Follow-Up #2 To 'When Will This Stock Market Bubble Burst?'

Summary

The stock market declined about 10% since reaching a record high about eight trading days ago.

The possibility (probability?) of higher interest rates became a headwind for the stock market.

Technically, the market’s trend is decidedly bearish at this time. But I would not rule out an attempt at a market rally very soon.

The market’s volatility makes trading leveraged macro ETFs interesting and I expect to do some of that in coming days.

Interest Rates and the Toxic Duration Risk

The chart below shows the performance of interest rates for the 3- and 6-months Treasury bills, and 2-, 5-, 10- and 30-year notes or bonds for the last 150 trading days. Interest rates on the 5-year note and all shorter term debt issues have been trending upward for many months.

At the present time, the respective yields on the 5- 10- and 30-year notes or bonds are 2.52%, 2.83% and 3.14%. Such are about 40% below their historic norms due, largely, to the persistent low interest-rate policies of the Fed and/or because of prevailing lower interest rates in foreign markets.

The Fed is expected to increase its discount rate three times during the coming year and that should continue to put upward pressure on the short end of the yield curve. Until recent weeks, the long end of the curve traded in a narrow range, but that could be changing.

The benchmark 10-year note surged during the last two weeks as it rose to a 4-year high while foreign yields were also rising, pushing bond prices lower worldwide. So the bellwether 10-year note is now well above its breakout level. Whereas the 2-10 spread has already bottomed (the red dotted line on the chart), the 5-30 spread (the black dotted line on the chart) may now be bottoming. The yield on the 30-year bond would have to increase by six basis points to 3.2% (the 2017 high) before it could reach its breakout level.

With the Fed selling about $600 billion of its debt holdings in 2018 and the Treasury selling about $1.2 trillion of debt obligations, the yield curve should shift upward during the year. There was a lot of talk in the financial press about rising interest rates during recent days and that may have been one of the factors that spooked the stock market which dropped sharply.

Conclusion #1:

The long duration notes and bonds are toxic when interest rates trend higher. Historically, the yield on the 10-year Treasury note averaged about 4.5%. If the 10-year got up to a return of 4.5% sometime during the next two years, a current holder at a yield of 2.52% would collect up to a total of 5.04% in interest payments while losing more than that amount from his principal. So why would any sane investor hold the 10-year Treasury note on those terms? Such debt instruments with their abnormally low interest rates are not assets. They are real or (at the very least) potential liabilities.

Trading with the Stock Market’s Trend

When I (as a stock market technician) take a bullish position in the market I want to have a well-defined bottom behind me on the price charts. And when I am bearish I want to have a well-defined top behind me. Anybody who does otherwise runs a risk of betting one way while Mr. Market goes the other way.

For perspective, take a look at the next three charts and see how these major stock market indexes made their bottoms in 2015-2016: After such bottoms were established, the S&P 500 Industrial Index (SPY), the Nasdaq 100 (QQQ), and the Russell 2000 (IWM) indexes trended upward and reached all-time record highs in January of 2018. In order for that to have happened, a significant majority of stocks in each of those indexes had to contribute to the market’s strong performance. The advance was led by the large-cap stocks most of the time. But during brief intervals the small-cap or technology stocks were also the leaders.

In the market analysis that I do, I use a proprietary concept that I call a “DTB” (Durable Tradeable Bottom) which becomes the base period from which I measure and appraise the market’s performance.

(1) The price index for each of these three market indexes had been weak for many months before they made a bottom beginning in August of 2015. The SPY and the QQQ then rallied, faltered, and then tested their August bottoms successfully beginning in February of 2016, thus forming double bottoms.

(2) The IWM rallied in October of 2015 but it faltered and then dropped well below that bottom in February of 2016. Nevertheless, subsequent price action would soon prove that the IWM could make a durable bottom from which it would soon outperform the SPY and the QQQ on the price charts.

(3) I was able to conclude that a “DTB” bottom had been established for the general market in March of 2016 and that certainly proved to be the case. But I also had input from other technical work that I do in my workbook. It is such analysis that I will now discuss.

What Kind of Stock Market Environment Will We Have During the Near-Term Future Starting With the Next Trading Day?

That is the question I ask every day when I update my workbook and look for trends and reversal patterns.

The top panel on the next chart shows the performance of 10 prominent ETFs (and three other market indexes that I constructed) during the last 150 trading days. You can read the ticker symbols on the legend and study the chart if you so choose.

