The trend is bearish, but it is at odds with the solid economic environment. That conflict almost always ultimately resolves in favor of the bulls. By some measures, investor sentiment is among the most bearish since March 2009; even in a bear market, equities will experience a strong rally before rolling over. Seasonality is a substantial tailwind through year-end. Risk-reward over that period is again skewed higher.
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After falling 10% during October, US equities have rallied the past two weeks, with SPX gaining more than 2% each week. NDX fell 3% today but it is up the most - about 7% - so far in 2018 (table from alphatrends.net). Enlarge any chart by clicking on it.
SPX had formed a topping pattern even before October had started, and falling 10% that month only strengthens the pattern.
But the set up for higher prices, at least before a significantly lower low, appears to be very strong. Our recent posts highlight an abundance of data supporting that view (here).
In the event, SPX gained 6% over the next 8 sessions.
The sharp sell off in October triggered a sell signal in a popular trend following system based on the 10-month moving average. In a post (here), we explained that (1) false sell signals with this system are common during a bull market - in half the cases, SPX started a new uptrend the next month - but (2) the October low - or very close to it - appears likely to be retested in November.
To that, we can add the following: even in a bull market, a 10% correction in the stock market is usually followed by a retest of the low in the weeks ahead.
The charts below show each 10% fall since 1981, with the blue arrows indicating the initial low and then the subsequent low retest. There are 21 instances and only 6 exceptions, 4 of which occurred between 1996-2000 (green arrows). Since the 2009 bear market low, there have been 6 separate 10% corrections before the current one, and only 2012 made a "V bottom" with no low retest.
Likewise, when SPX has been in an uptrend (defined as a close above its 12-month ma) and then falls 10%, the subsequent month (in this case, November) has been lower 73% of the time by 2.4%. So follow on weakness has been the dominant pattern. But in every instance, SPX closed higher within 3-4 months and over the next 12 months, the median maximum gain was a powerful 19% (from Steve Deppe).
From a pure trend stand point, investors can't be faulted for reducing (or removing) risk. SPX closed under its 10-mma and both the 50-dma and 200-dma are downsloping. Moreover, SPX, NDX and RUT all peaked last Wednesday with a "lower low" from mid-October. This is the definition of a downtrend. Vigilance is warranted.
At Monday's (today's) close, NDX is already just 1.7% from the October closing low. If it leads, then the rest will continue lower in the days ahead. The odds above support that outcome.
An alternative scenario is labeled on the S&P chart above: a "head and shoulders" bottom with today's low (RS) equal to the low from early October (LS) . This pattern only becomes valid with a close over last week's high at 2820 (red line). In that case, the full measured move targets a new all-time high above 3000.
Our guess is that a new all-time high is ahead.
On Thursday, the FOMC met, voted to keep rates flat but suggested a further rate hike was likely in December and that three more hikes were possible in 2019. That seems to be at least part of the rationale for the sell off the past 3 days.
But rate increases are indicative of a growing economy, with improving employment and corporate profits. There have been 7 tightening cycles in the past 38 years and the very broad NYSE index has peaked after the final rate hike every time since 1980 (when federal funds rates were 12 times higher than today). Since 1945, when the economy is growing, like now, the probability of a greater than 10% annual fall in the stock market is just 4%; 87% of the time, equities rise (from Goldman Sachs).
The most recent economic data supports that outcome. In the past 10 months, the monthly average gain in employment has improved to 213,000 (green line). If this holds until year end, 2018 will be the third best year for employment since 2000. The prelude to a recession is a decline in employment, not an increase (read further here).
Likewise, if the current downtrend in equities reflected underlying economic deterioration, the spread in bonds would be widening (gray line and red arrows); they're not. Default rates remain very low (from JPM).
Long uptrends in bull markets are underpinned by economic expansion. The undulation within that uptrend is normally a reflection of investor sentiment. The current low in equity price is being matched with extreme lows in investor sentiment.
