Revisit #5 To 'The Stock Market Correction Is Underway'

| About: SPDR S&P (SPY)

Summary

When the salient facts upon which I base my investment decisions change, I must compensate and change my decisions accordingly.

It usually takes a minimum of two trading days for the “Sobon Oscillator” to document a probable directional change in the market’s short- to longer-term trend.

During the three-day period ending on Wednesday (2-17-2016), the oscillator indicated that a "sea change" event occurred: the laggard small- and mid-cap stocks bounced and outperformed the large caps.

Conclusion: the weaker stocks during recent months may have found bottoms on their price charts and also showed strength relative to the large caps. That was bullish, at least temporarily.

Revisit #5 to "The Stock Market Correction Is Underway"

"A foolish consistency is the hobgoblin of little minds." - Ralph Waldo Emerson in his essay called "Self-Reliance," a book that had a profound influence upon the way I lived my life.

Introduction:

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.

This will be a shorter article than the five which preceded it in this series. In Revisit #4, while writing about the purpose and limitations of my oscillator, I stated that which follows:

"Most of the time my guesstimate will be ballpark correct after drawing the conclusions I draw. But to add to the complexity of the forecasting problem, I (like everybody else) must cope with exogenous events such as the bizarre jump in stock prices on one Friday (the 22nd of January) or the surprising news coming out of Japan the next Friday (the 29th of January) which triggered bullish price action in the market even though such news merely implied the Fed may not increase the funds rate, as was its stated goal, and little else. So when surprising events such as those occur, a guesstimate like the ones I make can be wide of its mark, if only temporarily."

According to the way that I interpret the feedback that I got from the oscillator, the data showed that a "sea change" event occurred during the three-day period ending on Wednesday (2-17-2016): the laggard small- and mid-cap stocks bounced and outperformed the large caps. That change was in sharp contrast to the price trends extant in the market for several months. Therefore, I will spend most of my time commenting on the significance of the price action in the market for those three days. However, I will also add commentary about interest rates which I did not discuss in detail in the previous articles.

Regarding Interest Rates:

A major reason why stocks performed the ways they did during recent years was due to the low interest-rate policies of the Fed.

Click to enlarge

The chart above shows the performance of interest rates on the 5-, 10- and 30-year Treasury issues during the last seven months. Historically, the yields on those securities were usually north of 4%, 5%, and 6%, respectively. For reasons best known by Fed officials (beginning with Ben Bernanke and his unproven "and wishful thinking" theories regarding QE2, Operation Twist, and QE3) low interest rates would aid and abet the economy recovery. QE1 did much to bail out the economy and the stock market during the fiasco of 2007-08. However, QE2, Operation Twist and QE3 benefited 1% of the people at the expense of almost everybody else.

In this article, I am not going to badmouth the Fed for doing what it did and continues to do. I did my share of that in previous articles. And other writers continue to do such right here on Seeking Alpha, as well as many others in the news media. I just want to call attention to the fact that low yields (at less than half the historical norms) available to investors in the bond market forced them to divert investable funds to the stock market in search of higher returns. That limited their options and encouraged would-be bears to buy and/or hold stocks thereby shifting the supply-demand balance decidedly in favor of the bulls (this situation was commonly referred to as "the Fed put"). So if anything, stock prices trended higher than they otherwise would have if the supply-demand balances for bonds had been "normal" at about twice the then prevailing levels of interest rates.

The next chart shows the performance of the high-yield corporate bond ETF (NYSEARCA:JNK) during the last seven months. Its current yield is 6.77%. Its name (junk) aptly describes the performance of the ETF as shown

Click to enlarge

in the chart by the price weakness relative to its downward sloping 10-, 21-, and 43 day moving average trend lines (which I normally use to show technical strength or weakness on an individual price chart) as well as the downward shifting trading ranges (the hashed lines). But, the actions of the Fed were not the only reasons why interest rates on Treasury securities got to be as low as they are at this time. In several European nations as well as Japan, monetary officials adopted negative interest rate policies. That caused a flight of capital to safe havens such as the debt securities issued by the U. S. Treasury, putting downward pressure on interest rates. That change did not happen because the U. S. economy was in great shape. No. That happened because the other economies were (and still are) in worse shape than ours.

Regarding the Performance of the SPY and Related Indexes

The next chart shows the performance of six well known ETFs during the last seven 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 RSP equal weighted index (NYSEARC: RSP); it is the black line on the chart. All of the other indexes shown are capitalization weighed and they include the S&P 500 index (NYSEARCA: SPY), the Nasdaq 100 (NASDAQ: QQQ) and the Russell 2000 (NYSEARCA: IWM), the S&P 100 large cap index (^OEX), and the S&P 400 mid-caps (NYSEARCA: MDY).

Click to enlarge

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 28 days later. On the right side of the chart you can see that the SPY, RSP, QQQ, IWM, MDY and the S450 made new lows in recent days. And having made lower highs and lower lows, which was a bearish indication for each of these broadly based market barometers. The lone exception was the ^OEX (the purple line on the chart) and it was at about its previous low. During the three trading days ending with Wednesday (2-17-2016) all of the indexes shown recorded sizable gains. What is significant about those gains is that the small- and mid-cap stocks outperformed the large caps. I was expecting the large cap stocks to follow the much larger number of small- and mid-cap stocks lower. The blue box on the chart frames the price action for the last 22 days. I will have much to say about those days when I discuss the oscillator below.

