Saturday, February 8, 2014

Weekly Market Summary

The low from the prior week did not look durable: many of the telltale signs of a solid bottom were not yet present. Several of those triggered on Monday and Wednesday; a good enough pitch to swing at (set upset up, targets and CBI).

Specifically, SPX landed on the trend line from March; created a positive divergence on both the 60' and daily timeframes; completed a second major distribution day; completed a second Vix spike; and had a Trin spike over 3. All of these signals were on our watch list and were detailed over the past two weeks (post and post). 

So, was that the end of the correction? There are three possible outcomes:
  1. SPY fails to make a new high (likely fails to clear 181) before retesting or exceeding the recent low. This is the most likely outcome based past behavior (2006, 2007, 2010, 2012) and some key indicators. It would be a buyable dip.
  2. SPY makes a marginal new high but is stuck in a sideways channel for many months before retesting lows later in the year (2005 and 2011). This is less likely, but still quite possible. It would be a sellable rally.
  3. It's still a 2013-style market, the correction is entirely over, SPY will now make new highs above 1950. This is what Wall Street expects and it is the least likely outcome. A full post on why that's unlikely is here
We think, net, that a second dip is the durable low and therefore buyable, and that a rally higher now is sellable. Details follow below.

Outcome 1: Retest Low

The decline this week looks similar to the one in August: two 'waves' lower and a double bottom. The bounce places SPY back in the green trading range it was in from November to December, from 177 to 181. 

The decline, however, is different in a few respects. First, the decline so far has been strong enough to pull the 50-dma lower. To prevent this, 181 (the upper green bound) needs to be regained next week. This would be a big positive and it is the key metric to watch.

When SPY crashes through its 50-dma on the first touch, there is normally a quick backtest. This happened in August, for example. It did not happen this time. The rise on Thursday and Friday is the first backtest (circle). June, by the way, was different: SPY bounced on the 50-dma twice right before crashing through.

When SPY crashes through its 50-dma on the first touch, it most often retests the low (or more) in the weeks ahead. This is especially true when the 50-dma is starting to decline. November 2012 is an example: low (arrow), backtest (circle) and then a second low (arrow). 

The same pattern of low, backtest and a second (or third) low was present twice in 2010.

And twice in 2007. We'll skip the 2008-09 bear market.

And, finally, also in 2005 and 2006. It's typical pattern.

In each case, note the negative slope of the 50-dma. Repeat: that's the key metric to watch in the next week.

A second low, therefore, seems to be likely now as well. That's confirmed by several other indicators. 

One is weakness in the small cap index, RUT. RUT has now fallen three weeks in a row. Since 1990, this has happened more than 30 times. Every time it has occurred when RUT has been in an uptrend (like now), the low of the third week (yellow) has always been revisited and usually exceeded (arrows). This makes sense: three down weeks shows weak momentum that takes some time to reverse. That's why double bottom (and inverted H&S) patterns are so common.

Next, the low this week was not accompanied by a rise in relative put buying. CPC never exceed 1.0. Every durable low after a >5% fall in the past decade has been marked by CPC over 1.1 and normally over 1.2. This one was not even close. Is this time different?

Similarly, if you use ISEE call/put data (which excludes market makers, so that it's a cleaner representation of investor sentiment), the same conclusion can be drawn. The current reading (20-dma) is 124, whereas durable lows have been formed at under 110 and more often below 100.  

Moreover, NYMO bottomed at -64. In the past decade, a durable low after every fall of >5% has been accompanied by a NYMO of at least -75 or less. 

Investor's Intelligence bullish sentiment remains high. This week it was 29% whereas durable lows have occurred when the index is zero or less (chart). Recall, the recent peak in early December was the highest bullish reading since 1987.

The chart below shows how SPX has performed after every similar bullish extreme. According to Ed Yardeni, extreme readings usually result in SPY visiting its 200-dma (near 170). Since 1987, SPX has traded below its 200-dma every time after one of these extremes except in 2003, which was the start of a cyclical bull market. The drop below usually takes place within 3-4 months; it has already been 2 months since the bullish extreme. On past history, it should occur in the next 1-2 months.

NAAIM (active manager) sentiment declined this week to 51; durable lows occur under 30 (chart).

So most indications (CPC, ISEE, II, NAAIM) are that sentiment has not yet washed out to a low. 

An exception is AAII: bulls are now 27%, in the range of prior lows. In 2013, this would be the durable low; in 2010-12, it was often not the durable low.  We have an upcoming test, therefore, of whether the 2013 market personality is still present. 

There was a large outflow of funds from SPY this week; according to Chris Puplava (his chart below), it was the largest in 10 years. Note, however, that 2013 had the largest equity mutual fund inflow in 10 years and the fifth largest inflow of the past 30 years (here). So a large outflow is following a large inflow.

More to the point, while some large outflows have been durable bottoms (late 2005, late 2012; green lines), just as many have not (early 2010, 2011, 2012; yellow). The last similarly extreme outflow was in 2008; not exactly the start of a bull market.

Finally, recall that January's low undercut the low in December. This has happened 21 times since 1950 and every time the Dow has lost a minimum of an additional 3.6% (mean of 14%). For SPY, that would target 171 (chart).

Net, a second low in the coming weeks seems to be likely. But it's not the only possible outcome. Let's discuss Outcome 2.

Outcome 2: Higher, Then Sideways Chop For Most of the Year

In 2011, SPY crashed through its 50-dma and then recovered without a second low. It even made a marginal new high. But the main feature of 2011 is that it traded sideways and then much lower for the next 10 months.

Why did this happen? ISEE call/put did not washout to a low in 2011. In other words, bullish sentiment was not reset through price and the market spent time (and then price) clearing out the bulls. A look at the AAII and II charts from 2011 (above) gives the same story on sentiment. 

The same thing happened in 2005. Recall that CPC spent 6 months (October 2004-March 2005) below 1.0, the only other time before now that CPC has been below 1.0 this long (currently 5 months). The outcome was the same as in 2011; a prolonged sideways market ensued for most of the year that eventually took out the bulls. 2005 was also one of the years with an II bullish extreme (chart above).

The current market appears to be setting up like 2005 in other ways. So far in 2014, utilities, health care and treasuries have been outperforming; cyclicals have been underperforming. In 2005, the same relative performance of low beta vs high beta took place for most of the year.

Moreover, recall that fund managers surveyed by BAML are very overweight cyclical stocks (banks, technology, discretionary) and very underweight low beta. Under similar circumstances, cyclicals have underperformed.

* * *

The fall this week further damaged trend by creating a lower low and by causing most 50-dma for the indices and sectors to invert. The bounce on Thursday and Friday put many back above those support levels. It could well have been a false breakdown. Again, regaining the 50-dma is the key metric to watch this week.

SPY is back to its 177 to 181 trading range. A break below 177 signals that Outcome 1 is unfolding. A break and hold above 181 signals that Outcome 2 is odds-on.

We think a second dip (Outcome 1) will be buyable and a rally higher now (Outcome 2) will be sellable. In addition to the rationale we have presented above, SentimenTrader published this study:

"Every time, since 1928, when SPX went from a 52-week high to a 70-day low within two weeks, it was higher in three-months, averaging gains of 8%". Full article here.

We note, however, that nearly every instance had a second dip within those three months (green box). That is especially true of the most recent examples in the past 20 years.

So, buy the second dip, sell the immediate term rally.

Our summary table follows: