After 27 months, SPX experienced its first 10% correction this week.
As we have detailed many times, this was an exceptionally long and uncorrected rise. Since its last 10% correction in mid 2012, SPX has risen an exceptional 59%.
Bulls will contend that the 2003-07 market was completely devoid of 10% corrections. This is misleading. That bull market struggled to break-even into the third quarter every year. It was a slow grind higher, completely unlike the pace of the past two years.
The big question is whether the correction is over and stocks will now rally into year end.
There were several indications that this week produced a wash out low. The most impressive of these is breadth.
SPX breadth became more washed out than at any time since the 2011 lows. By mid-week, just 40% of SPX stocks were trading above their 200-dma. Throughout the 2003-07 bull market, that level marked significant lows (lower panel). It also marked lows in 2010, 2011 and 2012 (green arrows).
The one caveat is that this is how bear markets begin (red shading). Even so, the initial low in 2007 was followed by a bounce to retest the prior high. A bear market without a bounce higher first would seem to be very unlikely.
The same breadth wash out occurred for the market leading Nasdaq. This week, just 20% of Nasdaq stocks were above their 200-dma, equivalent to lows in 2004 and 2011 (green lines). The only other times it was lower was during bear markets. Just looking at the percent of stocks above their 50-dma (middle panel), stocks were similarly oversold at least 10 other times in the past 10 years and each one resulted in a move higher over the next month.
Note, the move was net higher, but that doesn't mean that the ultimate low was in. 2011 is one example were the initial low was undercut. The same occurred in early 2008 before a strong bounce that ultimately led straight to a bear market.
There was a deterioration in participation at the September high, as fewer stocks remained in an uptrend while the indices moved up. That negative divergence has now been reset. The lows this week may be undercut in the weeks ahead, but the odds suggest net upside into year end, even if the overall market is ultimately heading into a bear market.
Volatility also spiked this week to 3 year highs. In a bull market, those spikes usually correspond to relative lows. There might be higher volatility ahead, but history suggests that volatility first subsides before spiking to a higher high: examples are both 2007-08 and 2010-11.
Volatility earlier this year reached historically low proportions (read further here). That led many to conclude that volatility would remain subdued for a multi-year period. 2004-07 and the 1990s were cited examples. This was flatly wrong. The spike in volatility this week was exactly the same pattern seen in both of those prior bull markets. Shown below are the 1990s.
Both 1994 and 1996 are similar to today. Both times, volatility spikes became more frequent and the advance in SPX became choppier; the prior years, like 2013, had been an uninterrupted and low volatility rise. Current markets may well be setting up for more volatility and greater undulation than most market participants expect. Nonetheless, the main point is the initial spike in volatility likely aligns with a relative low in SPX.
There are two more elements that we like to see at a low.
The first is for sentiment to become bearish. The evidence is very mixed, and for good reason. US equities were at all time highs less than a month ago, and time is an important element in washing out sentiment. The last wash out in sentiment occurred in 2012 and followed a pullback that was equal to the current one but lasted more than twice as long (chart from Charlie Bilello).
Fund managers have reduced their equity exposure in the past month but it is not at levels associated with a major low in the market. Fund managers are 34% overweight equities after reaching record high exposure this summer. A washout low would be under 20%; in 2012, funds were underweight equities (green shading; data from BAML; for more on this, read further here).
Among the weekly sentiment surveys, Investors Intelligence has the longest history. As we have pointed out before, investment advisors have been more bullish for longer than any period since 1987. Sentiment is only just beginning to move lower; if the past is a guide, it will take at least one month to become washed out (below 1.4x the number of bulls to bears).
But, the sentiment evidence is mixed. Last week, we showed that the Daily Sentiment Indicator was at a low (post). This week, NAAIM reached a low where only 10% of active investment advisors are net long. Put/call ratios (total and equity-only) have spiked to levels associated with near lows in SPX.
Equity fund flows are inconclusive. On the one hand, outflows over the past several weeks reached a minor extreme (squares). On the other hand, for a 10% fall, the outflows were small relative to February and August this year. And, stunningly, flows this week were positive (circle). In other words, investors were buying into weakness. Look closely and you can see that also happened in August 2013 and August 2014 on the way to the ultimate lower low in SPX (chart from SentimentTrader).
There's no clean conclusion from sentiment. One way to reconcile the differences is this: a temporary low in SPX has been reached but that it is part of a larger correction that will continue after a bounce higher. We have been discussing this scenario over the past several weeks: the A wave (down) completed this week, the B wave (up) is now underway and a C wave (down) will follow. That would allow sentiment (and asset allocations) to reach durable lows. It also implies a longer correction than what investors have become accustomed to (time).
