Correction or New Bear Market? 3 Easy Ways to Know (and Forecast)

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 |  Includes: AUNZ, DBC, FXA, FXC, FXE, FXY, GLD, SPY, UDN, USO, UUP
by: Cliff Wachtel

The biggest question in the financial media has been whether we are in a normal correction within the context of a bull market or at the beginning of the next leg down. The real underlying practical question is of course, should we be going long on risk assets or opening short positions?

Tool #1: The Weekly S&P 500 Chart With Selected Indicators Shown Below

Here’s a simple way to tell. Longtime readers know we like the S&P 500 as the best overall barometer of current risk appetite. Stocks are the best barometer of current risk appetite, and the S&P 500 is the best barometer of stocks.

Note that it isn’t the best leading indicator of overall risk asset market direction. That comes in tool 3, below.

However, for assessing whether a longer term multi-month downtrend in stocks-- and thus most risk assets--has begun, here’s a simple but effective instrument.

Look at this relatively simple chart, the S&P 500 weekly chart (click to enlarge).

S&P 500 Weekly Chart Courtesy of AVAFX 20 may.27

This simple weekly chart emphasizes a number of important points:

  • Over the past 5 weeks, we’ve had 3 lower lows and as of the close Friday are likely to be looking at 4 lower highs.
  • Note the 50 Week SMA is at 1071.45 and the weekly low for 2010 at 1061.37. Both of these are powerful support levels. A sustained (2-4 week or candlestick) move below this 1071-1061 zone typically means we will be spending a while below this line. As the weekly candlesticks show, we are now just above this support level.
  • From both the established price levels and Fibonacci retracement going back to early March 2009, big picture support levels become clear. In addition to the support levels shown by the Fibonacci retracement levels, note also the important price support levels.
  • The lower Bollinger Band on the weekly chart is at 1043. That will likely provide a support level as well, and likely it will be the starting point for some kind of reaction bounce. Note how since 2/22/2009 the S&P has made its bounces when at a major Bollinger band.

Zooming in for closer resolution using the daily chart, we get a few additional clues (click to enlarge).

S&P Daily Chart Courtesy of AVAFX 21 may 27

Tool #2: The Daily S&P 500 Chart With The Following Indicators

Moving both the 20 and 50 day simple moving averages (SMAs), the middle blue line and the red line, are turning down hard, suggesting strong downward momentum – a bearish sign.

Price is in the middle of the descending channel formed over the past month – no special bargains now. The 200 day SMA is at 1117 and will likely cap any upside, barring major bullish news. If the S&P can rally up to that 200 day SMA or the upper descending channel line, that price level will likely be a good point to watch for the markets to start reversing back down. If they do, you will have a good low risk entry for new short sales. By low risk, I mean that you can place a stop loss order just above these lines, ideally just a bit more than a ‘normal’ daily move up, so you don’t get shaken out by just random market movements. Anything above that means the resistance level isn’t valid and you should close a short position.

The red 50 day SMA is starting to fall towards the purple 200 day SMA. At the current rate of descent, we could get a very bearish ‘death cross’ (a falling 50 day SMA crosses below a flat or falling 200 day SMA) in 4-6 weeks, sooner if there is more panic, later if not. Barring a sudden enormously bullish event, a death cross usually means an extended downtrend.

For example, look at the below daily chart of the EURUSD (click to enlarge). The red line is the 50 day SMA, and the purple one is the 200 day SMA.

EURUSD Daily Chart Courtesy of AVAFX 23may27

Note how once the 50 day SMA crossed below the 200 day SMA on January 28th, the pair was never even able to sustain a move above its 50 day SMA.

Thus the death cross will be your final confirmation to trade with the downtrend in risk assets and uptrend in safe havens like the USD or AAA government bonds, preferably from the US or Canada.

Tool # 3: Using Inter-Market Analysis To Predict Stock Pullbacks, Risk Asset Divergences From the S&P 500

This one demands some more homework, but being able to forecast stock market reversals is more useful than confirming them. It isn’t hard, but you need to know what the risk assets are – those that are supposed to be moving in the same direction as stocks, and what are the safe haven assets – those that move in the opposite direction of stocks. You then need to watch these risk assets (those that follow the same overall direction of stocks) like commodities and risk currencies (AUD, NZD, CAD, EUR), and safe haven assets ( those that move in the opposite direction of stocks) like bonds, the JPY and USD.

When enough risk assets stop going in the same direction as stocks, or safe haven assets start moving in the same direction as equities, then a reversal in risk assets is likely. When a number of risk assets like oil or the AUD start to fall, or safe haven assets like Treasury bills or the USD start to rise in price, you know to be alert that stocks are due for a drop. When the opposite happens, stocks are due for a bounce. Watch for a sustained rebound in commodities and risk currencies (the AUD, NZD, CAD) for a sign of an extended rebound in stocks.

For example, if you look at charts 2 and 3 below, you’ll notice that the EUR/USD, which moves in the same direction as the S&P 500, turned down December 4th 2009 nearly 7 weeks before the S&P. That wasn’t enough of an indicator by itself, but the evidence started to add up fast if you looked at the following daily charts and saw:

  • The EURJPY, one of the most reliable risk barometers, had already fallen into a downtrend in mid November 2009
  • Gold had begun its downtrend December 3rd 2009
  • Crude oil on January 10th
  • The AUDJPY January 12th 2010
  • The AUDUSD January 15th

Thus when stocks began to fall around January 20th 2010, traders familiar with basic inter-market analysis had lots of clues telling them to get out of long stock positions.

For the time being, do not use gold, because it is neither a risk nor safe haven asset. Rather it moves on specific kinds of fear about the value of currency, and this can occur when stocks are rising or falling. See The Must Know Truth About Gold for details.

More on the details of inter-market analysis for forecasting stock market movements in a coming article. Note that like any technical tool, inter-market analysis isn’t foolproof. The above did not do a great job of calling the market pullback that began April 26th. That’s not surprising given the unusual cause of the current pullback, the EU debt crisis and its rapid unraveling as markets lost confidence that the EU could be fixed.

Disclosure: Long some long term income stocks, and long term USD and CAD positions.