8 Warning Signals Of Deteriorating Market Conditions

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Includes: AAPL, AMZN, FB, FNGD, GOOGL, IWM, NFLX, SDOW, SPY, SQQQ, TAPR, TVIX
by: JD Henning

Summary

Since at least early October many signals have been alerting us to rapidly deteriorating conditions in the market.

8 unique warning signals are summarized below with estimates on how significant the ongoing correction could become.

These indicators are the contributing basis for my active TVIX and FNGD trades on October 4th and 18th ahead of the two legs of the S&P 500 decline.

More recent signals this week suggest that the market decline could continue into a significant correction barring significant changes in policy and major macro-economic shifts.

Introduction

For the past several weeks I have taken defensive positions in the market leveraging the VelocityShares Daily 2x VIX ST ETN (TVIX) and recommending short-term hedge positions in similar funds like the ProShares UltraPro Short QQQ (SQQQ), MicroSectors FANG+ -3X Inverse Leveraged ETF (FNGD), and ProShares UltraPro Short Dow30 (SDOW).

The following 8 reasons are the basis for my current outlook and I will discuss in more detail:

1) Record high negative momentum gauge values and low positive gauge values.

2) Lack of technical support in the major indexes and the leading indicator of the Russell 2000 small cap index.

3) Fed continuation of interest rate hikes as GDP exceeds expectations again for the 3rd Quarter adding to inflation fears.

4) A large number of analysts forecasting further market declines including the Goldman Sachs Bull/Bear Risk Indicator at the highest percentage probability for Bear Market conditions since the 1960s.

5) We have crossed the "Tipping Point" for high probability of decline and bear market conditions as measured historically by market analysts.

6) The historical returns of the 5 days following an unusual -3%/+2% event as measured over the last 20 years.

7) Similarities to the February VIX shock and an end to two years of record low volatility events.

8) Other market anomalies related to the frequency of down days on the S&P 500 over the past 20 years.

Taken together each of these factors has contributed to my present longer term defensive posture as I will with much more granularity in the assessments that follow.

1) Record high negative momentum gauge values and low positive gauge values.

Among my earliest of the warning signals was my proprietary Momentum Gauges that have been setting new record highs each week on the negative momentum values. Each week I have been forced to extend the upper limit on the scale to capture the new record number of stocks satisfying the criteria for accelerating negative momentum across the three major stock exchanges as detailed in my research here.

For example, the Positive Momentum gauge dropped from a steady medium value around 65 in Week 39 (end of September) to values below 15 well into the red zone every week since September.

Similarly the Negative Momentum gauge that has not gone over 90 in the last two years, is now setting new highs over 100 every week in October. Ending this past week at 118 Negative momentum.

2) Lack of technical support in the major indexes and the leading indicator of the Russell 2000 small cap index.

My first technical alerts came from FANG stocks that had set up again for a strong negative breakdown. The mega-cap FANG stocks represent an oversized proportion of market index valuations and serve as very good early warning indicators by watching Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOGL). This technical signal was most visible in the highly leveraged FANG bear fund, namely the MicroSectors FANG+ -3X Inverse Leveraged ETF (FNGD) showing a positive trendline breakout on October 4th:

(Source: FinViz)

FNGD showing early signs of another technical breakout combined with the continued deterioration of the FANG stocks intra-day. Amazon (AMZN) and Facebook (FB) were among the first to break below key six month technical support levels as shown in the thumbnail charts below. This gave validation that a stronger move than the prior FNGD breakout conditions may be in the early stages.

File Uploaded: Current FANG stock charts - October 4, 2018 1:08 PM

(Source: FinViz)

At the same time Barclays Inverse US Treasury Aggt ETN (TAPR) was breaking out to new multiyear highs confirming a strong new shift in money flow.

