The Trend is Now Down

by: Bill L.

In previous articles I have been discussing the deteriorating internal strength, breadth, volume, and momentum of the stock market. In the last few months liquidity driven stock prices have ticked higher against a fundamental backdrop of severe non-traditional credit headwinds, furious insider selling, a higher future tax rate, increasing global trade barriers, an unemployed debt ridden consumer, and S&P valuations near all time highs.

After the 700 point slide in the Dow, many were wondering if this was just a correction, or the start of something else, I lean towards the latter. One of the things I was looking for to confirm this view was a pick up in terms of negative breadth and volume. Much like the deteriorating internals was a clue to the inevitable end of the uptrend, the down trend was confirmed today (February 4th) with an increase in internal selling strength. During the relatively weak bounce upside breadth statistics were extremely weak, today however, both NYSE Decliners/Advancers and Down/Up Volume ratios both exploded higher, not only easily surpassing the downside breadth recorded in the January sell off, but registering the broadest sell off since March ’09.

Chart 1: NYSE Declining Issues to Advancing Issues Ratio (1 Month)

Chart 1 shows a surge in downside breadth. This was an absolutely broad based sell off with no place to hide. For every one issue trading in positive territory on the New York Stock Exchange, there were ten issues that were in negative territory.

Chart 2: NYSE Down Volume to Up Volume Ratio (1 Month)

Chart 2 shows an absolute explosion in downside volume. The selling pressure was broad, powerful, and absolutely overwhelming; with a ratio of 35 to 1 of NYSE’s volume occurring on down ticks. While this may have created momentarily oversold conditions, buying in anticipation of a bounce is not advisable as over sold markets tend to become more oversold. Furthermore this is not a move that is consistent with the end of a correction, but the kick off to a downward trend.

Chart 3: NYSE Down Volume to Up Volume Ratio (1 Year)

Lastly, I would also point out that these are the highest levels for these statistics since the March low, and appear to be trending higher.

March ’09– July ’09 Trend Line Broken

Chart 4: Dow Jones Industrials (Daily – 1 Year)

The trend line formed from the March and July lows has been formidable, holding up the Dow for over 10 months. However two weeks ago price action provided us with a warning as the Dow finally breached this trend line. There were warnings even before this as secondary indexes broke this trend line months before. The BXK Banking Index and Dow Utilities Index broke this trend line early last October, and the Dow Transport index, S&P 500, and Nasdaq broke this trend line later that month. The less actively traded and riskier indexes seemed to have fallen one by one, and now it seems the Dow Industrials is succumbing to the weight of the negative technical evidence.

Looking at the SPY as a proxy for the S&P 500 we see further evidence that the trend has now turned.

Chart 5: SPY – S&P 500 Index ETF (Daily – 4 Months)

First, we can see that the SPY has broken the July – November low trend line. This break has been accompanied with several technical sell signals such as moving averages crossing over to the down side. Moving averages are one of the few technical indicators proven to be statistically significant, and tend to keep you on the right side of the trend. While mechanically following their signals subjects you to whipsaw in deep correction, this can be mitigated by using the Average Directional Movement Index or ADX. Looking at the bottom half of chart 5, we can observe several things. First, for months now the ADX line has been trending lower despite prices moving higher. Think of the ADX line as the strength of the trend, so as prices have moved higher the ADX line has been warning us that the trend was weakening. Second, negative directional movement ( the red dashed line) has now crossed above the positive directional movement (green dashed line). This tells us that negative movements have now become more dominant. Third, the ADX line is in the twenties, and trending higher, which is consistent with the beginning of a new trend gaining steam. So to summarize directional movement indicators have provided warnings, we have a trend line break in the indexes followed by mechanical technical sell signals, and we have added weight to those signals with the ADX line telling us we have the beginning of a new and strengthening trend.

Risk Aversion Trade Is Back
In my last article I mentioned sentiment indicators like the Put/Call ratio were indicating that risk taking was back in vogue despite a near global financial collapse less than a year ago. The analogy I used was, “no one wants insurance when your house isn’t on fire…” It appears the match has been lit.

Chart 6: VIX – CBOE Volatility Index (Daily – 1 Year)

The VIX measures the implied volatility priced into options; think of it as the premium charged on insuring your portfolio. Not only has it spiked, breaking the 200 day moving average, but it has also broken a long term downward trend line. Now that investors smell smoke, they have become willing to pay up for that insurance. Is this a blip – or a new trend? Looking at the US dollar index provides us with further clues.

Chart 7: UUP – US Dollar Bull exchange traded fund ( Daily – 1 Year)

Unfortunately for the bulls, I lean towards the trend in risk aversion lasting the rest of 2010. Despite all its problems, the US Dollar is ironically still a seen as a safe haven. Looking at chart 7 we can see it confirming the VIX, breaking its long term downward trend line and breaking above its 200 day moving average. Furthermore, in December when the dollar bottomed, sentiment had reached 3% bulls according to the trade futures daily sentiment index. People were as bearish on the dollar as they were on stocks in March ’09. Vice versa, traders were at record extremes in terms of their bullish posture on the Euro (FXE etf). This is extremely important because when sentiment reaches these kinds of lofty extremes, the following trend that reverses these extremes takes months to play out. This is consistent with a new multi-month trend, not a short term correction.

Gold, Silver, and Oil… Down, Down, and Down
Being bullish on the dollar, I have to be bearish on gold, silver and oil. All of these markets have seen huge runs accompanied by some of the most extreme sentiment readings I have personally experienced. But now with the dollar in just the beginning of a new uptrend, dollar denominated assets will suffer. Furthermore, because these assets are primarily traded through futures, they are infamous for “taking the stairs up, but the elevator (sometimes the window) down.” Buying here could be stepping in front of a freight train. I shall just let the charts do the talking.

Chart 8: GLD –Gold exchange traded fund (Daily – 1 Year)

The GLD exchange traded fund (which tracks gold) sports a head and shoulders reversal pattern. The neckline is broken, as well as a 1 year upward trend line, and it seems to be poised to test the 200 day moving average. The daily sentiment index set a record for consecutive bullish readings near the highs, and bullish gold sentiment has been everywhere. Tell me you have not noticed “Buy gold!” commercials on television… Believe me, they are not doing this because they care about your financial well being. They are selling you gold because the price of gold is high.

Chart 9: SLV – Silver exchange traded fund ( Daily – 1.5 years)

The SLV, which tracks silver, sports a similar chart; a head and shoulder reversal pattern, a trend line break down, as well as breaking the 200 day moving average. Similar sentiment readings were also recorded in silver futures despite a larger non confirmation; unlike gold silver did not break its all time highs.

Chart 10: USO – Oil exchange traded fund (Daily – 1 year)

Oil also sports a bearish chart. The USO, which tracks oil prices, had a warning shot in the form of a false break down in October. Then in December the USO broke its upward sloping trend line, followed by a retest of that line and now finally breaking the 200 day moving average.

Bears have been all but non-existent in the last few months, despite the continuous build up of negative technical evidence in almost all markets, and continuing credit problems worldwide. A low number of bears is a necessary prerequisite for the markets to reverse, and by some measures there are the fewest bears since 1987. Money is rushing out of all risky assets, and according to sentiment figures, this is a trend that should go on for several months. While current conditions would more than allow for a near term bounce, oversold markets tend to become even more oversold. Seeing as how the dollar is the only chart I follow that appears bullish, investors should be using rallies to exit positions in risky assets. Markets will turn up again eventually, and when they do you want cash on hand. However, I currently see little evidence that we are anywhere near that point.

Disclosure: Long SPY puts.