October was a very challenging month and our synopsis for
market strength through the tail end of October was wrong (see Positioning
for 4Q16). Many of our holding showed strong earnings reports and bright
guidance but sold off aggressively nevertheless. We were forced to take stop
losses and lost value in the portfolio last month.
We expect to see market strength in the near-term, perhaps
getting through the election will be the catalysts. In hindsight waiting until
after the election would’ve been a better time to position ourselves. A few
items that warrant attention and confirm the possibility of a near-term rally
(or at the very least bounce) are the VIX, the put/call ratio, transports and
the extended losing streak.
The VIX
The VIX is approaching levels of extreme market angst that
has been typically associated with a market bottom in the near-term. On the
chart below the future and spot pricing has been thrown into an inverted
reading (above one) that signals the market selling should be abating. The five-day
rate of change in the VIX is 39%. We typically like to see a +50% move in the
VIX over five days to confirm a wash-out of aggressive selling. Perhaps one
more day of extreme selling (post-election) would bring us to a level when we
step in aggressively.
On Dana
Lyons’ Tumblr, “Let’s look at the
most popular stock market barometer, the S&P 500. While the large-cap index
did close at a 3-month low today, it is only a mere 3.6% off of its all-time
high. And yet, if we look at the relative near-term volatility expectations of
the index – by comparing the 9-day VXST to the 1-month VIX – it is actually at
its 3rd highest reading since its inception in 2013. Why is that? We’re
guessing it is event risk – in the form of election-related headlines in
addition to the election itself.”
“Specifically, we
looked at all unique spikes above 1.14 in the VXST/VIX ratio. Since the
inception of the VXST in 2013, there had been 10 prior such spikes before the
current move. Here are the dates:
1/24/2014
3/14/2014
7/31/2014
10/9/2014
12/10/2014
6/29/2015
8/21/2015
12/11/2015
1/19/2016
6/20/2016
In most cases, the
extreme jump in relative short-term volatility expectations presaged more
selling pressure in the short-term. 8 of the 10 occurrences saw the S&P 500
lower at some point within the first week, with a median drawdown around -2% at
some point within that first week. That’s 4 times the normal median weekly
drawdown. That’s the (surprising) good news for bears.
The bad news for the
bears is that the jump in short-term volatility expectations would not continue
to pay off for long. In fact, after the rough first week, in a staggering
turnaround, 9 of the 10 precedents would close higher by the end of week 2 – at
a median return of +1.2%. Here are the aggregate numbers.”
Put/Call
The put/call ratio is also showing extreme caution in the
market with a reading of 1.37, well above the 1.25 reading we like to see
before stepping back into the market. In fact, this past week the Put/call
ratio hit 1.43 which is a full three standard deviations from its mean. This
has occurred 34 times since 2000. The market went higher in the next month 62%
of the time with an average return of 1.1% which is much higher than the average
one month return for the market of 0.3%. In the following three months after
these occurrences the market was higher 80% of the time with an average return
of 3.7% which is higher than the three-month average market return of 0.9%.
Assuming we are not headed for a recession and excluding the readings from the
2000 and 2008 periods the results are much stronger. This could be signaling a
bounce in the market over the next several months.
Similar analysis was done on Dana
Lyons’ Tumblr. He notes, “One nice
way of viewing the overall options sentiment picture is to divide the CBOE
Equity Put/Call Ratio by the ISEE Call/Put Ratio. Since a high CBOE ratio
is indicative of fear as is a low ISEE figure, the higher the CBOE/ISEE number
is, the more fear that is present, in the way of relative put activity.
Historically, we have
found the nice, round number of “1.00″ to be indicative of an extreme level
of puts relative to calls. That is, when the CBOE Equity Put/Call Ratio is
higher than the ISEE Call/Put Ratio. Since the inception of the ISE in 2006,
there have been 28 days registering a reading of 1 or higher, with yesterday
being the latest occurrence.”
“So what are the
implications of this elevated level of hedging on the 2 exchanges? Is it
necessarily a buy signal based on the contrarian concept? For the most part,
yes. However, like Tuesday’s post on the ramp in volatility expectations, the
contrarian behavior doesn’t always kick in immediately. It’s certainly not
uncommon for selling pressure to continue in the days following readings of 1
or higher. However, after a week, most occurrences have led to consistently
positive and above-average returns.”
Transports
We also like to see the market weakness unconfirmed from the
transportation sector. In the chart below we are finding a divergence between
the performance of the transportation sector (IYT) and the S&P 500 (SPY).
This “non-confirmation between the two
indexes usually reflected a degree of uncertainty that typically precedes a
change or a pause in trend, if not a reversal, in the market and in the
economy, implications that are as pertinent today as in Dow's day.” (AAII Journal).
From See
It Market, “Aaron Jackson
(@ATMcharts) continues to contribute some great charts to our stream. He
points out that the Transports (NYSEARCA:IYT) are showing relative strength.
If Transports can hold there own, perhaps the selloff is nearing an end…
or close to it.”
Extended Losing
Streak
We have now had nine straight days of losses in the S&P
500. This is a very long time. According to Jeff Hirsch with Almanac Trader, “Since 1950, there have only been 22 other S&P 500 daily losing
streaks of eight or more days. 11 of 22 went onto last 9 or more days. The
worst by performance occurred early in October 2008 when S&P 500 plunged
22.9% in eight trading days. The longest losing streak was in April and May
1966 at twelve days. Once the streak ended, S&P 500 generally enjoyed a
nice bounce and reversal of trend. This bounce and reversal can be seen in the {following} chart of S&P 500 30 trading days before
and 60 trading days after a losing streak of eight or more consecutive trading
days.”