File Uploaded: TAPR (inverse Treasury fund) - October 4, 2018 1:24 PM

(Source: FinViz)

TAPR at new 52 week high showing a significant breakout relative to aggregate treasury price movements.
The multiyear trend line breakdowns in the major indexes also illustrates what these signals may be pointing toward:
(Source: StockCharts)

Russell 2000 5 year chart below shows how the small caps have fallen further faster while the large caps are lagging but likely to have a similar percentage decline toward new support levels. iShares Russell 2000 ETF (IWM) has been a leading indicator relative to the larger cap indexes SPDR S&P 500 ETF (SPY).

My working theory is that the small-cap and micro-cap stocks may signal a support level before the mega-cap stocks find support, just as the smaller stocks broke down much sooner and further than larger stocks have to date.

3) Fed continuation of interest rate hikes as GDP exceeds expectations again for the 3rd Quarter adding to inflation fears.

U.S. government bond prices fell again Tuesday, pushing the 10-year Treasury note’s yield closer to a seven-year high amid gathering optimism about the global economy and expectations for tighter monetary policy from major central banks. ~ Wall Street Journal (Sep 25, 2018)

Adding to the view of stronger economic growth, the 3rd Quarter GDP data this week again beat expected forecasts and increased the likelihood of the Fed rate hikes continuing in December and even beyond.

Stifel's Barry Bannister - head of the firm's institutional equity strategy - was one of the few strategists who correctly called the February VIX termination slump that knocked the major indexes from all-time highs.

Fast forward to today when Bannister is out with a new note, according to which investors could be in trouble heading into next year as the Federal Reserve continues to tighten monetary policy, and keeps hiking rates. Specifically, Bannister claims in a new note that just two more rate hikes would put the central bank above the so-called neutral rate. (Source)

It is not simply that the rates are being hiked, but that a prevailing view holds that 3% interest rates are the start of a tipping point for markets that precipitates fund outflows and significantly reduces market liquidity.

Image result for fed fund rate chart

A 20 year chart of the Fed Funds rate shows the current hikes into 2018 that we are experiencing relative to prior rate adjustments and recessionary periods shown in grey.

4) A large number of analysts are forecasting further market declines.

There are a host of analysts across the financial spectrum now claiming they predicted a substantial downturn and this is the one. Many of these market analysts like to claim they were the first to call a top. I don't claim any special powers and I rely on many indicators to produce sufficient signals that I just can't ignore conditions any longer before I surrender my more bullish tendencies. This October has been such a time.

Goldman Sachs developed a Bear Market Risk Indicator based on five factors, in combination, that do provide a reasonable guide to bear market risk – or at least the risk of low returns: valuation, ISM (growth momentum), unemployment, inflation and the yield curve.

And, as Goldman's Peter Oppenheimer explained, while no single indicator is reliable on its own, the combination of these five seems to provide a reasonable signal for future bear market risk.

Goldman's indicator is inversely correlated with future returns, and as of this moment, Goldman is effectively forecasting a negative return from now until 2023. (Source)

The levels of the current bearish forecast are higher than both the 2000 and 1987 corrections and reach back as far as the 1960's for levels as high as today's GSBLBR warning.

5) We have crossed the "Tipping Point" for high probability of decline and bear market conditions as measured historically by market analysts.

The two factors measured in the chart below are (1) S&P 500 below 0% for the year and (2) US 10 yr rates over 3%.

Nedbank's Neels Heyneke and Mehul Daya, the strategists explain why they believe "we are approaching historical thresholds", where tighter monetary conditions in the US have traditionally been the "straw that breaks the camel's back" for the equity market and economic growth, and why "this time should be no different."
"This Is The Tipping Point": One Bank Is Calling For A 30% Market Correction

In fact using Y = -0.2992x + 0.8381 with current data as I calculated on Tuesday October 23 and again on October 26, we were at -0.102% on the Y axis. This puts us just inside the upper left corner of the inverse correlation box between interest rates and S&P 500 performance as illustrated in the graphic.

The key threshold for the S&P 500 was illustrated last Tuesday in my other reports where the index fell to the critical 2700 support line.

