In my last several articles, I have been outlining the case that the rise since the March 2009 lows has been corrective in nature. From a technical point of view, price action, volume, and breadth were all consistent with a correction rather than a primary trend. From a fundamental point of view, stocks are historically very expensive on a valuation basis. In terms of sentiment, a cavalier bullish attitude and a complacency towards risk was wide spread according to several measures. It is rare to see all of these events reaching a pinnacle together, the implications of which are exceedingly bearish. Bulls now hold on to backward looking positive economic data even though these types of data points are woefully inadequate in forecasting abrupt market turns, and failed to signal any warning before the massive selling during the first round of the credit crisis. Meanwhile more predictive economic indicators show a reversal and decline in consumer spending, the fulcrum of US GDP.
A Correction or Something More?
The market topped out on April 26, 2010, and has much further to fall before we can make any “bottom” calls. Sentiment and prices are simply much too high, and investors are simply far too bullish on risky assets. This topping process is remarkably similar to the top in 2007; you can literally take the headlines of 2007 regarding subprime being contained and the economy doing well and just supplant subprime with sovereign debt. The difference this time is that the economy and financial system are much more vulnerable. In the first round of the credit crisis individuals and systematically important institutions were at risk, now entire countries and governments are at risk of a credit liquidity drying up.
The Economy Is Not Recovering: The Daily Growth Index
In previous articles I have referenced the Daily Growth Index (DGI), which has shown that consumer activity has continue to decline. As expected the BEA’s GDP reading seems to be trailing the CMI’s leading indicator.
click to enlarge images
Chart 1: Daily Growth Index
Chart courtesy of Consumer Metrics Institute, edited by myself.
Note the red circled area; according to the DGI we can expect a flat to negative -2% annual growth rate for next quarter’s GDP reading. It seems the dreaded double dip has already begun. I would also note the difference between this contraction and the start of the contraction in 2007. During the start of the recession in 2007 there was a slow roll over in consumer spending. In this contraction consumer spending has just been falling off a cliff, and this implies that the upcoming contraction in GDP and earnings will be extremely sharp and catch most by surprise. It makes sense that the second round of the credit crisis would unfold much more quickly as everyone is already dealing with losses, whether it be in a bank’s portfolio, a consumer’s retirement accounts, or a home owner’s underwater mortgage loans. Look for disappointing results in the third and fourth quarter in terms of earnings, revenues, and general economic data.
I would note that the CMI has noted one area of transactions that are still strong and showing growth, so it is not all doom and gloom. Areas that are seeing a rapid rise are services regarding debt and mortgage default consultations.
The Signs of a Turn Lower
Since the intermediate term bottom in March 2009, the market has experienced two corrections, both relatively short lived, and retracing about 7-8%. With this most recent turn lower, most seem to be anticipating a similar move, so the question is what kinds of evidence should we see if this is the start of a turn lower (rather than a correction)? Typically, during a turn we see prices rising, but on decisively less volume, breadth and momentum. Even as internals deteriorate, sentiment rises as hopes and expectations elevate. There are usually several inter-market divergence amongst individual stocks and other risk assets; as things “stop working” money bounces around looking for something that goes up, creating a volatile, choppy environment. In terms of price action, tops often sport reversal patterns. While at any given time one might see one of these red flags, the message should not be ignored if one sees many or all of these occurring at once, while stock valuations are high.
Signs of a Turn: Price Action
What is a complacent market? One that completely writes off and ignores the largest intraday point drop in the history of the Dow. Despite having no explanation pundits have completely forgotten about the “flash crash.” What does that say about the strength of our financial markets if the Dow can drop 1,000 points in 10 minutes?
Chart 2: SPY – Daily Periods
Despite having several days of huge rallies, the market still sits at the near recent lows at prices established in August of 2009. In a little over a month the market has erased almost a year in upward progress. This means that 11 months worth of buyers who finally felt comfortable enough to start taking risks, are now underwater and psychologically trapped in their positions. Prices have broken down past several levels of potential support including the trend line from the March 2009 low, the 50 day moving average, and now the 200 day moving average. Typically during these kinds of transition phases, bulls will try and present “strong” fundamental arguments focusing on backward looking economic data. This reminds me of the larger picture; despite two of the largest declines in history, several bursting bubbles, record volatility and the fact that stocks have made no net progress in ten years, yet everyone is still completely enamored with the stock market.
