'It Ain't Over 'Til It's Over'

Summary

• Market remains vulnerable to negative news as some weakness persists.
• There are some encouraging signs of a coming bottom, however.
• For now a cash position is still recommended as selling pressure remains.

Just when it looked like the turbulence was subsiding, things got interesting again for the stock market on Friday. The back-and-forth action in the equity market has mirrored the high intensity tennis match between the U.S. and China over trade tariffs. There are some encouraging signs that the market could post a final low sometime in the coming week, which we'll discuss here. Until the market's internal selling pressure simmers down completely, however, it's too soon to assume the bottom is in since the potential for more downside still exists. Or as Yogi Berra famously said, "It ain't over 'til it's over."

The benchmark S&P 500 Index (SPX) closed Friday's session with a 2.19% drop after stocks were sold heavily from the opening bell on trade fears. The Dow, Nasdaq, SPX, and Russell 2000 declined between 1.9% and 2.3% during Friday's session. Equities fell out of bed following the news that President Trump ordered the Office of the U.S. Trade Representative to consider whether it would be appropriate to impose an additional $100 billion of tariffs on Chinese imports on top of the proposed $50 billion of tariffs announced on Wednesday. China quickly responded, saying it would "do what is necessary to protect its interests at any cost" if the U.S. ultimately pressed ahead with such a tariff plan.

Wall Street was particularly on edge by the hard-line tone of administration officials on Friday as they discussed the new proposal. There was also a sense that the administration was unconcerned about the effect the proposed trade policy is having the stock market. President Trump noted that the stock market might have to suffer a while as he works to protect the trade interests of the U.S. Meanwhile, Treasury Secretary Mnuchin said in a CNBC interview that he is not focused on short-term market swings and that there is potential of a trade war with China even though that is not the objective.

Selling was subsequently very pronounced Friday although none of the major averages violated their lows from earlier in the week. Every sector ended with a loss with the industrials sector suffering the largest decline with information technology, financial, materials, and health care all underperforming. Meanwhile the SPX violated its widely watched 200-day moving average on an intraday basis Friday, but recovered sufficiently to close the day above it. This keeps the longer-term uptrend line inviolate for now, though this week's trading could witness a temporary break below it.

Source: BigCharts

Our latest review of the market's internal structure shows that there is clearly some internal weakness which needs to be completely squeezed out before the bull is ready to run again. That said, there are some preliminary signs that a bottom may very soon be established in the stock market. One of the most conspicuous of these is the remarkable strength visible in the following graph of the NYSE advance-decline (A-D) line. Market breadth, which is one of the most basic of all measures of broad market strength, has been diverging higher even as the major averages have trended lower in recent weeks. This tells us that whatever trade news-related damage may be inflicted to stocks in the coming days should be short-lived and likely won't be exceptional in nature. At any rate the market's immediate-term trend remains down as we'll see here, so it's too risky to assume that the market will rally from here without first seeing a significant improvement in NYSE internal momentum.

Source: WSJ

Two of the most important charts right now are the iShares China Large-Cap ETF (FXI) and the PHLX Semiconductor Index (SOX). Both are highly sensitive to the immediate-term developments as it pertains to the ongoing trade dispute between the U.S. and China, particularly FXI. Moreover, FXI has proven to be an even more sensitive barometer of selling pressure than even the Dow or the S&P 500. Consequently, a break below FXI's February low would likely serve as a catalyst for additional selling pressure in the U.S. broad market due to heightened sensitivities to China. Needless to say that until FXI shows improvements in its price structure, the immediate-term outlook for U.S. stocks is still very much suspect.

Source: BigCharts

Notice also that the semiconductor stocks are showing relative weakness right now. The SOX actually under-performed most major sectors and all the major averages, so until we see evidence of a bottom and reversal in the SOX it would also be a good idea to refrain from making new purchases. Accordingly, a heavy cash position is still advised for conservative traders and investors right now.

Source: BigCharts

We also need to see definite improvement in the short-term internal momentum structure of the broad market. Below is the graph showing the 4-week rate of change for NYSE new 52-week highs-lows, which I use as an indicator for the stock market's near-term path of least resistance. This indicator reflects the incremental demand for equities, so until it reverses its decline the broad market correction which technically began in early January should still be considered to be underway.

Source: WSJ

It's also imperative that the number of stocks making new 52-week lows on the NYSE remain below 40 for a few days to let us know that internal selling pressure has completely diminished. While there was a sub-40 day on Thursday - the first in almost a month - there were once again more than 40 new lows on Friday.

The problem with the persistence of the 52-week lows is that it makes the stock market vulnerable to news-related shocks (like what we saw on Friday) as long as the downward momentum of new lows persists. It's still clear then that the weak incremental demand for equities which has plagued this market for weeks remains a problem. A continued defensive stance is therefore still advised as conservative investors should avoid initiating new purchases until the new 52-week lows improve enough to let us know that the selling pressure has completely dissipated.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.