File Uploaded: S&P 500 recover chart - October 23, 2018 10:33 AM

S&P 500 has accomplished the 2nd lower downturn leg to 2700 as forecasted. Now we need a very strong rebound from here to levels above 2800 as in prior events. The "tipping point" occurs if the S&P 500 goes negative for the year below 2695.

As we know the S&P 500 has now fallen to levels well below 2700 and has turned negative for the year. However, unlike previous drops below this threshold level the combination with rising interest rates has created what analysts are calling a "Tipping Point."

6) The historical returns of the 5 days following an unusual -3%/+2% event as measured over the last 20 years.

This relates to an unusual market anomaly posted @OddStats this week that shows 15 prior events over the past 20 years where the unusual market event we experienced this past Wednesday (-3%) and Thursday (+2%) has occurred previously:

If you calculate the average 5 day S&P 500 return following these 15 events you obtain a -5.79% average decline. Applying this average decline to the S&P 500 market index on Friday gives us a target of around 2504 on the S&P 500 shown below:

However, according to the table there have been prior events where the subsequent decline was less than 1% and higher than 10%. While nearly all the 5 day periods were negative there was little correlation to the 1 day period following the event. We are within that 5 day window for Week 44, the last week in October.

7) Similarities to the February VIX shock and an end to two years of record low volatility events.

I noticed analysts were increasingly comparing the current October conditions to those in February. So as I detailed in my February VIX shock article here:

What Is The VIX Telling Us From 3 Prior Events?

the biggest takeaway was that the market had clearly exited the 4th longest low volatility market period in the past 68 years. Looking back at the relevant periods comparable to the extreme low volatility we enjoyed up until February 2018 you can see some very significant patterns. We are very likely entering the decade long periods shown below the dotted lines on the S&P 500 chart below. As I documented back in February:

From the start of 2016 to January of 2018 a long position in XIV returned over 600% from approximately $20 to over $120 per share in two years. This was during a record period where the S&P 500 stayed within 5% of a 52-week high consecutively for more than 370 days. A stretch that we have not seen in about 25 years:

(Source: Sentiment Trader)

What we can observe from each of these record low volatility periods is charted on the 68 year chart of the S&P 500 below:
Interestingly, in the years following each of these 3 prior low volatility periods we see multi-decade declines with higher volatility and a series of descending tops. Eventually the S&P 500 recovered and re-entered another positive extended period of record low volatility as shown above. Another observation is that following the conclusion of each prior event there was no immediate recession period as depicted in gray on the chart. The nearest recession period was at least two to three years from the end of the period 3 event. While the sample size of these events is quite small, the relative significance of these record 350+ day low volatility periods may give us some reliable indicators of market behavior yet to come. In summary:

  • 2 of 3 prior low volatility period ended at or near an S&P 500 market top.
  • All 3 prior events were at least two years and as far as six years prior to any official recession period.
  • 2 of 3 prior events were followed by at least ten years of long term market decline.
  • In all three cases the market subsequently rose to new highs that also included new periods of record low volatility.

As I wrote back in February:

Does this mean we are entering a period of extended decline? Not necessarily, but I do think we are entering a period of increased volatility and much higher risk.

8) Other market anomalies related to the frequency of down days on the S&P 500 over the past 20 years.

Other market anomalies that have caught my attention further validate the possibility of a particularly unique market decline event. Again from @OddStats the following two charts show frequency events of the highest number of S&P 500 days of decline within 15 days and 25 days over the past 20 years.

(Source: @OddStats)

In both charts the indicator shows we are in a unique 20 year event. In the prior event shown below the market declined over 40% in 2000 into 2002. This may suggest a longer term downturn trend and not necessarily a short term correction.

(Source: @OddStats)

Taken together there are a number of signals showing unusually high risk probabilities and substantiate the approach I have been taking with regard to market hedges and cash positions in my trading portfolios.

I hope this mix of past and current signals may be of value to your trading decisions, just as the many different signals and cautions have been for me.

All the best,

JD Henning, PhD, MBA, CFE, CAMS

Disclosure: I am/we are long TVIX.

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.