“In the following
table, S&P 500 performance 1-, 3-, 6- and 12-months after an eight straight
day losing streak appears. 1-month later is somewhat mixed however, the average
gain is 1.81%. 3-months after is stronger with S&P 500 up 68.2% of the time
averaging 4.5%. 6-months and 1-year later S&P 500 further improved.”
Technical Picture
We are resting on the 200-day moving average for the S&P
500. All the daily oscillators are reading oversold and the MACD appear to be
heading lower indicating increasing negative momentum. If the 200-day moving
average won’t hold then we’ll most likely test the 2050 area which is the 38.2%
retracement from the February lows. The Nasdaq is also quickly approaching the
key 5000 support level while the Russell 2000 is approaching 1150. All the
oscillators and MACD paint a similar picture. If these levels hold as the
election cloud is lifted, this could be the case to start to buy stocks
aggressively in anticipation of a year-end rally. This will be a key week for
the markets. Should we see renewed interest in owning stocks with higher volume
and improvement in the MACD momentum picture we will make the appropriate
trades.
Longer-term Picture
As per Dana
Lyons’ Tumblr, “Coming into the week,
it didn’t immediately occur to us that we were on the verge of such an
important juncture across asset classes. However, the fact that our Trendline
Wednesday feature on Twitter and StockTwits included an unprecedentedly large
number of assets and indices suggests that we are indeed at a significant
juncture.
One such index
pertaining to the equity market that we did not cover on Wednesday is the Value
Line Arithmetic Index (VLA). It measures the “average performance” among a
universe of roughly 1800 stocks. Because of its construction, it is an
important barometer of the health of the overall market. The VLA’s present
relevance here is due to the fact that it is testing its Up trendline stemming
from the lows in 2009, currently around 4700.”
“Now, if the trendline
is broken, it doesn’t mean that the market has to necessarily tank. For one, it
could come back and regain the trendline like it did in March – although, that
feat isn’t likely to get repeated too many times. Furthermore, even if the VLA
breaks the line, it may merely enter a sideways pattern rather than a
significant correction. It is even possible that the index resumes its uptrend,
albeit at a shallower trajectory. Still, those would be less desirable outcomes
than having the VLA successfully hold the trendline.
Will it hold? We don’t
have a crystal ball. With our proprietary risk indicators still firmly pointed
lower, and coming off of elevated levels, there is a case to be made for lower
prices. Then again, as we discussed on Tuesday and Thursday, the short-term
sentiment picture has shifted completely and could easily support a bounce.
So this one could go
either way. And considering the importance of this index, it pays to keep close
attention on the 4700 level in the VLA.”
Lance
Roberts at Real Investment Advice went on to point out, “Importantly, as I addressed in the latest newsletter, the violation
of that crucial support suggests a further correction is likely. However, by the
time a break is completed, the market has already become short-term oversold
and a “sellable bounce” is very likely. As Bloomberg noted:
“The index’s
longest-ever run of losses was eight days, matched at the height of
the financial crisis in October 2008. The S&P 500 started falling on
Monday, September 29 and saw lower closes at the end of every trading day until
October 10, in what was its worst week in history.”
But a bounce and a
resumption of a bull-market are two different things. As was seen in both 2008
and 2011, the consecutive 7-day declines led to further selling before a bottom
was eventually found.”
“Given that we are
very oversold short-term, a bounce back towards previous support levels (now
resistance) is likely and will provide a better opportunity to rebalance equity
risk in portfolios. A failure to break back above 2125 very soon will
likely lead to further losses before the next buying opportunity is found.
Caution is advised.”
From Kimble
Charting, “Below looks at the
Valu-Line Geometric Index, on a “monthly basis,” over the past 28-years. The
Value Line Geometric Composite Index is the original index released, and
launched on June 30, 1961. It is an equally weighted index using a geometric
average. Because it is based on a geometric average the daily change is closest
to the median stock price change.”
“The index created a
“Monthly reversal” pattern at (1) and sellers stepped forward.
The index rallied in
2007, coming up just short of 2000 levels, where selling pressure came forward
at (2).
The index rallied back
to 2000 and 2007 highs last year, where it created back to back monthly
reversal patterns at (3). Since creating those monthly reversal patterns, the
index has created a series of lower highs, just along line (4).
This index remains
inside of a 6-year rising bullish channel, despite the weakness over the past
18-months. If the index would break below this 6-year rising channel, suspect
selling pressure would take place.”
Indeed, we have been watching the long-term chart for the
SPX all year. The MACD line passed through the signal line in a bearish way
last year and has recently turned lower. The RSI (14) dipped briefly below 50
earlier this year but has retaken the level. We will be watching for a break
below to confirm a longer-term down trend. The index also breached the 20-month
moving average earlier this year. It has since regained the moving average.
We have long stated the market will need to exhibit a
long-term bearish cross, a break below the RSI (14) 50 level and a downside
breach & a failed resistance retest for us to take a long-term bearish
outlook on this chart. We will see how the remainder of the year plays out.
Bottom Line: We are
waiting until after the election to reposition ourselves should the market
catch a bid. There are a few near-term momentum items that give us a clue as to
near-term market direction and we are prepared to capitalize on this
opportunity. Should the market fail to find strength at these levels we will
keep hedges in place and raise additional cash.
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
Web Site: http://www.squaredconcept.net/
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