There are many signs that astute investors look for to confirm that a bottom has been made after a market decline. One of the most important signs is the tell-tale increase in investor pessimism as measured by various sentiment polls. But an even more reliable indication that the market is primed for a short-covering rally is whenever the word “crash” appears in financial news headlines. In today’s report, we’ll discuss the latest signs that participants are on high alert over the possibility of a market crash. As I’ll argue here, "crash phobia” is a useful sign that the bottom is in and that near-term moves in the major averages are more likely to be to the upside than the downside.
Accompanying last week’s low in the major indices were many signs that investor psychology has taken a pessimistic turn. For instance, the CNN Business Fear & Greed Index fell to one of its lowest readings in months, hitting a score 23 (out of a possible 100). This reading was a decisive sign that retail investors were bearish on the stock market outlook. From a contrarian’s perspective, extreme bearish sentiment after the market has declined for several weeks is often a sign that too much short interest has built up and that the market is poised for a rally. Even after the impressive rally in the S&P 500 Index (SPX) in the last few days, the Fear & Greed Index still shows that more investors are bearish than bullish, with the latest reading coming in at 38. Source: CNN Business
Another sign that the market is suitably scared, and therefore vulnerable to additional short covering, is visible in the Rydex Funds Nova/Ursa Ratio Sentiment Indicator. This indicator is a useful way to gauge the intermediate-term outlook of traders in the Rydex series of bull/bear mutual funds. After the market’s setback in May, mutual fund traders have clearly turned pessimistic on the intermediate outlook. The Rydex ratio (below) has hit its lowest level since last December at the time of the previous major low. This suggests that there is more upside than downside potential in the major indices in the coming months.
Source: Market Harmonics
However, an even more important sign that investors are still quite fearful can be discerned from the latest headlines on several prominent financial news sites. One such instance was seen on June 10, when Shawn Langlois of MarketWatch wrote an article entitled, “When the ‘herds get spooked,’ this is what a stock market crash could look like.” The article drew attention to a scenario envisioned by Charles Hugh Smith of the Two Minds blog, who suggested that the Federal Reserve’s ongoing support of the bull market will be its ultimate undoing. Said Smith:
"Confidence in the absolute efficacy of Fed intervention breeds complacency, which is the essential backdrop of stock market crashes. Crashes don’t arise from a skittish herd, they arise from a complacent herd."
The following graph is how Smith envisions the unfolding market crash.
The mechanics of Smith’s crash scenario aren’t important for the purposes of our present discussion. What is important is that the word “crash” was used in the headline of an article that was picked up by several news aggregators and online financial portals. As I’ve argued here, the appearance of the word “crash” – and the heightened emotions it conjures up – is symptomatic of the widespread fear being felt among the crowd right now. This fear of a market crash has already been used to ignite a short-covering rally in the major indices, and it should continue to fuel the recovery in the coming weeks based on how conspicuously fear has manifested itself.
Providing further confirmation that the short-covering rally now underway has plenty of strength behind it is the reversal in the prevailing internal momentum currents for both the NYSE and Nasdaq markets. My favorite way to measure the internal strength of the stock market is to look at the 20-day (immediate-term) and 120-day (intermediate-term) rate of change in the NYSE and Nasdaq new 52-week highs and lows. This series of rate of change indicators shows the momentum behind the new highs and lows, which in turn tells us whether there is more buying pressure or selling pressure for stocks.
Right now the immediate-term (1-4 week) and intermediate-term (3-6 month) internal momentum for the NYSE broad market is bullish. Shown below is the 4-week, or 20-day, rate of change indicator. As you can see, this indicator has turned up sharply in recent days and suggests that the near-term path of least resistance for equities is now to the upside.
An even more profound indication that stocks have a lot of upside bias beyond merely the immediate term is shown in the graph below. This one is of the 120-day rate of change in the NYSE new highs-lows. It has been in a decisively rising trend for several months and is a powerful reason why the bears have been unable to maintain their advantage whenever they occasionally get control of the market’s immediate trend, as they did in May. With this indicator continuing to rise, it’s acting as a proverbial needle in the backside of the bears and is making a consistently bearish bias a sure way to lose money.
Even more surprising is the recent development in the 120-day momentum of the Nasdaq new highs and lows. This chart has gone vertical in just the last two trading sessions, suggesting that tech stocks will likely benefit from more short covering in the weeks ahead. It’s very rare that this indicator goes straight up like it has of late. This is another confirming piece of evidence that the latest bottom in the major averages will likely be a lasting one.
While the daily number of stocks making new 52-week lows on the Nasdaq is still a bit too high for my liking, the new lows are shrinking and – more importantly – the number of tech stocks making new highs is increasing. Moreover, the number of new lows on the Big Board has declined to well below 40 and it looks like the NYSE will soon be back to a normal, healthy condition now that internal selling pressure has diminished. Based on the prevalence of bearish sentiment among retail investors and mutual fund traders, the market should have plenty of fuel for a continued short-covering rally in the weeks ahead. Investors are therefore justified in maintaining a bullish bias toward equities since the weight of technical, fundamental, and sentiment evidence all point to higher stock prices in the intermediate term.
On a strategic note, I’m currently long the iShares Core Growth Allocation ETF (AOR). AOR seeks to track the investment results of an index composed of a portfolio of underlying equity and fixed income funds intended to represent a growth allocation target risk strategy. The fund’s holdings include U.S. Treasury, agency and corporate bonds, as well as U.S. stock funds and equity funds which track emerging and developed markets outside the U.S. After confirming an immediate-term buy signal per the rules of my trading discipline by closing two days above its 15-day moving average, AOR on June 7 also closed above its psychologically important 50-day MA on a weekly closing basis for the first time in almost a month. I’m using a level slightly under the $44.18 level (intraday basis) as the initial stop-loss for this trading position.
Disclosure: I am/we are long AOR. 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.