Mr. Dow: Where to Now?

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 |  Includes: SPY, XHB
by: Prieur du Plessis

On Sunday, I managed to do what most people would consider quite impossible – I got lost in Central Park while on my daily run! I guess I was a bit preoccupied with the buzz of my meetings in New York City, and not really concentrating too hard on identifying and remembering beacons.

A lack of beacons is also possibly why investors are struggling to navigate the cross-currents of stock markets at this juncture. Friday’s sharp sell-off at the time of the 20th anniversary of the 1987 crash was all that was needed for broad complacency to make way for more than a modicum of fear.

The realization that the fall-out of the sub-prime situation could have much more dire consequences than originally expected triggered a 367-point decline in the Dow Jones Industrial Index, representing only the twelfth largest points decline on record.

I have been worried about the sustainability of the stock market’s rally for a while, particularly the lack of breadth against a backdrop of overbought and overvaluation levels, and a deteriorating economic, and earnings outlook. It is for this reason that I recently posted two articles expressing my concern, namely “Lack of stock market breadth flashes red light,” and “Global stock markets: pop ‘n drop.”

But where to now with Mr. “popped and dropped” Dow? Let me walk you through some of my thinking in an attempt to determine the lay of the land.

The graph of the S&P 500 Index below is typical of most global stock markets, and illustrates how equities abruptly made a U-turn last week after having strengthened non-stop since the Fed’s ”inflate or die” policy kicked-off in earnest on August 17, 2007 with a cut of the discount rate.

Source: Stockcharts.com

There are a few observations from the chart that deserve mention:

  • After the low volume characterizing most of the rally, stocks tanked on increased volume last week.
  • The MACD oscillator (bottom portion of the diagram) is firmly in sell mode, whereas the RSI indicator (top portion) has also become bearish having broken through the neutral (i.e. 50) line.
  • The 50-day moving average (blue line), i.e. an indicator of the intermediate trend, is still intact but looks in danger of being broken to the downside.
  • If you think the composite picture appears gloomy, spare a moment to look at the graphs of the two major headaches of the U.S. economy – housing and financials. Using the S&P Homebuilders Index ETF (HXB), and the S&P Bank Index as proxies for these sectors, the charts below certainly do not seem to be pointing to a bull market about to recommence in a hurry.

    Source: Stockcharts.com

    Source: Stockcharts.com

    In my opinion investors were caught by surprise by last week’s weak economic reports, and a reigniting of credit squeeze woes, causing a reassessment of risk and large-scale switching from stocks to the perceived safe haven of bonds.

    The Volatility Index (VIX) is the obvious measure of investors becoming more risk averse and, needless to say, it surged dramatically over the past few days. The strengthening of the Japanese yen is also of particular interest as rallies in the yen usually coincide with corrections in global stock markets. A rising yen forces the unwinding of the “carry trade,” leading to the selling of stocks. This is clearly shown by the strong inverse relationship between the yen (blue line) and the Dow Jones World Stock Index (black/red line) in the following graph.

    Source: Stockcharts.com

    The CBOE Put/Call Ratio is another interesting yardstick with which to gauge extreme bullishness or bearishness. This indicator (blue line on graph below) nets out the total put volume and total call volume, providing a data series that oscillates between excessive levels of bearishness (top end of graph), and excessive levels of bullishness (bottom end of graph). In the nature of contrarian indicators, the Put/Call Ratio is quite strongly inversely correlated with the S&P 500 Index, and at this point indicating a turnaround from extreme bullishness, and a reversal of the stock market’s fortunes.

    Source: Stockcharts.com

    The pictures aren’t looking good, and the situation at the coalface of the economy is not looking any better. I would not be surprised to see profit numbers increasingly undershooting expectations over the next few quarters. I also have difficulty seeing price-earnings multiples expanding off valuation levels not exactly screaming “buy” If, and I doubt whether it is a particularly big “if,” I am right on these two scores, then the math is simple to arrive at lower index levels. I suspect “Mr. Market” has also come to this line of thinking in mapping out Mr. Dow’s path.