The chart below shows the performance of 24 industry groups included in my workbook. About 390 equally weighted stocks are included in these 24 groups. Much of the price action shown on a chart like the next one is difficult to read because many of the price lines are bunched up and/or overlapping. That should not be a problem because the main purpose of this chart is to show what happened to the prices of the groups during the last three trading days. With the exception of the utilities and gold stocks, the other 22 groups all showed strong gains. So, such gains were pervasive in the market.

Click to enlarge

With that as prologue, let's see where my analysis goes from here.

Documentation by the "Sobon Oscillator"

Let's see if I can shed light on the stock market's never-ending mystery: "Where is it going to go from where it is now?" I will (1) explain the salient features of the market action framed by the four white boxes on the chart and then (2) guess what may be signaled for the near- to longer-term future as the market trends toward its usually ill-defined long -term goal.

Click to enlarge

To provide perspective, let's start by going back one week to the four-day work week ending with Friday the 5th of February.

But to facilitate understanding of the tricky analysis relating to the oscillator, let's quickly review what the many variables shown in the four panels on its 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, the Russell 2000, 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 are 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 eight 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, L7and 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 white colored boxes on the chart. The section on the right side of the chart (the blue box) shows data relating to this week's market activity. That will bring us to the cutting edge of the future.

The market closed down sharply on heavy volume on Friday the 5th of February (the first white box). And that was followed by similar action on during Monday and Thursday of the following week. So the negative trend remained bearish. However, on Friday the 12th of February the market closed up sharply on moderate volume (the second white box). And that was followed by similar action on Tuesday and Wednesday the 16th and 17th of the month. Up until then, the breadth indicators for the highs and lows and also the moving averages turned bullish for the first time. Prior to that time, these breadth indicators were choppy but still bearish.

In a previous article in this series I stated that if the ^OEX index (large caps) started to underperform the market it would be "Katy bar the door" for the market and the SPY could drop well below my target of 173. However, instead of the ^OEX weakening, the small- and mid-cap stocks bounced off their bottoms and began outperforming the large cap stocks. So, I must now abandon my previous decision about a decline in the SPY from 192 to 173. At the present time the SPY is trading at 192.30.

Furthermore, the next chart shows what has been happening in stock markets around the world.

Click to enlarge

The foreign stock markets also showed strong price gains during the last few days. With many of the foreign economies on life support provided by their central bankers, I still believe that we may still have an international economic house of cards on our hands at this time. The chart shows 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. It just adopted a negative interest rate policy. And the imbalances QE caused in the United States are also 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). Mario Draghi may soon do something just as stupid in Europe. 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 not forget about that.

Furthermore, add to that the fact that a contentious political campaign is underway. The citizenry wants change. And the Republican Party is in disarray. In his classic "An Essay on Politics," Ralph Waldo Emerson wrote that when the citizenry is ready for change, change will occur peacefully or otherwise. And such will bring about the way the game of politics is played. Consider the following: (1) during the Revolutionary War of 1776, Tom Paine galvanized the colonists to fight for their rights with his book called "Common Sense." And then, at the behest of George Washington, he wrote his "Sunshine Soldier" poem. Washington and Jefferson agreed that the revolution would not have succeeded without the contributions made by Tom Paine. (2) Bernie Sanders may be the Tom Paine of our times. He may not become a presidential nominee, but he is raising issues that are certainly enlightening the common people in this country. We won't know what the outcomes of the upcoming elections will be until November. (3) The President's nominee to fill the vacancy on the Supreme Court will likely be contested by the Republicans. And such political theater could also polarize the citizenry. And (4) it would be a very long-shot proposition, but if anybody can do something to bring about changes in the leadership of the Republican controlled House and Senate, Bernie may be the man to do that. If such should happen, the effects on the stock market would not likely be bullish. This is another unquantifiable risk that investors should be aware of.

I will conclude by making the following statements: (1) from 2008 until the beginning of 2015, the profitable strategy for investing in the market was to "buy the dips." (2) Going forward, I thought the correct strategy would be "sell the rallies." But now that the oscillator is giving a bullish signal for the near-term future I would not be hasty and do that. (3) I had a short position in an inverse ETF which showed a profit until it was stopped out with a 1.0% loss on Tuesday. I do not have any open positions at this time so I am sitting with cash. Buy I could open a new position at any time. (4) Traders, however, could decide that the volatile nature of the current investment environment can provide an abundance of opportunities to ply their trade. (5) The use of inverse ETFs could be a way to hedge one's general stock market risks when he is exposed to such while holding long positions. And (6) the only judge and jury that I must answer to is Mr. Market. He can be as deceptive 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 likely show a profit from my trading activities.

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.

This will likely be the last update that I write in this series. I wish to thank (1) the editors at Seeking Alpha for making four of the five previous articles in this series Editor's Picks, (2) , the more than 600 new followers of my articles for their votes of confidence, and (3) the readers 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.