Revisit #3 To 'The Stock Market Correction Is Underway'

| About: SPDR S&P (SPY)

Summary

In my article dated January 10th in this series. I stated that the SPY would drop 10% from its then current price of 192 to 173.

After a bizarre one-day rally on Friday, January 22nd drove the SPY up five points to near 191. It dropped three points to 188 on the following Monday.

One week later, on the 29th of January, officials in Japan announced that they would pursue a negative interest rate policy to offset deflationary pressures on that economy.

That didn't make sense. They already dug Japan into a hole with QE based on steroids. Instead of quitting digging, they are going to dig some more at a faster pace!

Stock markets around the world responded bullishly and prices rose sharply; the SPY rose three points (2.4%) to 193.7.

My opinion is as follows: the aforementioned news may be short-term bullish for the stock market, but longer term (beginning within a couple weeks), it could become very bearish.

Introduction

In this article, I will comment on the Japan's negative interest rate policy and update readers about the feedback that I got from the "Sobon Oscillator." If anything can keep track of what is going on with fast-moving stock market developments, the oscillator can. So, after making some routine statements, I will cut to the quick and see what I can do to shed light on the major issues extant.

All of the statistical data used in this article was processed in my workbook. And all of the price and trading volume data fed into the workbook was downloaded from Yahoo Finance. I make extensive use of index numbers in the analysis that I do. So, wherever you see multiple price lines on a chart or bars where trading volume data is shown, the performance of one line or bar is fully comparable to any other such item relating to stocks or ETFs.

There is much to be considered about the performance of the stock market, so I will be as brief as I can in some sections of this article to make space in other sections where detailed commentary is required.

Regarding Developments in Japan

In my article posted on the 19th of January, I wrote the paragraph that follows:

"When Ben Bernanke began and then continued to use his unproven QE theory, he gave the idea respectability and it gained traction with central bankers around the world. The idea was adopted by many of them who followed his lead. At the present time, there isn't one really strong economy among all the industrialized nations. We may even have an economic international house of cards on our hands at this time. The chart shows" (that chart is not shown in this article) "what has been going on in foreign stock markets. It includes Australia, Canada, Germany, China, Japan, Spain, England and France. The economies in all of those countries are weaker than that of the United States. Japan is a country poor in natural resources and it has an aging population. It also has to export goods to pay for its much needed imports. Officials there have been using QE policies based on steroids. And the imbalances QE caused in the United States are similarly being caused in Japan. Its stock market and those in the other countries are weaker than ours (as measured by the performance of the SPY). There is an "unquantifiable risk" that trouble could occur during nearby years which may be beyond anything we can reasonably imagine at this time. And investors should take that into consideration." (Emphasis added)

The chart referred to in that paragraph showed that eight foreign stock markets were making new lows, and all of them were weaker than the SPY. In recent days, they followed the SPY higher.

Adam Whitehead is one of the contributors to Seeking Alpha that I follow regularly. He has considerable expertise when it comes to foreign economies. I exchanged comments with Adam and asked him, "If Japan was the first domino to fall among the weak economies around the world, which ones would follow? His reply was terse: "The European countries and then the United States." And on Friday, the 29th of January, his new and comprehensive article about Japan was posted on Seeking Alpha. Sobering although it may be, I agree with Adam's conclusion that if Japan was the first domino to fall, European countries and the United States could follow.

In his book titled "The Great Crash" written by John Kenneth Galbraith in the 1930s, he made a statement about the consequences suffered after the stock market crash in 1929. The market did not find a bottom until 1932 and after that the recovery was painfully slow. When the Fed tried to remove its stimulant in 1936, the economy reacted negatively. And, it didn't really recover until the beginning of World War II. And the stock market did not get back to its 1929 level until after the war ended. Galbraith's terse statement about the crash was as follows: "Few people escaped its consequences because few people were meant to escape them." Those were sobering words that led me to realize that "things only endure according to the amount of virtue they contain."

