Let's Revisit: 'That Was Awful, But Was It The Start Of A Bear Market?'

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Includes: DIA, IWM, QQQ, SPY
by: ANG Traders

Summary

Our article about the terrible first trading week of the year generated a comment from a reader that we should investigate the sentiment indicators over a longer time frame.

We looked back 20 years and found conformation of our previous patterns, plus a new pattern that was not visible at the shorter time frame.

The balance of probability still points to the market being in a correction, but not a new bear market.

In our article, "That Was Awful, But Was It The Start Of A Bear Market?", we dealt with the meaning of having the first trading week of 2016 being the worst in history. We suggested that anything anyone might predict about the future has to be viewed through the lens of probability, and these probabilities can only come from historical patterns.

We mentioned the valuation indicators, PE and Book Value, but emphasized the psychological (sentiment) indicators since we see the broad market as a manifestation of Human crowd behavior (with the caveat that HFT may distort recent patterns).

We received what we think was fair criticism about the time domain being too short in our historical search for patterns, which then makes our probability estimates less robust. In response to this suggestion, we have increased the size of our historical pattern search to 20 years.

The graph below shows eight points in time when the AAII bullish sentiment was less than 22% bullish (marked in blue). The S&P 500, rose in seven of the eight, with the eighth being the present time we are in and ,therefore, not yet part of a pattern. Even the January and February 2008 low bullish readings produced a market rally that lasted three months before collapsing--while at a bullish reading of 53%!

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Again, we emphasize that nobody has any knowledge of what is going to happen, but this historical pattern favors at least a medium term rally.

The graph below shows the Rydex Bull Funds indicator versus the S&P 500, and we can see two patterns. The first is the same one that was visible in the recent time frame; low relative Rydex bull readings corresponds to local minima on the SPX. Notice that this pattern holds even during bear markets.

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The second pattern, which was not visible in the shorter time frame, is the periods of divergence (red) and convergence (green) between the Rydex and the SPX. The bear markets of 2000 and 2008 both occurred after a period of divergence (red) between the Rydex and the SPX. The present situation shows that the Rydex and the SPX are still in convergence which implies a low probability of a bear market.

Let's return to the present situation to see how the Rydex and SPX are behaving. The graph below shows that neither the Rydex or the SPX have formed a local minima, so we can expect some further downward pricing; there are still more bulls that need to give up.

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In conclusion, by looking further into past history, we were able to discern a pattern of convergence/divergence between the Rydex Bull Funds and the SPX that is not evident in shorter time frames, and this pattern seems to reinforce our view that the balance of probabilities points to a correction, nasty perhaps, but not a bear market turn.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.