A Spring-Loaded Stock Market

Summary

• Stocks still under pressure but vulnerable to short-covering rally.
• A lack of bad news for a few days is all that's necessary to spark one.
• Bottom signal hasn't yet been confirmed, however.

After a long, grueling four weeks the stock market’s immediate-term trend is still undecided as the major indexes are testing an important longer-term trend line. As I’ll explains here, while the market’s internal health remains weak and selling pressure is still an issue, an important development is taking place. Specifically, the stock market has become “spring-loaded” in a proverbial sense and could soon witness a major short-covering rally. In this report, we’ll discuss what could catalyze this rally and what needs to happen before we get the next confirmed broad market buy signal.

Stocks rallied during the first half of Monday’s session and regained most of Friday’s news-driven plunge. Yet by day’s end the major indexes surrendered nearly all their gains and closed only slightly higher. The S&P 500 (SPX) finished with a gain of 0.33% while the Dow closed only 0.19% higher and the NASDAQ Composite rose 0.51%.

Last Friday’s selling was clearly overdone as evidenced by the impressive bounce-back in the first half of the trading session. As we talked about in Monday’s report, the stock market remains vulnerable to negative news as long as its internal condition remains weak (as measured by the new 52-week highs and lows). But with NYSE market breadth showing signs of strength, a lack of bad news means the buyers have an incentive to keep stocks stabilized as best they can in an otherwise choppy environment.

The day-to-day headlines are symptomatic of the stock market’s recent volatility increase. Monday’s rally can be attributed to a de-escalation of trade war fears after weekend interviews from several members of the Trump administration gave Wall Street the impression that the White House is trying to tone down its virulent rhetoric against China. Treasury Secretary Steven Mnuchin assuaged investors’ fears by stating that he doesn’t expect a trade war between the U.S. and China and that any such dispute between the two powers would likely have no “meaningful impact.”

From a purely market perspective the widely followed 200-day moving average of the S&P 500 Index (SPX) remained firmly intact on Monday, which also served to buoy investors’ spirits after Friday’s disastrous session. Investors are now looking ahead to comments from China’s President Xi Jinping, who is scheduled to speak at Tuesday’s Boao Forum, which partly accounted for Monday’s late-session reversal.

Source: BigCharts

On the positive side of the ledger, stocks have a couple of major technical supports in its favor as the market attempts to establish a meaningful bottom. One is the aforementioned strength in NYSE market breadth as measured by the advance-decline (A-D) line. As previously discussed, market breadth has been diverging higher even as the major averages have trended lower in recent weeks. What this suggests is that whatever trade news-related damage may be inflicted to stocks in the days ahead should be short-lived and likely won’t be exceptional in nature. The relative strength shown in this indicator, below, also suggests that there is enough buying interest across several major industries to prevent an all-out meltdown should news-related selling escalate once again.

Source: StockCharts

Along those lines, another indication that the stock market could soon find a bottom is suggested by the following chart exhibit. This graph of the 20-day price oscillator of the S&P 500 Index (SPX) is a measure of how “overbought” or “oversold” the stock market is in the short term based on the 4-week rate of change in the SPX price. Remarkably, the 20-day oscillator has fallen to only its third most “oversold” reading since the 2015 broad market correction! In other words, large cap stocks are about as sold out as can be expected given the fundamental and sentiment backdrop of this market. This chart also suggests that the market is “spring-loaded” as suggested in today’s headline and therefore vulnerable to a potentially strong short-covering rally in the very near future. While it’s anyone’s guess as to what could light the fuse of the next significant technical rally, one such possibility would be a positive resolution to the U.S.-China trade war dispute. Even that isn’t really necessary, though, for as long as the market remains undisturbed by additional bad news headlines (like Monday’s session, for instance) the market could still generate enough support to kick off a short-covering rally based strictly on how oversold it has become.

Source: WSJ

Before the market arrives at its next extended rally phase, however, there is still one important area which needs to see major improvement. I’m referring of course to the continued tendency of equities – particularly rate-sensitive stocks – to show up in unacceptably high numbers on the new 52-week lows list of both exchanges. The elevated number of new lows is the predominant sign of the lack of incremental demand for equities and is the simplest reason for the market’s lackluster showing in recent weeks. The persistence of rate-sensitive stocks being dumped has been the bane of this market and has prevented an otherwise strong fundamental backdrop from positively asserting itself. There were 53 new lows on the NYSE for Monday compared with 56 new lows on the NASDAQ. Both exchanges registered a decisively negative new high-new low differential for the day, which is yet another sign that internal selling pressure remains a problem that needs to be addressed before the bull can reassert itself.

That said, the negative high-low differential hasn’t been severe enough to act as a catalyst for a market crash. The following graph exhibits the daily trend of the cumulative 52-week highs and lows on the NYSE. As can be seen here, while the slope of this indicator is downward it isn’t falling sharply enough to suggest an across-the-board urgency to sell stocks. Nonetheless, until this indicator reverses its decline I recommend that conservative investors refrain from initiating new long positions in broad market ETFs while limiting purchases to only those stocks which display exceptional relative strength, both technically and fundamentally.

Source: WSJ

Aside from the NYSE new highs and lows, if there’s one indicator I could point to as being of paramount importance in determining the strength of the short-term trend I’d point to the U.S.-listed China stocks. Specifically, the iShares China Large-Cap ETF (FXI) needs to improve before we get the all-clear sign that the ongoing broad market correction which began in February is finally over. A 2-day higher close above the 15-day moving average (see chart below) would be the first “heads up” sign that the broad market is about to turn a corner. Aside from FXI being a long-time leading indicator for the SPX, the sensitivity of the U.S. stock market to China right now is as high as it has been in a long time. Thus any improvement in FXI from here would likely bode well for domestic equities.

Source: BigCharts

For now, investors should keep a significant amount of their powder dry as we wait for the internal selling pressure which has plagued the market in recent weeks to dissipate. When we see the number of stocks making new 52-week lows on both the NYSE and the NASDAQ shrink below 40 for several days, we’ll have the first serious indication that internal health is being restored to the market. This, in turn, will allow us to initiate new long positions as the stock market’s fundamental position remains strong and its longer-term technical trend is still positive. At this point, it’s simply a matter of waiting for incremental demand to return as measured by the new highs and lows. Until then, a defensive position is still advised.

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.