In the first article I wrote in this series, I included the paragraph which follows. It is long, and because of the important issue it addresses, if the reader reads it and nothing else that follows that would be fine with me, because he might get an idea of the magnitude of the potential downside risks that will be involved in the market during the near- to longer-term future. At the present time, Mr. Market appears to be oblivious to such risks:

"With the free-market economic processes being "corrupted" by the Fed's wishful-thinking policies, there was little need for corporations to launch capital expansion programs despite low interest rates because prospective demand growth was tepid, due to the fracture of secular growth trends caused by the 2007-08 financial fiasco. Besides, corporate leaders could easily boost stock prices by using profits (and/or borrowing money at low interest rates) to finance share buyback programs which (not surprisingly) increased the value of their stock options. And when financial assets are diverted from investment in capital assets, the role that the "accelerator" has as a determinant of economic growth is diminished. There was (and continues to be) high underemployment and little growth (if any) in per capita discretionary income (which is the main driver of the "multiplier"). The Fed was (and continues to be) more concerned about fighting deflation than inflation or the imbalances in the economy which it helped to create. To Wall-Street types "bad news was often considered to be good news" so they took advantage of the so-called "Fed put" and pushed stock prices higher from time to time simply because the flow of lackluster economic news gave the Fed excuses for not increasing interest rates. Things endure according to the amount of virtue they contain. And there wasn't much that was virtuous about the performance of the Fed, the do-nothing Congress or corporate America before and after the fiasco of 2007-2008. Can there be any doubt about the reasons why economic growth has been anemic? … That tells us the why the underpinnings of the economy were (and still are) weak and dependent upon the Fed for the life support... And on the basis of what is currently being talked about by Fed officials regarding their interest rate policies (with a quarter-point hike in the discount rate in December 2015 and another such "data-dependent" boost in each of the four quarters of 2016), it may be that they are finally acknowledging the fact that their policies since the end of Q1 (which did bailout the economy) were counterproductive. If the aforementioned rate increases occur, the Fed's policies might be less counterproductive than they had been, but counterproductive nevertheless because QE does not get to the root of the problem."

(Emphasis added.)

Right now, the mood on Wall Street is bullish, because the news coming out to Japan could deter the Fed from raising interest rates like it said it might do. That opinion is extremely naïve. And it shows the carpe diem attitude that the shysters on Wall Street are not focused at all on the longer-term problems looming on the horizon. The decision to resort to negative interest rates shows that (1) the Japanese economy is more of a basket case now than we might have thought it to be, and (2) that makes the weaker economies among the industrialized nations more of an international house of cards today than we might have thought them to be just a few days ago. The bearish implications of that conclusion are far more significant than the bullish spin that the Wall Street types are putting on the Fed's possible deferral of possible interest rate hikes!

I will end my discussion of this topic by repeating what was stated above, because its message is worth repeating: "There is an "unquantifiable risk" that trouble could occur during nearby years which may be beyond anything we can reasonably imagine at this time. But, instead of nearby years, in might be as soon as this year? Seeing what the officials in Japan did, Mario Draghi may do something just as stupid in Europe. It shouldn't take long for the Japanese officials to realize that they are making a bad situation even worse. It is not a question of "what" will happen. It is now a question of "when" will it happen. And, investors should take that into consideration."

Regarding the Recent Performance of the SPY and Related Indexes

The first chart shows the performance of six well-known ETFs during the last six months, and also my index of 450 stocks, which I call the S450 (the blue line on the chart). It is an equal-weighted index that correlates well with S&P's equal-weighted index (NYSEARCA:RSP); it is the pink line on the chart. All of the other indexes shown are capitalization-weighted, and they include the S&P 500 index (NYSEARCA: SPY), the Nasdaq 100 (NASDAQ:QQQ), the Russell 2000 (NYSEARCA: IWM), the S&P 100 index (^OEX) and the S&P 400 mid-caps (NYSEARCA: MDY).

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As can be seen towards the middle of the chart, all of these barometers made lows in August at about the same time, and all of those lows were tested some 25 days later. On the right side of the chart, you can see that the IWM, MDY and S450 made new lows in recent days. The SPY and the QQQ are struggling to stay above their previous lows. And the ^OEX outperformed the SPY for the last 60 days because of its greater-than-average weightings. I will have more to say about most of these indexes later on in this article.

Don't be fooled by the surge shown for the QQQ during recent months (the black line on the next chart). That was not caused by a plurality of its 100 stocks doing well. No.

