Breakout or Bull Trap?

| About: SPDR S&P (SPY)

There is a strong confluence of data aligned to the downside, they are highly suggestive the market is ripe for a large correction. In my previous article, I expected weakness throughout August and September. August was one of the worst in recent history, but since then September has erased those losses... for now. However, starting immediately, there is a strong possibility that the market is about to turn lower and erase all the gains made in September and then some.

It’s the Economy Stupid: Part Deux
A data series I have been following regularly, the Consumer Metrics Institute’s Daily Growth Index (DGI), has continually shown deteriorating underlying conditions. Mainstream economic analysts are currently not worried, but I am. I think they are mistaking an inventory restocking cycle and a rebound in record pessimism recorded in early 2009 for a cyclical recovery. But the DGI shows a clear contraction in consumer behavior.

Chart 1 – Daily Growth Index, Courtesy of the Consumer Metrics Institute, edited by myself.

click to enlarge

As usually, the BEA is way behind, showing almost 2% growth in the previous quarter. The DGI however is showing another drop. Last month when I presented this chart, the DGI was showing a -4% contraction rate. That has since gotten worse and is now showing almost a -6% contraction rate. The trend here is clearly down. Since such a large portion of the US economic activity is derived and supported by consumption, this chart plain and simple spells doom for the US economy. Expect future GDP readings to turn negative.

Sentiment versus Reality:
The economy is clearly contracting but sentiment is flying sky high, a condition that can only end one way, very badly. Three weeks ago, the American Association of Individual Investors (AAII) released their weekly sentiment survey, it showed there were only 20% bulls, a contrarian bullish signal that media pundits quickly jumped all over. However, now that the signal has reversed, the mainstream media has barely reported the extremely bearish contrarian signal. In fact, it has been celebrated by some as a bullish signal.

Chart 2 - Weekly AAII sentiment survey, Courtesy of AAII

First, note that the percentage of bulls is well above the historical average, and the percentage of bears is well below. Second, note that bullish respondents have sky rocketed; it is extremely rare to see the percentage of bulls over 50%, in fact, this is the highest reading all year. The last time bulls reached 50% was in late December, early January, right before the Dow lost over 1,000 points rapidly in the next two weeks. The current readings are also more extreme than the readings in April when the market put in its high (48.5% Bulls, 29.7% Bears).

Chart 3 - Cash Levels at Mutual Funds
Courtesy of:

Mutual fund managers don’t seem to be immune to the spreading optimism either, in fact they recently reported the lowest levels of cash ever at 3.4%. There is no long term buying power left to push prices significantly higher. Similar levels of cash have caused crashes of 50%, I suspect this time will be no different. Furthermore, at previous troughs in cash, they occurred after long rallies; this time, the market has been range bound of almost a year. If we break down from this range, as I suspect, Mutual funds will have no capital gains to fund redemptions, and this could cause a death spiral effect as they sell positions to fund redemptions, which causes lower prices, which cause more redemptions, etc.

Option speculators are also getting back into the action.
Chart 4 – Put Call Ratio

Looking at the total put call ratio, we can see that those gambling through options have also returned to their most recent levels of optimism. What is interesting is that while the market has been rallying, options gamblers were consistently buying puts in disbelief all the way to the top. Now, suddenly, they believe the opposite, that the market will break out to higher levels. On the other end of the spectrum, large professional speculators according to the most recent Commitment of Traders report, have been selling their long positions in the S&P E-mini, and this week that trend has continued, increasing their net short position. On top of that, during these last two weeks insiders used the rally to sell shares at an astonishing pace, outpacing buyers by a margin of 650:1 two weeks ago, and 290:1 this week. So if you are buying at these levels, know that the smart money as well as insiders are betting in the opposite direction.

To me this is so striking, the difference between the real economy and investor expectations. In a newly released report, there has been a record set in terms of Americans living in poverty. The DGI shows a contraction that will most likely be more severe than the 2008 contraction. Investors, on the other hand, expect nothing but clear sailing and for stocks to soar. All bearish signals are forgotten with any rally. The 50/200 DMA death cross, the cluster of Hindenburg omens, the obvious turn in the economy… all forgotten with just a few days of rallies. In a year from now investors will look at these obvious signals and wonder what they were thinking.

The Stock Market:
Patterns, indicators, volume, and breadth all paint a consistent picture of a top forming

Chart 5 –NYSE Composite vs McClellan Oscillator and Summation Index

Just as everyone is now convinced the market will break out to the upside, measures of market breadth have reached overbought levels, leaving the market vulnerable to a correction. Furthermore, the McClellan Oscillator as well as the summation index shows a bearish divergence, indicating that this recent rally is not as internally strong as the previous rally. So to recap, market participants are more convinced than ever that this time, the market will break out higher, however, the internals of the market show that this recent rally is actually internally weaker than the previous one.

Another useful tool is the Elliott wave model, which can be extremely useful in tracking the market trend, determining targets, and possible turns. I find it so incredibly ironic that today, as we approach significant Fibonacci resistance, and what can be interpreted as a near complete and terminal Elliott pattern, the NBER is saying the recession is officially and finally over.

Chart 6 - SPY

First, the market has reached a strong potential stopping area; the area between the 4th wave extreme and the 61.8% Fibonacci retracement level. I would consider the upper range of the stopping area near 116, at which point wave (a) equals wave (c). The numbers over each bar in wave (c) represent the TD-Sequential indicator which shows a completed TD-Sell Setup. Below, momentum is clearly in the overbought range. I’ve drawn a white line showing that this is in fact the highest reading going all the way back to April 15th, seven days before the April high, and 14 days before the “flash crash.”

Economists, the NBER, and investors seem convinced that the economy and stock market are set to go higher. Ironically, this is one of the best reasons to be bearish. The market tends to do whatever will cause the most pain to the most people, in this case, that would be to start another leg down immediately. The direction of the economy, sentiment, breadth, volume, indicators, and price patterns are all aligned, and the collage is a bearish picture.

Disclosure: Long SPY Puts.