The news Tuesday regarding the latest European bailout program could ignite another leg up in stocks. Spain may ask for "bailout lite," which would take the form of a "precautionary" credit line from the European Union. The bond market also received some good news on the ratings front. From the Wall Street Journal:
In a reprieve for Madrid on Tuesday, Moody's Investors Service said Spain's sovereign-debt rating remains investment grade, concluding a review by the ratings firm that some had feared would result in a downgrade to junk status.
The ECB has indicated it will buy Spanish bonds only if Madrid first applies to the euro-zone governments' bailout fund for a line of credit, called an "Enhanced Conditions Credit Line (ECCL)." Senior Spanish officials signaled on Monday and Tuesday that Madrid is now more open to applying for an ECCL. One reason for the shift, the officials said, is that Spain no longer fears that European authorities and the IMF would impose significant extra fiscal austerity on the country as a prerequisite for aid. Many IMF and European officials now agree that overzealous budget cuts deepen recessions more than they strengthen a country's finances.
Weekly Support In Play
While charts filled with indicators can be somewhat intimidating, the concept of support is easy to understand and visualize. As shown on the weekly S&P 500 chart below, stocks broke out on European Central Bank and Fed news in September (above horizontal blue line). The horizontal blue line previously acted as resistance; it may now act as support. The S&P 500 also is trying to firm near the upward-sloping trendline from the summer lows. The green arrows highlight areas of support.
In a similar manner, technology stocks are trying to firm up near the weekly support line shown below. If tech can shake off the "Intel (NASDAQ:INTC) and IBM (NYSE:IBM) blues", it would be a good sign for all risk assets. If the NASDAQ breaks below the blue trendline established at the June low, it would bolster the bearish case.
European Bonds Point To Risk-On Rally
As of early Wednesday morning, the positive reaction to Tuesday's European news is carrying into day two. The graph below shows declining bond yields in Spain. Lower yields means bullish buyers have been stepping in as fears of a Spanish default are subsiding.
The bailout hopes have also attracted buyers in the Italian bond market. As shown below, Italian yields are attempting to make an important lower low, which is helping define a downtrend in European bond yields. A downtrend in yields typically means a favorable environment for global stocks. The black lines show a bearish chart pattern for yields known as a "descending triangle."
Stocks Making A Stand?
Back in the United States the ratio of risk-on to risk-off is trying to hold support (see green arrow below). The dotted-blue line has acted as resistance several times (red arrows); now it may act as support for stocks relative to bonds. The upper portion of the chart shows a widely used indicator, the Relative Strength Index (RSI). The purple arrow shows a breakdown in RSI coincided with the stock market's weakness in April/May 2012. In the present day, RSI is trying to hold above the red line. Bulls want the red line to hold; bears want RSI to move below 50.
The chart below shows the performance of technology relative to bonds. When the ratio rises, tech stocks are in favor. When the ratio falls, bonds or risk-off is in favor. In early May 2012, trendline A was violated in a bearish manner (near red arrow); the S&P subsequently shed an additional 100 points (see vertical red line bottom of chart). In the present day, bullish support is still holding above the green arrow. Another break of trendline A would increase the odds of further corrective activity in risk assets. Conversely, if the trendline holds, it would be a good sign for stocks, precious metals, and commodities. If you are bullish on stocks, you would like to see the ratio below continue to rise.
Monitoring Risk-On vs. Risk-Off
If the past three years have taught us anything, it is that the financial markets can turn on a dime when policymakers and/or central bankers hint at or announce new programs. The schizophrenic nature of the battle between inflationary and deflationary forces requires maximum flexibility. The video below was created on October 14 or prior to this week's "Spanish bailout lite" news cycle. The charts in this article have been updated as of the close on October 16. Even though the video analysis was done when risk-off had the upper hand, bullish "what to look for" commentary expands on the concepts covered in this article. The following markets are covered in the video: NASDAQ at the 1:57 mark, S&P 500 2:13, bonds relative to stocks 4:52, SPY/TLT DeMark analysis 5:51, QQQ/TLT 9:53, emerging market bonds relative to Treasuries 12:37, junk bonds vs. Treasuries 15:25, short tech vs. long stocks 17:30, China vs. U.S. stocks 19:08, and SPY vs. AGG at the 20:50 mark.
After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.
IBM, Intel Adding To Tech Weakness
If we knew the market was on the verge of a correction, it is logical that we would prefer to be short rather than long (own stocks). If short ETFs, such as PSQ, are gaining strength relative to the S&P 500, it tells us the odds of a correction are increasing. Tuesday's disappointing earnings reports from IBM and Intel may allow technology to continue with its recent lagging stance.
Although the chart below looks complex, the concepts are easy to understand if we review them in isolation. When the ratio of short tech (NYSEARCA:PSQ) to the S&P 500 is rising, shorts are gaining strength relative to the general market. After point F below, the S&P 500 dropped 108 points. Point F coincided with a bullish trend change for PSQ relative to the S&P 500. Step one for a bullish change in trend is the violation of a trendline (see above 1A). Step two requires a higher low (see 2A). Step three takes place when a higher high is made (to the right of 3A). Unfortunately for the bulls, the ratio of PSQ/S&P 500 is once again trying to complete the same three steps (see 1B, 2B, and 3B). If the ratio below holds above the green line this week, it is bearish for stocks and bullish for PSQ. If the ratio breaks below the green line, it is another risk-on signal. How the chart below looks at the end of the week is more important than how it looks as of Tuesday's close.
Emerging Market Bonds Trying To Stay Aloft
At the 12:38 mark of the video above, we noted two potentially bullish conditions that were in place on the "risk-on vs. risk-off" chart below of emerging market bonds (NYSEARCA:EMB) relative to Treasuries : (1) the black trendlines were holding (still are), and (2) RSI was above 50 (still is). If RSI can remain above 50, it would increase the odds of another leg higher in risk assets. If RSI drops below 50, it leaves the correction door open.
How Do We Use All This?
It is clear the battle between the bulls and bears is at a possible inflection point. If stocks and intermarket relationships hold support, the immediate threat of a waterfall decline will have passed. Under those conditions, we would consider scaling back further on our small stake in hedging vehicles, such as PSQ. If the S&P 500 can close above 1,461 and the charts above say "risk-on", we would consider adding to our long positions. Our short list of possible buys includes Europe (NYSEARCA:EFA), materials (NYSEARCA:XLB), and energy (NYSEARCA:XLE).
If risk markets and the ratios above break support, we must be ready for acceleration in the short-term downtrend. Under bearish conditions, we would keep hedges such as VXX in place and consider adding to them or raising more cash.
Unfortunately, the debt-saddled world we live in requires constant monitoring and the ability to change your short-to-intermediate-term outlook rapidly. Flexibility and an open mind may be an investor's best ally in these risk-on/risk-off markets. Since news from Europe could flip the switch back to risk-off without warning, we will try to provide some insight via Twitter (@CiovaccoCapital).
Disclosure: I am long PSQ, FXI, XLB, EEM, EFA, VXX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.