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The surge was caused entirely by strength in only six heavily weighted stocks: Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), Intel (NASDAQ:INTC), the "A" and "C" classes of Google (NASDAQ:GOOGL) and (NASDAQ:GOOG) and Starbucks (NASDAQ:SBUX). Had it not been for them, the QQQ would not have exceed its high made about 100 days ago. Also much of the strength that you saw in the SPY, QQQ and IWM indexes in recent days was caused by "the double-counting effect" of the larger cap stocks in these weighted indexes.

And don't be fooled by what you may have seen happening in the SPY on Thursday, 28th January. The SPY was up 0.54%, while the RSP was only up 0.16%. And the ^OEX (100 large-caps) was up 0.93%, while the MDY (400 mid-caps) was only up 0.04%. This pattern of outperformance by the large caps occurred frequently during recent months. When the equal-weighted indexes consistently underperform their weighted counterparts and the mid-caps underperform the large caps, that shows speculative interest in the market is waning, and as such, has bearish implications for the market.

And since we are dealing with the performance of stocks in the market, we may as well take a look at the chart below, which shows the performance of 24 industry groups included in my workbook. Much of the price action shown here is difficult to read, because many of the price lines are bunched up and/or overlapping. That should not be a problem, because the sole purpose of this chart is to show the few groups that are the strongest or the weakest performers, and not to highlight the many bunched in the middle. The 50 level (shown by the yellow hashed line) is the dividing line for showing which groups are priced above or below their respective levels during a 22-day base period existing six months ago. At the present time, none of these groups is priced above that level. That is an indication that the top of the market is behind us. And if so, the bottom must be ahead of us. The numbers attached to the names of the industry in the legend list the number of stocks included in that group.

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The RSP is the bold black line on the chart. Like all of the groups, it is an unweighted index, so the chart accurately shows which of the groups are outperforming or underperforming the market because of the apples-to-apples comparisons. With a capitalization-weighted index such as the SPY, that would not be true.

Documentation by the "Sobon Oscillator"

So now let's see if I can do my best imitation of Sherlock Holmes and shed light on the stock market's never-ending mystery: "Where the hell is it going to go?" But instead of using Dr. Watson as my foil to present my case, I will make reference to the "Sobon Oscillator" (my version of a crystal ball that is never cloudy and always does what it was designed to do rather well). And (1) I'll explain the salient features of sequential short-run time spans relating to the stock market's performance during recent weeks and (2) guess what such may signal for the near-term future as the market trends toward its ill-defined goal, which we can only guess at.

Perspective is needed to provide meaning about where the stock market is at this point in time. But I am not going to go back to the First Book of Genesis to provide that. Let's start by going back to the end of the holiday and tax-loss selling seasons in 2015.

And to facilitate understanding of the tricky analysis that follows, let's quickly review what the many variables shown in the four panels on the chart are all about:

(1) The first (top) panel shows the daily price change from the previous day for the SPY, RSP and the S&P 100 index (^OEX). For perspective, it also shows such data for the Nasdaq 100 index ((NASDAQ:QQQ)), the Russell 2000 ((NYSEARCA:IWM)), my index of 450 stocks (which I call the S450) and my index of 45 technology stocks (which I call the Teck45).

(2) The second panel shows the volume of trading in the SPY, QQQ and IWM ETFs as well as the S450 and Teck45 indexes. The higher the volumes, the greater are the convictions about what investors (speculators?) think they are doing in the market.

(3) The third panel shows breadth indicators for stocks making "highs or lows" in the S450 index, (which I use as a proxy for the RSP, with which it correlates highly) and also the SPY (with a lower correlation due entirely to the SPY's capitalization weightings). The time spans for the eight series of highs or lows range from about one week to six months, as the shorter ones (referred to as S1, S2, S3 and S4) are lead indicators for the longer ones (the L5, L6, L7 and L8). So they help lead the market to where it will evolve over the longer term as it makes "higher highs and higher lows" (with that being bullish) or, perhaps, "lower highs and lower lows (and that being bearish)."

And (4) the fourth (bottom) panel shows breadth indicators for the "moving averages" for the 450 stocks. The time spans for the seven moving averages range from about one week to six months. The shorter-term breadth indicators (referred to as S1, S2 and S3) are lead indicators for the longer ones (the L4, L5, L6, L7 and L8), since they, too, must help to lead the market to wherever it is trending (be it up, down or sideways).

Since the longer-run trend of the stock market must be a "sum of the parts" that reflect what happened during sequential short-run intervals, let's consider what happened during the three short-run time periods framed by the different colored boxes on the chart. The unframed section on the right side of the chart shows data relating to the week ending Friday, 29th January. It bring us to the cutting edge of the future.

