Follow-Up #2 To 'Will The Stock Market Crash?'

| About: SPDR S&P (SPY)

Summary

To significant degrees, the market is being manipulated indirectly by the dovish and wishful-thinking policies of the Fed and directly by the high frequency traders.

Contentious political campaigns are underway. And their outcomes could have profound affects upon for the stock market.

Will the do-nothing Congress ever bail out the Fed? If it doesn’t do that soon, it could be “Katy bar the door” for the stock market.

I will use the “Sobon Oscillator” to explain what is going on in the market.

Introductory Considerations

During recent weeks (1) Alan Greenspan stated in a TV interview that he expected the yield on the benchmark 10-year Treasury note to increase from its then current level of 1.63% to 3% to 5% during nearby years; the yield on the 10-year increased to 1.79%.

(2) On the same day Larry Fink, the CEO of BlackRock, said that if the government didn't launch an aggressive fiscal spending program soon, there could be a 15% decline in the stock market.

(3) Mary Jo White, the Chairwoman of the SEC, recently said that the agency was having a difficult time trying to reign in the high frequency traders… That should not be surprising because of the revolving door practice that exists between the SEC and the business community… Before Mary Schapiro (White's predecessor) left office, she said the agency would soon be proposing a disclosure rule that would force public companies to reveal all the money they devote to political activities. But as soon as White took control of the SEC in 2013, the effort to shine light on dark money came to a halt. White removed disclosure from the list of rules on the agency's agenda and it hasn't come back since… Last week, Elizabeth Warren asked President Obama to replace White as Chairwoman of the SEC.

(4) Members of Congress have long been aware of what high frequency traders were doing. On July 13, Rep. Peter DeFazio (D-OR) introduced legislation that would levy a 0.03% tax on transactions for stocks, bonds and derivatives to discourage the kind of speculative financial trading that led to the 2008 Wall Street collapse and the 2010 Flash Crash. That tax would amount to three cents per $100 of securities traded. DeFazio said that "the knuckleheads who run Congress" won't bring the bill to the floor for a vote.

(5) I continue to believe that the market is being manipulated indirectly by the dovish and ineffective interest-rate policies of the Fed and directly by the high frequency traders. I will have more to say about the Fed's low interest rate policies and HFT manipulation below.

(6) Contentious political campaigns are underway so what happens in political arenas in coming weeks could profoundly affect the stock market.

(7) The unconventional technical analysis that I do is based upon empirical studies and also the harsh lessons I learned from Mr. Market while attending the School of Hard Knocks.

And (8) unless indicated otherwise, 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 use index numbers extensively. 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 comparable to any other such item relating to stocks or ETFs.

Regarding Politics, the Writing Is on the Wall for Everybody to See

Contentious political campaigns are underway. And the Republican Party is in disarray. In November, control of the Presidency, the House and the Senate will be at stake. The electorate wants changes made in the way the game of politics is being played. And the surest way to bring about meaningful change is to get rid of the overly partisan politicians who have been obstructionists and replace them with others whose politics are more in line with the well-being of the electorate.

We live in an empirical world and history shows that people "only" get the kind of government they deserve. Politicians have biased opinions and there is nothing wrong with that. But sometimes their opinions are lopsidedly partisan and that precludes reasonable compromise, which is what works in a democracy. And to various degrees, the obstructionists try to bamboozle the electorate in order to get elected and then pursue their own selfish goals.

In the award-winning movie called "Red October," an actor said,"I am a politician. That means I am a liar and a cheat. And when I'm not kissing babies, I'm stealing their lollipops." Those lines are sobering and symbolic of what often goes on in politics. So if the electorate makes bad choices when they cast their votes, it will be stuck with more bad government such as that which we got from the do-nothing Congress for more than the last seven years. Good choices could result in good government. It is as simple as that. It would be nice if every voter understood the difference between real and phony political issues when he casted his vote. But election results are oftentimes determined by an ill-informed electorate.

To provide perspective on political issues that really matter, let's consider the extracts from Emerson's essay on politics (written in 1844) which follow: his observations are as relevant today as they ever were.

(1) "The theory of politics considers people and property as the two objects for whose protection government exists. Personal rights demand a government based upon the consensus of the people. But property demands a government that favors the owners over the owing. Too much weight allowed in the laws favoring property allows the rich and the politically powerful to encroach upon the poor and keep them poor."