Neither the breadth nor the volatility studies shown above would be in conflict with a retest of this week's low in the week(s) ahead.
The last element of a durable low is a loss of downward momentum. Into a low, momentum normally bottoms before price. That means the fall is rapid, then decelerates and bases. As an example, below is the 17% fall in mid-2010 compared to the current fall. Some sort of basing should ideally take place before the next move higher (chart from McClellan).
In the chart above, the rally within the green box is the B wave after which the C wave completes the decline. In 2010, that phase of the correction lasted about one month.
Which bring us to the current market. The decline accelerated Monday thru Wednesday. The momentum low was on Wednesday, the same day as the price low. Even the more minor declines in the past 18 months showed a separation of momentum and the low in price (lines in the upper panel).
In comparison, during the 2011-12 period when SPX last dropped by 10%, the lows showed decelerating momentum in either or both RSI (top panel) or MACD (bottom). Price chopped at the low as momentum dissipated.
The same was true after corrections of 10% or more in 2009-10.
The weekly pattern is the same. The lows after 10% corrections since 2010 have created a divergence in momentum each time. One possibility is that SPX moves up this week before moving lower; since January 2009, SPX has dropped 4 weeks in a row 6 times; on 5 of those it moved up the following week. The one exception was in May 2011 but most of the weekly declines in that stretch were very minor.
SPX had closed last week on its 200-dma for the first time in two years. The pattern has been for SPX to bounce on the first touch of the 200-dma without losing more than ~2% (more on this pattern here). This week was one of those few times in the past 20 years that the closing low was 2% below the 200-dma. What happened next in similar cases?
Perhaps the most relevant comparison is from July 1996. Recall that 1995 and 2013 are the only years when the 200-dma was not visited at least once. When the 1995 streak ended, SPX made a long pierce, bounced, returned below the 200-dma, based and then moved higher. That process took several weeks. Note in particular the hammer candle; the same candle formation occurred this past week. Note also the loss of downward momentum at the low in price.
Although the streaks above the 200-dma were much shorter, the breaks lower in 2005 are also relevant. Both times, price oscillated near the 200-dma, working off the downward momentum and shaking off longs before moving higher.
In none of these cases was the break of the 200-dma on its own significant. In each, the trend ultimately resumed higher. We will be looking specifically at the MACD and the slope of the 13-ema (arrow in the lower panel in the two charts above). A crossover in both will provide confirmation that the downtrend has likely ended.
Trend, as you would expect, is unattractive. None of the indices in the US or abroad are above their 50-dma or their 13-ema. In the US, 7 of 9 SPX sectors are also in short and intermediate downtrends. Again, on strength, we will be looking at crossovers in the MACD and 13-ema to confirm that the downtrend has ended.
The bounce in SPY at the end of the week retraced 38% of the fall from the September high. It also stopped below the August pivot low. Above 189-90, there is the potential to run all the way to the 196 area, to the weekly R2 as well as the current 50-dma. That would be a typical B wave.
Much attention was paid to the relative strength in RUT this week. More than anything, that had to do with the large fall in the prior week that broke what had been support for one year; this week's gain retraced only a portion of that fall. RUT also landed on a long term support line, and bounced. It remains in a downtrend, especially so long as it is under the key 1080-90 level (blue line). Note how downward momentum and basing has not yet taken place as it did at prior lows (circles).
NDX both broke a long trend line and undercut the August low. This was the first time that a prior pivot low was decisively broken in two years. That signifies a change in market character. Friday's bounce ended under both of these key levels. Note also the yawning MACD and declining 13-ema (bottom panels; circles). We will be watching these as a confirmation of trend continuation or reversal.
Seasonality this coming week is neutral. There is no consistent pattern of gains or loses overall or in years (like this one) where an election is two weeks away. The election is likely to be a positive influence the week after: more often than not, stocks rise into an election, something to keep in mind on weakness this week (chart from Stock Almanac).
In summary, breadth and volatility measures are consistent with a low in price, but sentiment and momentum are not. We think the market is likely to work on forming a base, and a B wave higher followed by a C wave lower could be part of that. We are very cognizant that the November-January time period is typically the strongest of the year and believe, at least for the time being, that the current weakness is part of a long overdue correction as opposed to the beginning to a more serious bear market.
Our weekly summary table follows.
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