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Summary

  • We note many similarities between the markets in 2011 and 2014.
  • The “buy the dip” mentality among traders is evaporating & equity indexes are breaking key levels.
  • Those who fight history are doomed to suffer the consequences.

We have been warning of froth in the markets and the risk of a substantial correction since April (Sell Stocks Into Strength). Recent market activity suggests the current pull-back may be more significant than the numerous minor pull-backs experienced since 2011. As we write, the German Dax index gapped down, breaking emphatically our key 9000 level, the U.S. S&P 500 (NYSEARCA:SPY) may test the important level of 1900, and the Russell 2000 (NYSEARCA:IWM) is edging closer to its critical Head-and-Shoulders neckline at 1084.

The equity markets may finally be experiencing the deepest correction since 2011. We believe the configuration of the decline in 2011 will be a good road map to follow. Note the many similarities between 2011 and 2014:

2011

2014

Equities rally hard for 2.5 years into a July market top.

Equities rally hard for 2.5 years into a July market top.

Volatility (VIX) makes a multi-year low in summer of 2011.

Volatility (VIX) makes a multi-year low in summer of 2014.

A market moving event affecting the interest rate market: Standard and Poor's downgrade U.S. sovereign debt from AAA to AA+

A market moving event affecting the interest rate market: Central banks arrive at inflexion point on monetary policy. Markets begin anticipating an earlier tightening in the U.S. and U.K.

Geopolitical: Riots in Athens with the threat that Greece may leave the Euro-Zone and jeopardize the Currency Union.

Geopolitical: Civil war in Ukraine with threat that Russian troops may come across the border and intervene.

Deterioration in the relative performance of Russell 2000 small caps relative to large caps in the run-up to the market top.

Deterioration in the relative performance of Russell 2000 small caps relative to large caps in the run-up to the market top.

U.S. 10-year, U.K. Gilts and German Bund yields in progressively accelerating down-trend in the weeks prior to the equity correction.

U.S. 10-year, U.K. Gilts and German Bund yields in progressively accelerating down-trend in the weeks prior to the equity correction.

A down-trending U.S. Dollar Index (DXY) reverses up in 2011.

A down-trending U.S. Dollar Index (DXY) reverses up in 2014.

Among our seven indicators, we note that:

The stock/bond ratio violated the 200-day moving average for the first time since 2012:

(click to enlarge)

The S&P 500 Advance-Decline Line has reversed down and is threatening its 100-day moving average:

(click to enlarge)

The WMA U.S. Market Risk Indicator and the WMA Europe Market Risk Indicator have been deteriorating since early July. Europe is moving to Risk-Off.

Sentiment is souring as we see a reversal down from the Extreme Optimism. The WMA Market Sentiment Indicator shows growing pessimism….as we have not seen since 2011.

Long rates are falling. We are more concerned by rising long rates (our 6th indicator on the list), notably a 10-year U.S. yield above 3%. Current falling rates are the result of a deterioration in the risk environment. Falling rates are obviously not a result of the strong U.S. macroeconomic data. On one hand, falling short rates may be consistent with a cyclical bear, within the secular bull, due to de-risking. On the other hand, rising long rates (which weigh on firms who use debt in their capital structures and make bonds more attractive) would signal the possible beginning of a new secular bear.

Finally, the VIX volatility index has moved up from 10.35 in July over 17 this week.

Conclusion

Conditions are ripe for a 2011-style bull market correction. Similar drivers for the 2011 correction are again present today. Key levels on many important indexes are being broken, and we see the "buy the dip" mentality among traders evaporating. August and September have regularly been difficult months for equities - don't fight the seasonality.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Road Map 2011