(2) "The society always consists in the greatest part of young and foolish people. The older and wiser people, however, know all about the hypocrisy of courts and politicians" …"Year after year, property will write every statute that relates to property. What the owners wish to do, they will do either through compliance with the law or in defiance of it."

(3)"Every State is corrupt;" it's just a matter of degree. The word "politic" signifies "cunning" and, therefore, "the State is a trick"…"The two main political parties are parties of circumstance and not of principle" … "All public ends look vague and quixotic when compared to private ends … All reformers have been partial reformers and have committed, in some manner, to the supremacy of a bad State."

(4)"Society is an illusion to young people who naively think that it is rigidly established. The older statesmen know that a society is fluid and any part may become its center and compel the system to revolve around it" …"The government must follow, not lead, the character and progress of its citizenry."

And furthermore (5)"Mother Nature is not democratic, nor limited-monarchical, but despotic. And she won't be fooled by any tinkering with her authority. The education of the general mind doesn't stop. Therefore, when the citizenry is ready for change, change will occur, one way or another," peacefully or otherwise and such will bring about change in the way that the game of politics is played.

All things considered, we can only hope that the electorate won't be bamboozled and the upcoming election results will right many of the things that are wrong with the do-nothing Congress; and, after that, the Supreme Court which is also in gridlock. On Election Day, we will find out the extent to which the citizenry is really ready for constructive change.

At present, it looks like Hilary Clinton will trounce Donald Trump in the presidential race and the Democrats could gain control of the Senate. But unless there is a large grass roots turnout on Election Day, the Republicans could keep control of the House. If such should happen and because the politics of Paul Ryan and the Tea Party types among the right wingers are to the right of Attila the Hun, the political gridlock could continue and major political problems extant could go unresolved.

With a divided government, it is likely that there would not be significant changes in the way things are done in Washington. And that could augur ill for the economy during the near-term future and, eventually, the stock market. A sweep by the Democrats would likely have an immediate negative effect on stock prices because it could end the gridlock and lead to changes that are not favored by Wall Street types.

I expressed my candid opinions in the paragraphs above and I am sure that there are readers who will disagree with me. No problem. In a democracy, all citizens should have strong and biased opinions. It is during the election process that reasonable compromises can be reached. And the better informed and involved the electorate is, the more constructive should be the compromises.

Interest Rates and the Fed's Dog and Pony Show

The chart below shows the performance of interest rates for the 5-, 10- and 30-year Treasury notes and/or bonds for the last 150 trading days. At the present time, their respective yields are 1.28%, 1.79%, and 2.55%. Such are at least 60% below their historic norms; due, largely, to the persistent low interest rate policies of the Fed.

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The high yield on the 10-year Treasury note for the last 15 years was about 5%. If the 10-year doubled its current yield and got up to a yield of 2.58% sometime during the next three years, a current holder at a yield of 1.79% would collect up to a total of 5.37% in interest payments while losing several times that amount from his principal. Why would any investor in his right mind buy and hold the 10-year Treasury issue on those terms?

Such debt instruments with abnormally low or even negative interest rates (which Yellen and others at the Fed refuse to rule out) are not assets; they are real or at least potential liabilities. They should be sold aggressively at current price levels.

The hawks and doves among the Fed's governors continue to take turns talking about the pros and cons of raising interest rates. It appears that their collective goal is to bamboozle investors into thinking that raising rates is possible or even probable when their record shows they have little or no intention of doing so. They say their policies are data dependent, but they have no qualms about moving the goal posts as such relate to the data.

By keeping interest rates at low levels for so long, they painted themselves into a corner, and it is abundantly clear that they don't know how to get out of it without causing problems in financial markets, which appears to be their primary concern. Collectively, the Fed governors have virtually no credibility at this time.

I maintain that if the Fed officials were really serious about normalizing interest rates and boosting the economy, they would (1) quit paying interest to banks (about $8 billion a year) on excess reserves that the Fed created, (2) quit trying to peg interest rates and let them rise to free market rates (they talk about the virtues of free market capitalism, but they continue to do their best to subvert it), (3) donate back to the Treasury all of the bond holdings they bought with money they created and thereby reduce the national debt, and (4) tell the members of the do-nothing Congress "to quit screwing around with partisan politics and approve fiscal programs to stimulate the economy and reform the tax code to avoid an economic disaster."