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The pink box frames much of what happened in the market during the final days of 2015. What there was of the "Santa Claus" rally didn't amount to much, and may have been trumped by tax-loss selling considerations. The oscillator ended the year showing weakness in all of the short-term breadth indicators, but that could have been caused by year-end tax-loss selling pressure. So I waited a few days to see what the investment community did as trading resumed in January, before trying to determine the significance of that weakness.

On Monday, 4th January (the white box), the market declined sharply, so it was probable that the selling pressure in the market during the final trading days in December was not due entirely to year-end tax-loss selling. And with all of the breadth indicators declining like they did on heavy volume, further weakness was "signaled" by the oscillator for the market during the near-term future. Why? Consider that which follows as I start with Monday and also deal with action in the market for the entire week.

(1) The price change data for each and all of the indexes shown in the first (top) panel declined by more than 1.0%. And the volume of trading in each of them was twice the daily norm, as shown by the bars and dotted lines in the second panel. The same thing can be said for the three days ending with Friday, 8th January. So the selling being done was being done with conviction.

(2) The breadth indicators for the moving averages (the bottom panel) were weak at the beginning of the week, and they just kept getting weaker right up to and including Friday, when the S1 breadth indicator (it must lead the others) showed a reading of -92% for the S1, which is the most sensitive of these indicators, down to -62% for the L8, which is the least sensitive. So obviously, the stock market was weak, and weakening, and there was nothing to indicate a change was likely anytime soon.

And (3) the breadth indicators for the highs or lows (the third panel) were also weak at the beginning of the week, and they, too, got weaker (especially on Thursday and Friday) when the S1, S2, S3 and S4 breadth indicators gave negative readings ranging from -81% for the S1 to -74% for the S4. The longer-term breadth indicators for the highs and lows were also following suit, and they ranged from -69% for the L1 to -30% for the L4 as they were being led lower. This confirmed the conclusion that the general market was weak, and weakening, and there was nothing to indicate a change was coming.

The only conclusion that I could draw from what started on Monday and continued through Friday, as shown by the oscillator, is that the momentum in the market was broad based and decidedly bearish. And, therefore, it would probably go lower during the near-term future. How low? The SPY is widely regarded as the benchmark indicator for the market. My guess was that it could drop another 10% from its then current price of 192. That would take the SPY down to 173. And until I revise my target price for the SPY, the guesstimate of the 10% drop to 173 will remain in effect.

That brings us to Monday, 11th January (the white box). What happened with the breadth and other indicators in this box was significant, but I am not going to go into a detailed explanation of such. They were weak, and just got weaker during this period. I will make a long story short by just saying the SPY dropped from 192 to 188.

That brings us to Monday, 18th January (the blue box). In retrospect, it was abundantly clear that the sharp increase in stock prices on Friday, 22nd January was unpredictable because it was not forecastable (except by insiders who may have known what the consequences of their actions might be). Why? Consider that which follows:

(1) After the market closed on Friday (the blue box), I updated my workbook, like I normally do at that time each day. And when I looked at the changes made to the 24 breadth and other indicators included in the oscillator, it took me less than a minute to know that something of a suspicious nature occurred, and it didn't pass my "smell test." Analysis of the changes made in all of the indicators requires me to have an explanation for every change that occurs each day. So, it was only natural for me to search for an answer to the problem I detected. And after further investigation, I was sure that we would not get a bullish performance in the market on Monday, 25th January. Why? Read that which follows:

(2) Friday's moderate volumes of trading in the SPY, QQQ and IWM didn't correlate with the large price gains in those indexes. The volume of trading relating to my S450 index did correlate with its price change because of the way I use index numbers to accomplish that feat. So, I suspected that the trading volumes for the SPY, QQQ, and IWM should have been much greater than they actually were.