The dark blue line with white dots shows my index of 450 stocks (the S450) and it correlates well with the SPY 500 Industrial Index (SPY, the red line); outperforming or underperforming it from time to time (mainly because the SPY is capitalization-weighted while my S450 stock index is equal-weighted; also, my S450 includes some fractional weightings for about 50 small-cap stocks; such are not included in the SPY and they account for about 5% of my S450 index).

From March of 2016 (and especially since the election in November) and then up until the end of January 2018, the stock market was in a strong uptrend until it made record highs on various market indexes at the end of January. During most of that time span, the large-cap stocks outperformed the mid- and small-cap stocks. The technology stocks (as measured by the QQQ and my index of 37 technology stocks) also showed 50-day periods when they were the darlings of Wall Street and they too stumbled for a while. The technology stocks regained their footing and then they participated with the QQQ to lead the market higher until the end of January of 2018 while the small-cap stocks became laggards.

Conclusion #2:

The large-cap stocks were the primary leaders in the market from February of 2016 until the end of January of 2018. Since then, the large caps have been leading the market down. And because of the sharp declines on very heavy volume with the mid-cap and small-cap stocks equally as weak, the market lacks stability. At times, it seemed like the market was in a free-fall mode.

The two panels on the bottom of the chart are sensitive short-term trend-and-reversal indicators. Both of them were quick to reflect the weakness that occurred in the market on real-time bases and they are giving bearish readings at this time. The upper panel shows sets of breadth indicators comprised of moving averages and also highs and lows. The bottom panel deals exclusively with data for highs and lows. If you look closely at the red, black, blue and pink lines on the panel, you should see how poorly this indicator performed when the price action in the stock market (as measured by the SPY and my S450 index) was sloppy or weak while it was in a consolidating mode and (2) how well the indicator performed most of the time when the price action in the market stabilized and then trended higher. A clearer presentation of what this indicator does will be shown on the bottom panels of the next chart. That may seem redundant but I wanted to show these indicators on both the 150-day and 30-day charts.

This chart is the crown jewel of all the charts that I have in my workbook because it is more comprehensive and time-sensitive than the others. It shows breadth indicators for 32 indexes that I use for trend analysis purposes. The time span covered is 30 days. I also have a 150-day version of this chart. It would be almost unreadable if I showed it here because it would be five times as wide as this one and shrunk to the same size as this chart. It is handy at times when I want to back-test something.

(1) The first panel shows price lines for the major market averages and all of them trended upward as they reached historic highs in January. However, since then the trend reversed from bullish to bearish.

(2) The second and third panels show day-to-day price changes and the volume of trading for those averages, respectively. The price changes and trading volumes show when there was broad-based and bullish or bearish participation by the investment community.

(3) The fourth panel shows breadth indicators for eight moving averages. When the stock market was trading at its all-time high all of these moving averages were unusually strong, with net readings of plus 80% (meaning 90% were above trend and only 10% below trend). Since then the breadth indicators plunged to net readings of minus 92%.

(4) The fifth panel shows breadth indicators for stocks making highs or lows for eight time periods ranging up to 150 days; all of which got much stronger right after the Republicans passed their tax bill (scam?) last December. During the last eight trading days, there was virtually no strength and only weakness in this indicator. When I get a net reading on a high-low breadth indicator of minus 92% that means the vast majority of stocks among the 460 stocks in my workbook are participating and leading the decline.

(5) The bottom two panels are sensitive summary indicators. The first panel is a refined version of the highs-and-lows phenomena referred to in the fifth panel. These indicators are among the most informative ones that I got. If and when something significant starts to happen in the market with regard to a trend continuance or its reversal, such should be reflected almost immediately in this particular panel.

And (6) the second of these bottom panels is a summary of the 32 indicators shown above. The STTL (short-term signal line) alerts me a significant change that may occur in the trend of the market. The STTI (short-term-trend indicator) shows when the trend changed from bullish to bearish five trading days ago. It continues to be decidedly bearish at this time.

I do not have any long positions in stocks at this time. And I will not initiate any such positions until I can see that the bottom of the price line on a relevant stock chart has been defined. But with the market being volatile, I think it is prudent to trade leveraged ETFs at this time. So I may continue to trade long positions in the SPY, QQQ or the IWM and/or their related leveraged ETFs.

Thank you for reading and have a nice rest of your life.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY, QQQ, OR IWM over 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.