What Kind of Stock Market Environment Will We Have During the Near-Term Future?

For perspective, let's start by taking a look at a chart showing the performance of the S&P Industrial Index (NYSEARCA: SPY) beginning with January of 2015. (The next two candlestick charts were downloaded from StockCharts.com.) The six dotted- or solid-line trend lines range from 20 to 150 days.

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A quick study of the chart could show that (1) the SPY was in a strong uptrend until July of 2015. (2) it plateaued, showed weakness on its upward sloping trend lines, and then made a correction in August that was short lived. So (3) it went down to test the October bottom in February of 2016. And (4) the test was successful and the market trended higher until the 9th of September when it dropped sharply to 213. During the last five weeks, it rallied but failed to make a new high. At the present time, the SPY (at 213) is showing weakness on most of its upward sloping trend lines, but its top is not yet well defined.

The next chart shows the performance of the iShares Russell 2000 Index (NYSEARCA: IWM). It moved in sympathy with the SPY, but at the present time, it is below its high made in July of 2015. It wouldn't take much downside price action from the current level of 120 to make its top well defined.

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Such an interpretation of the SPY and the IWM would be woefully inadequate because the SPY and the IWM are not adequate proxies for the "general market" although many investors might think so. Among other things, an informed investor needs to know the answers to four questions: (1) why the market's uptrend ended in August of 2015? (2) Why its rally from the August-October bottom was short lived? (3) Why its rally from the February-March bottom was sustainable up until the present time? And more importantly, (4) how the market will likely perform during the near-term future up until the time that it corrects or might even crash?

But before I can provide plausible answers to those questions, I will need to explain some things about the "Sobon Oscillator."

The thesis upon which my oscillator is based can be simply stated: When speculative interest in the market waxes, the stock market goes up. And when speculative interest wanes, the market goes down. With that as prologue, let's take a look at some charts that are parts of the "Sobon Oscillator."

The S&P Industrial Index is the red line on the next chart. In order to get a comprehensive understanding of the market, it was necessary for me to consider many other market barometers and invent a few of my own.

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This chart shows the performance of 10 prominent ETFs during the last 150 trading days. Also shown are (1) my index of 450 stocks (the dark blue line and referred to in the legend as S450), and (2) my index of 40 technology stocks (the purple line and referred to as Tech40). The S450 index is unweighted (as is the Tech40) and it correlates very well with the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA: RSP), the black line on the chart. The other equal-weighted index charted is the First Trust NASDAQ-100 Equal Weight Index ETF (NASDAQ: QQEW); it is the light green line.

All of the other indexes shown are capitalization weighted, and they can be identified by the colors of their lines as shown in the legend on the chart. They include the S&P 100 large-caps (^OEX), the S&P 400 mid-caps (NYSEARCA: MDY), the S&P 600 (^SP600) small caps, the NASDAQ 100 (NASDAQ: QQQ), the iShares Russell 2000 (NYSEARCA: IWM), the iShares Russell large caps (NYSEARCA: IWB), and the iShares Russell mid-caps (NYSEARCA: IWS) …. I will discuss the performance of these indexes shortly.

The next chart shows the performance for the 10 prominent indexes for the last 300 days.

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The small white box on the chart frames the 24-day base-period when all of the indexes were making a common tradeable bottom last February, which I call the LTB (Last Tradeable Bottom). The base-period is used to establish individual index numbers of about 50 (plus or minus 0.05%) from which the performance of all of the items shown on the chart could be measured uniformly. Such numbers were also established for each of the 450 stocks and ETFs included in the "Sobon Oscillator."

The hashed gray line on the chart shows the index number of about 50 for the SPY which had an actual base-period price of 189.8. Its index number and price have since risen from the February low to 56.1 and 213.0, respectively, for gains of 12.2%.

