What's Causing the Pop 'n Drop Pattern in Global Markets?

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 |  About: SPDR S&P 500 Trust ETF (SPY)
by: Prieur du Plessis

Have global stock markets run into a cul de sac? Bulls with long and short horns alike will probably admit that the rally since August 17, 2007 (i.e. when the U.S. Fed cut the discount window rate) was probably “too much too fast.”

The bar charts below show how global mature stock markets, as represented by the MSCI World Index, the major U.S. stock markets, and the MSCI Emerging Market Index fared since August 16, and for the year-to-date periods respectively.

Source: Plexus Asset Management (based on data from I-Net Bridge)

A cul-de-sac implies a U-turn. This is how Richard Russell, 83-year-old author of the Dow Theory Letters, very aptly summarizes the situation:

When you pull a rubber band out as far as it will go, the counter-force energy in that rubber band tends to pull the band back towards a state of ‘neutrality.’

The same thing applies in a big stock move, and at this point just most of the U.S. stock averages have been stretched to an extreme. Therefore, it would be entirely normal to see the stock market and all the major stock averages pull back, take a breather, correct.

A few days ago, I alerted readers to the fact that the so-called market internals (i.e. lack of breadth and poor volume) were diverging from the seemingly positive price trend, thereby casting doubt on the sustainability of the rally (see “Lack of stock market breadth flashes red light”). This in itself is not a timing indicator, but a warning signal of impending danger.

It would appear that danger has sneaked up over the past few days when analyzing the following graph of the Dow Jones Industrial Index (i.e. representing many large-cap companies that have been leading the broader market higher over the fast few weeks):

Source: StockCharts.com

The most worrying factor of this chart is the fact that the MACD oscillator gave a short-term sell signal four days ago (see blue histograms dropping below the zero line in the bottom section of the diagram). Also notice that both Monday’s, and Thursday’s declines were characterized by a pick-up in volume. Rising volumes on down-days is not a good sign.

Interest-rate-sensitive sectors in particular – REITS, financials and retailers – are looking weak, whereas another laggard on the way up – small caps – is now leading the market down.

Nervousness seems to have crept into the market over the past few days as reflected by the Volatility Index (VIX) edging up. The chart below illustrates the near-perfect inverse relationship between the VIX Index and the S&P 500 Index. Suffice to say, trend reversals are usually of larger magnitude than what we have seen over the past few days.

Source: StockCharts.com

One can argue about a myriad questionable fundamental factors such as the U.S. economic outlook and its implications for global growth, stretched valuation levels and earnings growth turning negative, but the short-term technical picture now also looks decidedly bearish.

Some stock markets are undoubtedly more overextended than others, but I would be surprised if most markets are not affected in some way by a downward correction – commonality (i.e. sentiment) should ensure that.

A “pop ‘n drop” pattern seems to be global stock markets’ fate, at least for the short term. Time will tell whether the rest of the journey will require coming all the way back from the cul-de-sac, or whether a longer, but more steady, route can be found.