Volume Gives Shorts the Upper Hand

Rather than signaling the end of the bear market, the more probable outcome for the current rally in the S&P 500 is for it to fail somewhere between current levels and 806. Trading volume can help us understand market participants’ collective desire to buy or sell a particular security or index. To formulate probable outcomes for the current rally in stocks, we will compare the S&P 500 long ETF (SPY) with the S&P 500 short ETF (SH). As we walk through this analysis, notice we are focusing on observable facts rather than forecasting what the future may hold. We assume we will get more of the same (lower lows in SPY/S&P 500 Index) until we see evidence to the contrary (higher highs, better volume, etc).

We briefly covered investing based on probable outcomes in Odds Continue To Favor Lower Lows In Stocks. We will state again the importance of cutting losses in any position when you are wrong. We are near trendline overhead resistance for stocks and we have a FED announcement today – big moves up or down would not come as a surprise. Risk management remains very important to both the shorts and the longs.

There are numerous reasons to doubt the staying power of the current rally in the S&P 500. Based on the notations in the chart below (and other factors), there is little evidence to suggest the current rally is anything other than a bear market rally. The conclusion we draw is the odds continue to favor lower lows in the U.S. stock market. At the same time, we acknowledge the lower probability outcome (a new bull market) is possible, but not probable. For long-term investors, holding cash still has better odds than owning the S&P 500 Index.

If we do see a break above the trendline in SPY (above), volume will help us determine its potential staying power. Stocks could move above the trendline for a few days and then reverse, especially if the break above trend occurs on relatively tame volume. A strong volume breakout holding for a few days would add to the bullish case. We just have to see how it plays out and make adjustment accordingly – no need to guess here.

We can look to confirm our probabilities above by examining the S&P 500 inverse or short ETF (SH), which makes money when the S&P 500 falls, and loses money when the S&P 500 rises. Volume and trends continue to support favorable outcomes for SH. The lower probability outcome is for a permanent break of the upward sloping trendline (thick purple line).

Based on what we know as of Tuesday’s market close, it is premature to call an end to the bear market. As conditions evolve and the charts change, we may draw a different conclusion. However, bullish conclusions may not come until after stocks head toward lower lows.

Fair and Balanced: If the lower probability outcome occurs, the small chart of SH shows the gap that could be filled between the purple trendline and 200-day moving average (thin red line). Said another way, if the lower probability outcome occurs, SH could drop under $70, illustrating the need to (a) admit we could be wrong, (b) plan for it, and (c) have a specific risk management plan in place to protect capital if needed. Probabilities are just that – they are not certainties.

Now we will examine the current state of investors’ willingness to accept risk. We will use bonds to do so, but the results affect all risk assets, including stocks. The chart below shows the ratio of investment-grade U.S. corporate bonds (LQD) to long-term U.S. Treasury bonds (TLT). The reason for looking at this ratio is quite simple. When investors feel more confident about future economic activity, they are more willing to take on the added risk associated with corporate bonds to earn a more favorable return (line trends up). Conversely, when investors feel less confident about the future and are more concerned about defaults, they will favor the safe haven and lower returns available in Treasuries (line trends down). The results are not encouraging for the sustainability of the current rally in stocks. With the primary downtrend below intact, we have more evidence to support a continuation of the primary downtrend in the S&P 500.

On Tuesday, we did get some good news on the housing front. Unfortunately, the chart of Lennar (LEN) looks less than bullish for long-term investors. Some nice gains will likely come in the homebuilders sometime in the future. However, it is still to early to buy in our book. We need to see more.

Numerous calls have been made for the end of the bear market in Chinese (FXI) stocks. Rather than buying, we would prefer to remain patient. A sustained break of trend here could be the first significant crack in the bear market dam. Bullish outcomes for FXI could pave the way for other risk assets to follow. Watching FXI with an open mind is a good use of our time.

When the charts above become more attractive on a long-term basis, we will gladly become open to bullish interpretations. While every chart above may break the downward sloping trendlines in the coming weeks and months, we would prefer to see it happen rather than hoping it happens or forecasting that it will happen. When the trends become more favorable, there will be plenty of time to make money. For long-term investors, not short-term traders who have an understandably different approach, inverse positions remain more attractive than long positions in the vast majority of risk-related markets. If trendlines begin to break in the bulls favor, our interest in numerous asset classes would increase.

Comments

[Steve in Gr...:]

Thanks, Mr. Ciovacco, for another great article.

Mar 18 08:40 AM

[Paul from C...:]

Interesting article... I'm starting to build my position in SDS after selling SPY. The better advice I'm hearing is that we will resume falling after a period of sideway movements. There is few new buyers and no earnings to support any bear market rally.

Mar 18 10:16 AM

[Doc 224899:]

Some of the SPY volume will go towards "safe havens", like GLD or SH. GLD is, in some ways, less pessamistic than SH, to people who have put their faith in SPY.

People holding SPY will want to sell as the price rises so they can cash out before the next big slump in the broad market.

Fewer and fewer people will be willing to buy those SPY shares as the price rises, because the likelihood of profiting from the buy decreases as the price goes up. Volume shrinks, as we're seeing now.

People wanting to get their money out of SPY are going to start freaking out as fewer and fewer people are willing to buy their shares, and SPY will tank. There will be fewer and fewer people willing to put their faith in the market as it slides, so more money will wind up on the sidelines and overall market volume will still be relatively low due to lack of trust.

Mar 18 11:56 AM

[APM:]

Today's market action after the Fed announcement convinced me more that this is dead cat bounce. The fact that Fed is forced to intervene in such unprecedented scale is a good indication that things are going terribly wrong.

I was expecting the market to turn around in April when the earnings hit the news, now I am not so sure. We may see significant downward movement before the end of the month.

Mar 18 04:40 PM

[Gtarras:]

Although I am bullish, I thoroughly enjoyed the article. Great advice, simple, to the point, Thanks.

Mar 18 05:51 PM

[Mad Hedge F...:]

I'm liking this more and more. The quality of this rally is convincing some investors that this could be the big one. After financials (XLF), which are having an obvious dead cat bounce, the leaders of the past week have been the sectors that led into this recession, like consumer discretionaries (XLY), retailers (RLX), and home builders (HGX). The chart of Home Depot (HD) tells the whole story. These are exactly the sectors you would expect to move in a new bull market.

Mar 18 08:54 PM