Last week we noted: (1) SPX had broken down through its 2013 trend line; (2) defensives were outperforming cyclicals; (3) ex-US indices, currencies and commodities were breaking much lower; (4) treasuries appeared to have broken above their downtrend; and (5) breath was signaling distribution.
The bottom line last week was this: strong uptrends do not typically end abruptly and we would expect, based on past performance, for the indices to make at least one higher high. But, the risk/reward is becoming much less attractive.
The full text and chart is here.
Which bring us to this week:
- As expected, SPX made a higher high on a closing weekly basis.
- But, risk was 2.1% downside versus a return of 0.5% upside and a net gain of 0.1%. Risk, in other words, was 4x larger than return. That's poor.
- Trend:
- All the US indices and sectors made lower lows this week. All made lower highs as well, except DJIA.
- Ex-US indices continue to decline under their 50-dmas. The euro, aussie, oil and copper ended the week on new lows. These are serious divergences with US indices.
- Treasuries confirmed last week's break above their down trend. TLT is now back in its upper trading zone. Treasuries are acting in concert with ex-US indices, commodities and currencies. The correlations are all working, excepting US indices.
- Breath deteriorated further with a second 90% down day this week and no offsetting 90% up day.
- Volatility exploded 34% higher on Monday:
- The historical implication within the next few days are for higher prices in the indices, which we have now seen.
- Over the next one to four months, the historical tendency is for downside to SPX, with a typical pullback of more than 5%. Think of this as one measure of risk going forward. Read more here, here and here.
The key is still determining the current risk/reward. Risk/reward is calculated based on expected downside relative to expected upside. Some examples:
- We have mentioned similarities in breath and trend between now and 2011, and that in 2011 the indices subsequently continued higher before heading much lower; over the next year, upside was 5% higher while downside was 12% lower. Risk was thus 2.4x larger than reward.
- In March 2000, SPX hit a high at 1553. Seven years later, in July 2007, it hit 1555 (almost exactly the same). In the next month, SPX fell 12% to 1370. It subsequently peaked at 1576 in October. If SPX repeats the pattern, upside to 1576 is 3.8% versus downside of net 8%. Risk is thus 2x larger than reward.
- There are many prior weekly closes between 1530-1560, i.e., 1-3% higher. If you take the VIX study at face value, risk is thus 3.5x larger than reward.
Seasonality in March and April is strong, and a tailwind. The Fed's pomo program is also a tailwind. On balance, however, there are many more headwinds. Still, there is no way to say - whether you are Tom DeMark or Stan Drunkenmiller - those upside targets will not be reached first. But risk/reward does not appear to be even close to 1:1.
All Star Charts reminded us of this this week: According Ted Williams, the first rule for good hitting is to get a good ball to hit. His advice was to wait for your pitch. “A good hitter can hit a pitch in a good spot three times better than a great hitter can hit a ball in a questionable spot.”