Signs of a Turn: Quality Disconnect
A few months ago I noted how most of the daily trading volume was in “basically bankrupt” names, Citi, Fannie, Freddie, etc. While some took acceptation to this, I continue to view this as a major problem going forward. To me this says the psychology of the market is that of a busted gambler, doubling down after losing big in hopes of just getting back to even. To better illustrate, let us look at the HSKAX. The HSKAX is a market neutral fund, meaning they try to have equal long and short positions. They try and outperform the market by buying quality stocks and shorting the dogs.
Chart 3 – HSKAX Market Neutral Fund
We can see that the fund has severely underperformed the market despite the huge rally in the broad market. What we can infer from this is that the stocks with quality balance sheets have been largely passed over for long shots. People are instead looking at charts like Citi, and thinking how rich they will be “if it ever gets back there.”
Signs of a Turn: Head and Shoulders Reversal Pattern
The SPY price chart sports a head and shoulders reversal pattern. Referring to Edwards & Magee, the Bible of stock trend analysis, the key points to this pattern include: a) a rally at the end of a long trend constituting the left shoulder, b) a minor correction, c) another rally surpassing left shoulder, forming the head, d) another reaction taking prices back near the level of the first reaction, e) one final rally occurring on lower volume and breadth, the right shoulder, f) a sell off that breaks the neckline, or the line connecting the lows of the first two reactions. Edwards, Magee also note that if volume falls on each rally leg, one should add an extra “red tab” on the chart. Another “red tab” should be added if prices fall beneath the lows of the first reaction.
Chart 4: Head and Shoulders
We can see here that the pattern is complete now that prices have declined beneath the neck line. The initial price target for this pattern is the distance from the head to the neck line, so expect the SPY to decline to near the low $80's in the upcoming weeks. A corresponding target on the S&P index would be a level near the low 800's and 8,00 give or take on the Dow.
Signs of a Turn: Golden Section
Looking at a weekly chart, other interesting price phenomenon consistent with a corrective structure ending. Charles Dow, R.N Elliot, and many other notable market observers noted how corrections tended to end near Fibonacci Ratios. In this case the correction appears to have ended exactly at 61.8% retracement level, creating a Golden Section.
Chart 5: SPY – Weekly
On a weekly basis, we can clearly observe the declining momentum and the type of divergence that occurs at turning points. We can also observe there has been a cross to the negative side for the first time since the top in 2007.
Signs of a Turn: Market Breadth
In previous articles I discussed various measures of market breadth and their possible implications. I noted that the ratio of declining stocks to advancing stocks, as well as the ratio of down volume to up volume had been growing and growing, indicating that even while prices were still increasing, below the surface there was some serious selling pressure building. You may remember a chart I posted several months ago showing the increasing trend of down volume/up volume; at the time I stated that with a with a incredibly strong bearish reading of 35:1 that selling pressure was intensifying and the uptrend was in serious trouble. At the time I thought that was impressive, but that was then and this is now.
Chart 6: NYSE Down Volume to Up Volume Ratio
Since then stocks have easily surpassed 35:1 with an eye popping 120:1 down side day. This means that for every share bought, over a 120 were being sold, and selling was 5 times more intense than in early June during the “flash crash.”
And If That Wasn’t Enough: Death Cross Is Imminent
Another sign of a longer term bear phase is the crossing of the 50 day moving average below the 200 day moving average, affectionately known as the “Black Cross” or “Death Cross.” Studies have shown that this is a statistically significant signal and reliable indication of the trend to come.
Chart 7- SPY – Daily
We can see here that the S&P 500 has completed a Death Cross, indicating that the long term trend is now down. I believe this signal has added weight because it is occurring simultaneously with cross in several other markets; European stock indices, Asian stock indices, the NYSE composite, junk bonds etc. Virtually all “Risk On” investment vehicles. While some may dispute the reliability of moving average signals, what we can say for sure is that its implications are bearish, and the fact that it is occurring alongside a turn in consumer activity, fractured bearish price action, a completed reversal pattern, Fibonacci resistance, and strong downside breadth, elicits a very bearish collage.
Disclosure: Author is long SPY puts.