Before going forward from here, I will now refer back to the area on the chart to the left of the white box because that is critical to understanding why the market rally attempt in October-December of 2015 was short lived and why the stock market rally since February-March was sustainable. (1) The period from August to October 2015 was a false bottom and therefore not sustainable. Why? Because the small and mid-cap stocks began to lead the market down in July of 2015 and they lagged badly on the upside when the rally attempt started in October. Therefore, the correction was incomplete because the excesses in stock prices of the small- and mid-cap stocks were not corrected so the market faltered and that led to the test in February-March. The incompleteness that I refer to is not apparent on the chart because (1) I did not show how the price indexes would have performed if they had been converted to index numbers of about 50 during the August to October decline. (2) But (for example) if you would look closely at the chart, you would see that the bottom of the IWM (the brown line) was well above the bottom of the SPY (the red line) so the performance of the lines is not comparable. (3) A sustainable tradeable bottom can only be determined as it evolves on a real-time basis after the rally has started. And (4) it became apparent to me in November and December of 2015 and prior to drop in January of 2016 that the August to October bottom was a "false" bottom.

Technical analysis is a continuous process. Its trend signals are only good until a reversal is indicated as we go from one base period to another. So I just have to detect the beginning of a reversal before most of the other investors do in order to gain an advantage while trading the market. Absolute truths do not exist in the real world so why should anyone expect to find them in analysis relating to the stock market? In 1911, Hans Vaihinger wrote a thesis expounding the merits of his "As If" philosophy. And philosophers, scientists and researchers of all stripes have made good use of it ever since then. I draw my conclusions about the outlook for the stock market today "as if" I knew what was going to happen during the near-term future. And if the assumptions upon which I base my conclusions today change and I need to change my opinion tomorrow, so be it.

The blue columns shown in the middle panel on the next chart show the average percentage gain from the base period that occurred in the index numbers for all of the 450 stocks on a daily basis.

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The "average" percentage gain for all of those stocks got as high as 21.5% last August. Since then, that gain dwindled to where it is now at 14.5%. At the present time, 85% of the 450 stocks in the LTB show gains from their respective LTB base period prices, with 63% of them still showing gains of 10% to well over 50%.

The CTT (Current Tradeable Top) is another one of my new indicators. It measures average percentage declines for the 450 stocks from their 100-day highs. That average dropped to minus 7.8% on Friday the 14th of October (its low for the year). At the present time, 7% of the 450 stocks are showing declines of 10% to 40% from their highs made since February.

The LTB and the CTT indicators are now among the most important trend indicators among the 34 indicators in my oscillator. If and when the market indicates a significant directional change from a tradeable top or bottom, that must be reflected in these two indicators on a real time basis.

The bottom panel on the chart shows one of five sets of breadth indicators that I use in the Sobon Oscillator. The SCI (Short Crossover Indicator) and the NTTI (Near-Term Trend Indicator) are the indicators I had been using to forecast the near-term trend for the market. The SCI is the lead indicator for the NTTI. On Friday, the 9th of September, the SCI turned negative as it dipped below the neutral (zero) line. The NTTI weakened but it was still giving a bullish indication. They both waffled around the neutral line until recent days when they declined into negative territory and gave a bearish reading.

These indicators cannot be expected to give meaningful readings when the market is being manipulated. To compensate for such manipulation I rely upon the LTB, CTT, NTTI and LTB indicators referred to above.

With that detailed explanation of the chart out of the way, let's consider what happened in the market during the last 15 months.

Remember, when speculative interest in the stock market waxes, the market goes up. And when such interest wanes the market goes down. For perspective, let's consider what happened with these indexes since the overall market began to correct in July of 2015. (1) That was when the mid- and small-cap stocks began to decline while the large-cap stocks moved sideways. In August of 2015 a broad-based decline began and it looked like a sustainable bottom was being made. Such a bottom can only be identified when the ensuing rally proves that it is broad based as it evolves. However, this rally was led by the large-cap stocks while the mid- and small-cap stocks lagged badly, indicating that the latter did not complete their corrections so speculative interest was still waning. Hence, the August to October bottom would prove to be a "false bottom" so the mid- and small-cap stocks would continue to lead the market down until it made its low in February and March of 2016 when speculative excesses were washed out of stock prices.