The Advisor and Investor Model (AIM) from Sentimentrader, which combines sentiment survey data from several sources, is indicating a bearish extreme. Since 2009, sentiment has not been much worse and in each case, an equity low was close and risk-reward was strongly skewed higher (from Sentimentrader; to become a subscriber and support the Fat Pitch, click here).
Now, it is true that sentiment turns bearish in bear markets and equities fall further, but most often a significant, multi-week rally occurs first, especially when the bear market is just starting. In 2001-02, for example, current sentiment preceded rallies of 10%, 15% and 20% in SPX.
Another example: on November 1, with SPX higher than today, the Fear & Greed index was at a lowly 7. In the past 20 years, SPX has subsequently gained 86% of the time over the next month by a median of about 4%.
Likewise, according to Mark Hulbert, short term market timers in the Nasdaq were 39% short last week, and the jump higher in the index through Tuesday had not made them more bullish. "That’s extremely bullish behavior because it suggests that the prevailing mood is particularly pessimistic." His post is here.
The charts below show the history of this sentiment measure since 2009. Last week's bearish sentiment was very close to that at the exact bottom in March this year (arrow on first chart). Sentiment like this also marked the 2016 election bottom (second chart) and equity lows in 2012 and 2015 (third and fourth charts). Equity lows in 2009, 2010, 2011, 2013, and 2014 occurred with sentiment less bearish than now. The biggest exception over the past 10 years was February 2016, in which the low washed out with timers being more than 60% short (second chart). In short, current sentiment is at a bearish extreme; it may not mark the exact low, but risk/reward should be biased higher over the next weeks/months.
It would be easier to brush off the extremes in bearish sentiment as being part of unfolding bear market if economic or corporate data were weak, but that's not the case. Moreover, there is now an unusually strong seasonality backdrop.
SPX has risen over the next 6 months following a mid-term election every time since 1946. That's 17 occasions in a row. Shown below are the last 14, since 1962: the average gain has been 15% with risk-reward more than 5:1 positive (from Quantifiable Edges).
Likewise, SPX is down 5% since a month before the election. It either rallies more than 5% in the next two months or it will be only the second time in the past 84 years that returns during this period have been negative (from DB).
On a shorter timeframe, the period from last Friday through year-end has been higher 22 of the last 23 times (96%) by an average of 3.3% when the indices were positive territory YTD (from Wayne Whaley).
It's unlikely the election results, which created a split Congress, will have a long-term negative impact on US equities. Since 1928, the current combination has occurred concurrently with an average rise of 12% in SPX over the next year (from BAML).
Finally, it is worth mentioning that there was "follow through day" (FTD) last Wednesday. This is a William O'Neil indicator that shows strong buying interest after a low has been formed, defined as a more than 1% gain on increasing volume 4-7 days after the low. Since 1971, when this occurs at a 20-day high (like last Wednesday), SPX has been higher on Day 20 85% of the time. 77% went on to either double their gains from the low or close at a 200-day high; even the worst performer gained at least another 2% after the FTD. So far, Wednesday's close marked the high, but it would be the first time an FTD like this marked the top if stocks do not recover (from Quantifiable Edges).
In summary, the current weakness in equities is likely part of the "low retest" that accompanies most market corrections. The trend is bearish, but it is at odds with the solid economic environment. That conflict almost always ultimately resolves in favor of the bulls. By some measures, investor sentiment is among the most bearish since March 2009; even in a bear market, equities will experience a strong rally before rolling over. Seasonality is a substantial tailwind through year-end. Risk-reward over that period is again skewed higher.
On the calendar this week: CPI on Wednesday, retail sales on Thursday and IP and OpX on Friday (from IBD Investors; for a trial subscription, please use this link).
On the calendar this week: CPI on Wednesday, retail sales on Thursday and IP and OpX on Friday (from IBD Investors; for a trial subscription, please use this link).
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