The Risk Of A Market Crash Abates - For Now

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About: SPDR S&P 500 Trust ETF (SPY)
by: Optimized Investments, Inc.
Summary

Historically, bull markets regularly establish secular trend lines that serve as support for prices, and breaks of these lines are consistent harbingers of imminent bear markets.

Last week, the S&P 500 bounced higher off of its Long-Term Support Line, allowing investors a reprieve after coming very close to the edge of the proverbial cliff.

Investors can breathe a sigh of relief – at least for the time being. Nevertheless, economic pressures are building, and it's only a matter of time until this very long business cycle is complete.

S&P 500 Bounces Off Long-Term Support

Last week, we published a report that previewed the potential outcomes from the S&P 500's status just above a combination of its 40-week (200-day) moving average and its Long-Term Support Line, both of which had coincided at about 275 on the SPDR S&P 500 ETF Trust (SPY).

While investors have long considered the 200-day moving average to be a critical threshold that determines the outlook for a stock, index, or ETF, many don't appreciate the more impactful significance of a Long-Term Support (LTS) Line being broken. That's because significant breaks of these secular trend lines almost always foreshadow an imminent bear market.

Many long-only investors will be glad to know that the S&P 500's test of its LTS Line last week was successful. They may not have known that they were faced with the possibility, but tens of millions of buy-and-hold investors should breathe a sigh of relief that a bear market is not about to maul their wallets – at least not right now.

Chart 1 below shows a weekly chart of the SPDR S&P 500 ETF (SPY) with a red circle/yellow highlight on the price action for the last few weeks. The ETF had dropped precisely to a meaningful confluence of both the 40-Week Moving Average (dotted-red) and the Long-Term Support Line (dashed-green) – then last week SPY shot sharply higher (4.5%) after bouncing off the critical support level at 275.

Chart 1: The S&P 500 ETF (SPY) surged sharply higher, gaining 4.5%, after bouncing off the dotted-green Support Line and the dotted-red 40-week Moving Average.

What caused this Superball-like bounce? Technicians will say that it is the Support Level itself, combined with the fact that economic indicators have yet to roll over, that was the force behind the reversal of the downward price trend. Fundamentalists will tell you that stock prices had dropped too far too fast, had become oversold below fair value, and conditions were ripe for those who buy the dip.

Investors who believe that news drives markets will tell you that last week one particular story put stocks in reverse higher off their downward trajectory. Moreover, another story that came out on Friday is likely to boost stocks sharply higher this week:

1) Last Tuesday, Federal Reserve Chairman Jerome Powell made a dovish speech saying that Fed Funds interest rates may be going back down. Apparently, the specter of economic slowing has shaken the Federal Reserve off its hawkish, rate-tightening mission and back into being open to easing.

However, one must wonder: is the Fed leading the market or following? Considering that the 10-year Treasury Bond yield ($UST10Y) has fallen from 2.85% six months ago to 2.12% on Friday, June 7 – down -25.6% in the most significant decline over that span since the Financial Crisis, the answer seems obvious. Economists now expect the Fed to reduce rates by 0.5 percentage point in September and by another 0.25 percentage point in December.

Nevermind that declining interest rates and an inversion of the yield curve are a sign of economic weakness – one that we can deal with later – so we must assume investors believe. Right now, the Fed lowering rates is the opposite of the Fed increasing rates, and that means more money available to businesses at a lower cost, which equals increased profits and higher stock prices, so buy, buy, buy!

2) Late last Friday (June 7), President Trump announced that there would not be a 5% tariff (which he previously threatened to increase to 25% by October) placed on goods imported from Mexico at the deadline he set on Monday (June 10). Trump said that Mexico capitulated and pledged to increase efforts to stop illegal immigration, which he had tied to the tariffs.

However, critics say that nothing of substance has changed, and no agreements were signed with America's number one trade partner. Trump was likely spooked by the overwhelming public outrage at the forecast cost of such tariffs for America's voters on billions of dollars of products ranging from guacamole to gaskets. Senate Republicans also let the White House know that they were not on board with Trump's proposed plan, and would likely take legislative action to stop it if enacted.

Trump threw in the towel on his ill-conceived concept to stem the all-time-record high flow of the citizens of Mexico, Guatemala, and Honduras to the United States. The latter two of those countries have lost 1% of their populations as refugees head north in what has become a humanitarian crisis. However, for most investors, the flow of illegals is someone else's problem, and US businesses are justifiably relieved to see that the tariffs won't go into effect after all.

As a result of these developments and others, expect stocks to respond bullishly on Monday, probably for the rest of this week, and perhaps into next. That means that long-only investors who were savvy enough to be aware of the potential for a break of the Long-Term Support Line last week are now breathing easier. At least until stocks threaten to drop below that Support Line again...

Breaks of Long-Term Support Lines Signal Bear Markets

The reason we have given extra attention recently to the Long-Term Support Line (dotted-green lines) is that breaks of secular Support Lines have historically proven to be markers of the start of Bear Market downturns.

That statement has one caveat: The breaks must be accompanied by a significant deterioration of macroeconomic factors and stock fundamentals, or it won't be a definitive break. Instead, those breaks become only temporary as investors buy the dip. The most obvious example of such a head fake was the fourth-quarter 2018 drop below the Support Line. A quick recovery to start 2019 followed this break because economic indicators were still adequately positive – enough to influence investors to buy stocks and return them above the danger zone. If conditions had been satisfactorily adverse, investors would have continued to sell to avoid losses, causing the market to continue to decline.

Chart 2 below shows a weekly chart of the SPDR S&P 500 ETF (SPY) from 1994 to present. In this timeframe, you can see three significant Long-Term Support (LTS) Lines shown by the dashed-green lines. Each time there was a definitive break of the LTS Lines, stocks continued downward and became a bear market.

Chart 2: Significant breaks of Long-Term Support Lines (dotted green) can serve as excellent identification of the start of bear markets.

We could take this analysis back before the turn of the last century – into the 1800s, when charts were consistently maintained – and continue showing the parallels throughout history where bull markets regularly establish Long-Term Support Lines, with breaks of those lines becoming harbingers of imminent bear markets. However, we're sure you get the point – when we see the LTS Line broken to the downside in a significant way, its a sign that the market is unlikely to recover and its the beginning of a new phase of economic contraction.

Disclosure: I am/we are long SPY. 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.