’m seeing yet even further signs of the market weakening as fewer stocks are participating in the rally this year. This is shown when viewing the Russell 3000 Index, which covers roughly 98% of the entire US market cap and is a good reflection of the total stock market. In the chart below, the Russell 3000 is in the top panel while the cumulative advance-decline line (ADL) for the Russell 3000 is shown in the bottom panel. While the Russell 3000’s September peak exceeded its July peak, the ADL for the Russell 3000 failed to do so, which suggests a non-confirmation and may be hinting at a further decline in the market. The ADL is currently sitting near its August lows which suggests the Russell 3000 may fall a further 3%.

    russell 3000 ad line
    Source: Bloomberg

    Taking a closer look under the hood of the Russell 3000 shows a bifurcated market in which the megacap stocks (S&P 100) are showing the strongest performance while small cap stocks (Russell 2000) are showing the most weakness. While the ADL for the Russell 3000 is not confirming the recent high, that isn’t the case with the S&P 100 (largest 100 stocks in the S&P 500).

    sp100 ad line
    Source: Bloomberg

    Looking at the Russell 2000 (small cap stocks) shows where the weakness lies as the ADL for the index currently rests where it was back in November 2013 and suggests the Russell may fall down to the 1080 level after any near-term bounce.

    russell 2000 ad line
    Source: Bloomberg

    In addition to measuring breadth with advance-decline lines, looking at the percentage of stocks above a key moving average is also a useful tool for gauging breadth and market bottoms. Typically, whenever we see the percentage of members within the Russell 3000 drop to 35% or lower we are near a bottom. At 32.1% currently, we are likely near a short-term low as seen below. That said, there is also some bearish developments to take from the below chart and that is the divergence between price (top panel) and the percentage of members above their 50-day moving average (bottom panel), which is shown by the red and green arrows. Prior significant peaks like the 2011 and 2012 declines were preceded by an erosion in members north of their 50-day moving averages prior to the decline as fewer troops (stocks) were following the generals (indexes) higher. For this reason I would view any market bounce as suspect and with a healthy dose of caution.

    russell 3000 breadth
    Source: Bloomberg

    Other points of concern come from looking at 52-week highs and lows by members within the S&P 1500 (made up of the 1500 stocks within the S&P 500, S&P 400, and S&P 600), which shows a weakening market. For example, since October of 2013 the percentage of stocks hitting 52-week highs has been contracting even though the market itself continues to hit new highs. What is even more alarming is the expansion in 52-week lows during pullbacks. During the July-August pullback we saw new 52-week lows hit 3.7% and then the S&P 1500 recovered and hit a new high. While the market has pulled back mildly since Friday and is well above the August lows, we are seeing the stocks hitting 52-week lows expand to 5% and shows greater market deterioration than the headline indices themselves (see yellow boxes below).

    sp1500 breadth
    Source: Bloomberg

    Summary

    While we have likely seen a short-term low today and could see the markets recover in the days ahead I would treat any bounce with a healthy dose of caution given the numerous bearish divergences and non-confirmations as the internal health of the market has been eroding for months. This suggests that should we get a near-term rally the lack of internal strength implies the markets may not gain much traction before succumbing to a further and potentially steeper pullback ahead.

    Images: via Flickr (licence attribution)

    About The Author – Chris Puplava, Financial Sense Online

    Chris graduated magna cum laude with a B.S. in Biochemistry from California Polytechnic State University, San Luis Obispo. He joined PFS Group in 2005 and is currently pursuing the designation of Chartered Financial Analyst. His professional designations include FINRA Series 7 and Series 66 Uniform Combined State Law Exam. He manages PFS Group’s Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account. Chris also contributes articles and Market Observations to Financial Sense and co-authors In the Know—a weekly communication for Jim Puplava’s clients only—with other members of the trading staff. Chris enjoys the outdoors.
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