And (2) all of the indexes bottomed in February and March and then trended higher. Such was a complete reversal of what happened after the August to October decline in 2015. Moreover, some did so more dramatically than others and therein lays the major key to understanding the waxing of speculative interest: the small- and mid-cap stocks (which are generally considered to be more "speculative" than the larger so-called "investment-grade" stocks) outperformed the large-cap stocks. So, the RSP outperformed the SPY, the MDY and the ^SP600 outperformed the ^OEX, and the QQEW outperformed the QQQ. The IWM is loaded with small-cap stocks and it underperformed almost all of the other indexes from July of 2015 through February of 2016; but it outperformed all of them until recent days when the small- and mid-cap stocks underperformed the large-cap stocks.

In the first of three articles in this series, I listed three other keys to understanding the substance of speculative interest. I will not repeat such here.

Now, I want to call your attention to the performance of the ^SP600 small-cap stocks. This index was a strong relative performer since the bottom of the market was made in February-March because it was probably manipulated higher by the high frequency traders such as Goldman Sacks, Citigroup and other major traders. The SPY trades at about 213 while the ^SP600 trades at 737 (that's about 3.5 times the price of the SPY). During the past 40 days, for example, the volume of trading in the SPY and ^SP600 averaged about 102 and 62 million shares per day, respectively. The dollar value of the shares traded in the SPY was about $22 billion per day but such for the ^SP600 was about $46 billion. The high frequency traders must have made a lot of money since February while they walked the price of the ^SP600 higher as it outperformed the SPY by a wide margin.

But during the last several days, the ^SP600 was among the weakest performers among the indexes I follow: the IWM underperformed the SPY, and the MDY and IWS underperformed the ^OEX and the IWB, respectively. I also track the QQQ but it is not a very good indicator because the 10 most heavily weighted stocks in the index account for more than 50% of the index. If it wasn't for Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), and in recent weeks Apple (NASDAQ:AAPL) - combined they account for 22% of the index - the QQQ would have underperformed the SPY.

So, as far as we know asset prices were indirectly manipulated higher by the policies of the Fed while stock prices were directly manipulated higher by high frequency traders and also by buyback programs of corporations. Foreign banks (such as the Swiss National Bank) have also purchased huge amounts of shares in large U.S. companies with money that they created.

Look at the next chart. It shows the performance of the five component parts of the Sobon Oscillator for the last 22 trading days. Oscillators fluctuate within a range of plus 100% to minus 100%. When they get above plus 80% or below minus 80%, they are usually in overbought or oversold territory. (When an oscillator gets to a reading of plus 80% for example, that is a net reading. It means that 90% were positive and the remaining 10% were negative.) And history shows that such lopsided pluralities do not last very long.

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Until four trading days ago, the market traded in a narrow range with an upward bias: (1) The daily volumes (second panel) approximated their daily norms while (2) the daily price changes (top panel) usually showed gains or losses that were about half of their norms. (3) The breadth indicators for the highs and lows (fourth panel) were modestly strong as were (4) the breadth indicators for the moving averages (third panel). And (5) the bottom panel shows trend lines that I usually use to make near-term forecasts for the market; those being the Short Crossover Indicator and the Near-Term Trend Indicator. The columns referred to as S1, NU and RE are momentum indicators. All of these indicators gave weak bullish readings during the 18 days referred to.

However, during the last four trading days, all 32 of these indicators dropped into bearish territory probably because (among other things) of the increase in yields on Treasury notes and bonds and speculation that the Fed really would increase interest rates before year end. I'll believe that when I actually see it happen.

The SCI and the NTTI indicators turned negative as they dropped below the neutral line. To know when the market will reverse to the downside I would have to know when the manipulation stopped. I do know how speculative interest waned in July of 2015 prior to the drop in August. But unlike the situation in August of 2015 when I was able to call the drop, it is too soon for me to state with a high degree of confidence that a sharp drop in stock prices is imminent at this time. However, the IWM and the ^SP600 have begun to underperform all of the other indexes in recent days, And if they continue to do so, it could be "Katy bar the door" for the stock market.

I do not own any stocks at this time. I have had some success trading leveraged ETFs during the past year. And I expect to do more of that during the near-term future. I would like to inform readers when I initiate a trade but such trading opportunities occur in unexpected ways and there is no way that I could write and post an article about such on a timely basis. If and when I have something meaningful to add to the message conveyed in this article I will write a follow-up to this article.

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

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.