(3) With regard to the SPY, QQQ and the IWM, the trading volumes on Wednesday and Thursday were much higher than they were on Friday. However, the price change data for those days showed modest gains, or even losses. But on Thursday, each of the averages showed a strong price and volume gain during the final hour of trading. Considering that and seeing what happened to the prices of those ETFs on Friday, the only logical explanation I could think of was that during their strong close on Thursday, (A) a flood of buy orders poured in to the relevant ETFs. But the managers of those ETFs did not get much chance to deploy all of the incoming money on Thursday. And then they had to deploy the cash with at-the-market orders the first thing on Friday when trading resumed. And (B) the buyers of all those ETF shares may have known that would happen, so they may have also bought the futures before trading began on Friday and driven them higher. That might be considered "front-running," which is illegal. But it wouldn't be illegal if they didn't get caught. Was my conclusion absurd? Maybe it was and maybe it wasn't. But it turned out to be the correct conclusion.

Nobody will ever convince me that there wasn't some hanky-panky going on. My explanation fits perfectly with what happened on Friday - first with strength in the futures on Friday, and then with the daily trading volumes, coupled with the daily price performances of these ETF from Wednesday through Friday. Much of that sequence of events could not have happened accidentally, because many hundreds of millions of dollars were in play.

(4) At about 7:00 pm on Friday, I posted a comment to my previous article (Revisit #2 in this series), explaining why the market would be flat to down on Monday, 25th January. And I exchange comments with the readers who responded to it. I also sent messages to two astute contributors to Seeking Alpha with whom I have a good rapport, Eric Parnell and Lawrence Fuller. If you (the reader) are not a follower of the articles these gentlemen write, I suggest that you take a look at their articles, because they are always worth reading.

(5) If I was right in drawing the conclusion that I did on Friday evening, on Monday, 25th January there would be no repeat carry-over effect during the start of trading. Therefore, no buy-at-the-market orders from the ETF managers to start the day. With stocks being deliberately pushed higher on Friday, I thought there was a better-than-50% chance that the market would be flat to down. And during Monday, the market sold off sharply. The SPY was up 3.8 points (2.1%) on Friday and down 2.9 points (1.5%) on Monday. The QQQ and the IWM showed larger gains on Friday and also larger declines on Monday. Case closed.

During the week ending Friday, 29th January (this is the section of the chart on the right of the chart that is not framed by a box), the market was down sharply on Monday, as I speculated it might be. It was up on Tuesday and down on Wednesday, with the price change data and the trading volumes correlating about as they should. But then on Friday, the news out of Japan triggered the surge in buying that resulted in price gains for all of the price change indicators rising by at least three times what I call the "neutral norm," and the advance-decline for the 450 stocks in my S450 index was a lopsided 93% in favor of the advances. Considering that this was largely a one-way market movement, the volumes of trading were about right for the kinds of gains being scored in the market.

I had been targeting a drop from 192 to 173 for the SPY during the near- to longer-term future. It was headed in that direction until the bizarre price gains occurred on Friday, 22nd January. And then there came to 4% gain in the SPY on Friday, 29th January, that resulted from the surprising news that came of Japan and lifted the SPY to 193.7 on its price chart. (Some people see something like that happen, shake their heads and conclude that the stock market cannot be forecasted. But a surprising event can never be forecasted, because if it could, it wouldn't be a surprising event. Such events seldom occur. Although day-to-day prices may not be predictable with a high degree of reliability, short-term trends can be. I am not a day trader. I average less than three trades a month as I try to trade the short-term trend indicated by the oscillator.) Obviously, my guesstimate of a drop in the SPY to 173 was wrong. In my personal trading account, I had a nice gain going in a 3X leveraged and inverse ETF position I initiated a couple of weeks ago. At the present time, I have a nominal loss in that position. If the market is up again when trading resumes on Monday, 1st February, I will liquidate that position and limit the loss to 1.0%, and thereby cut my losses short.

When writing an article like this, I never tell readers what they should do in the market. I write the story according to the way I understand it. I may tell readers what I am doing when I buy or sell stocks. It is up to them to make their own personal investment decisions.

The only judge and jury that I must answer to is Mr. Market. He can be as deceptive, specious and misleading a hombre one can encounter. But he is also the unbiased arbiter of who wins or loses in the market. Whenever I am wrong, that will be made manifest, and I will sustain a loss in my personal investment account. But if I am right, I will then have tilted successfully with him and will likely show a profit from my trading activities.

I believe that the very recent bullish price action in the market is not sustainable. If and when I believe writing another updated article in this series would be the prudent thing to do, I will write it. Until then, I wish to thank the readers for taking the time to read my articles, and especially those who commented on the subjects about which I wrote. Best wishes to all.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.