Time For The Bulls To Slow Walk

by: Clif Droke
Summary

Internal weakness on both exchanges has recently increased.

Investors should hold off on new long positions for now.

The bull will survive this latest internal correction, however.

In the first two months of 2019, stocks had one of their best performances in years as the S&P 500 Index (SPX) rose at an almost 45-degree angle with barely a pullback along the way. At the start of March, the SPX finally ran into the 2,800 level which has proven to be an insurmountable obstacle since last November. Now that the SPX, along with the other major averages, has pulled back and taken a breather, now would be a good time to evaluate how much gas the market has in the tank. As I'll explain in today's report, the market's key indicators suggest a longer period of consolidation - or "pause that refreshes" - is needed before stocks continue their recovery.

It has often been said that a bull market needs a fair amount of skepticism among investors in order to realize its full potential. Often expressed as the "wall of worry," this idea is based on the observation that as participants increasingly fear the future economic outlook, there tends to be a corresponding rise in short interest. This short interest increase can then be used to spark short-covering rallies, thus extending the bull market cycle through a continuing series of rallies and brief pullbacks. We now appear to have reached one of those "pullback" periods in the bull's recovery.

While worry is typically a good sign for the bull market's health, there is an exception to this rule, and that's when the market shows signs of being internally weak. Specifically, when the number of stocks on both the NYSE and the Nasdaq exchanges rises to above 40 for several days, it suggests that selling pressure is increasing - even if the major averages remain buoyant. And if this below-the-surface selling pressure continues long enough, it can weaken the market enough to allow sellers to force the major averages sharply lower before the buyers return.

When this condition of rising new 52-week lows continues for several days or weeks, investors' worries can actually have an adverse effect on the stock market. In other words, rising fear can spark a market decline if the market's internal condition is weak enough. While we haven't yet arrived at that point, we're getting closer to it. In previous trading sessions, we've seen the number of stocks listed on the Big Board that have hit new 52-week lows increase to slightly above 50. This marks the first time since December that there have been more than 40 new 52-week lows on the NYSE. While this isn't quite enough to confirm that an internal correction is underway, it does indicate that the market is facing increasing headwinds in the immediate term.

Another way of looking at the market's slowing momentum is in the following graph, which shows the 4-week rate of change of the cumulative NYSE new 52-week highs and lows. As you can see here, the momentum of the new highs-lows is not only slowing, it also has turned slightly lower in the last few sessions. A decisive break of the previous 2 ½-month upward trend in this indicator is needed to confirm that the market's near-term path of least resistance has changed from up to down. But the topping formation visible in this indicator, combined with the recent above-average number of new 52-week lows on both major exchanges, is enough of a warning to tell us to at least walk slowly from here. What that means in plain terms is that investors should hold off on initiating new purchases among individual stocks and broad market-tracking ETFs for now. Until the market's internal condition as reflected in the 52-week highs and lows has improved, a more defensive stance is definitely warranted.

Source: WSJ

Unlike the last time we saw a notable spike in the new 52-week lows prior to last year's plunge, in recent days, the increased new NYSE lows haven't been concentrated in just one area. Last summer, there was a huge and sustained increase in rate-sensitive securities which made new lows on almost a daily basis - from September through most of December. In the last couple of days, the increasing new lows have been spread across a variety of sectors, including financial, healthcare, energy, and shipping. We haven't seen enough evidence to warrant a bearish short-term posture on the stock market, but this should definitely be considered as a preliminary warning.

Technical considerations aside, there has been plenty of negative news headlines to allow the bears to make an attempt at regaining control of the immediate-term (1-4 week) trend. One source of the uncertainty hanging over the stock market is the latest U.S. jobs report which was released last week. The February Employment Situation Report revealed that non-farm payrolls increased by "only" 20,000 in February, which was well under the consensus expectations and significantly below January's 311,000 payrolls added. It was also well under the recent average of around 200,000. This gave Wall Street pause for thought as fears of a slowing economy persist.

However, the latest jobs report also showed that average hourly earnings for February increased by 0.4% and were up 3.4% year-over-year. Investors in the retail sector should be pleased with this since it supports recent consumer spending levels. The weak job numbers and strong hourly wage gains combined to increase volatility in the Treasury bond market. Participants have clearly become more interested in the safety of Treasuries in recent days, as evidenced by the latest rally in the iShares 10-20 Year Treasury Bond ETF (TLH), below. Investors have tended to turn to the safety of government bonds during periods of global instability or political turmoil in the last year, and this time appears to be no exception.

iShares 10-20 Treasury Bond ETF

Source: BigCharts

Yet, another fear confronting investors is the European Central Bank's latest decision to hold off on increasing interest rates. The ECB has also announced new funding for eurozone banks in the form of targeted longer-term refinancing operations (TLTROs). The ECB cut its growth forecast for 2019 to 1.1 percent last week, giving investors a reason to worry about a global economic slowdown. The latest plunge in the Invesco CurrencyShares Euro Currency Trust (FXE) to a new 52-week low is symptomatic of these widespread fears. FXE is a useful proxy for the euro currency, and the continued decline in the euro is a reflection of the perceived weakness in the eurozone economy.

Invesco CurrencyShares Euro Currency Trust

Source: BigCharts

There is enough circumstantial evidence to warrant a cautious stance toward equities in the coming days. As long as more than 40 stocks show up on the new 52-week lows of both major exchanges, investors should hold off on making new commitments. I also recommend taking some profits on extremely profitable long positions while raising stop losses on all long positions. Pruning the laggards from your portfolio would also be a good idea at this time in case internal weakness accelerates from here. That said, the market's underlying fundamental condition remains favorable for the bulls and we should see a resumption of the market's forward march once the latest news-related headwinds subside.

On a strategic note, traders can maintain a long position in my favorite market-tracking ETF, the Invesco S&P 500 Quality ETF (SPHQ), which I initiated back in January after the ETF closed two days above its 15-day moving average following December's plunge. I suggest using an intraday stop-loss slightly under the $30.00 level for this ETF on an intraday basis. This is where the influence of the widely-followed (and psychologically significant) 50-day moving average can be seen in the daily chart shown below. In the event that the $30.00 level is violated in the coming days, I'll move to a cash position in my short-term trading portfolio.

Invesco S&P 500 Quality ETF

Source: BigCharts

Meanwhile, investors can maintain longer-term positions in fundamental sound stocks in the top-performing real estate, consumer staples, and tech sectors. As previously mentioned, I expect the broad market recovery to continue once the latest internal correction has ended.

Disclosure: I am/we are long SPHQ, XLE, XLF. 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.