Technical Index Review 3/27/2010

SPX – S&P 500 Index

In our final Weekly Review for 2009, we sketched out what we believed was the most likely projection for the SPX in 2010 and we reproduce that chart at the top of this page.  The bold line was our preferred trajectory for the index but it didn’t work our as we expected.  The index did see a sharp decline from a January peak and it did post a meaningful low around our February 4th turn date (actually on Feb. 5th) but it was not nearly as deep as we expected.  Also, the ensuing bounce carried to new recovery highs, which although we made allowances for it, was not what we expected.  This brings us to the alternate scenario whose initial stages were sketched out by the broken chart line.  So our best projection now is that the SPX is heading for an April 5th peak that is likely to roll over into an interim low around May 28th.  We’ve given a target for that peak around the 1228 area, which is the 62% retracement level from the ’07 highs.  Whether that target is attained within the time allotted is unclear but we would place more emphasis on the turning point provided by the cycle date than the actual price target.

The April 5th cycle date meshes well with the end of the quarter, which is notorious for bullish climaxes due to portfolio window-dressing.  It also allows for a reaction to the March employment data that is due for release next Friday.  The market will very likely maintain a bullish bias into the employment report.  Enough talking heads are projecting an increase of 200K to 300K in Payroll Numbers and that will keep traders motivated to game the reaction, especially since the bulk of that increase will be due to temporary Census workers.

Trading head games aside, we have some serious concerns about this market.  Many of these issues have been dogging the market for a number of months already and they are now coming to a head.  The most pressing issue is the 4-year cycle low which is due in late September.  We would like to see a 5-6 month decline into that longer-term trough and that would mean that the market would have to react to the April 5th 82-day cycle peak and establish an intermediate-term top, in order to allow for somewhat of an orderly decline into the September trough and also make for a meaningful 50% to 62% retracement of the advance from the March ’09 lows.  If the April 5th reversal is missed and the market continues to meander higher, we will likely have to wait for the late-July peak projection, which will not allow enough time for a meaningful and orderly correction into the key September low.  That would likely mean a sharp sell-off, similar to what we saw into the October / November lows of ’08.  Most traders would pose another scenario, that the market continues relentlessly higher and will not likely suffer anything more than a garden-variety 10% bull-market correction.  We argue against the bull-market scenario at this point for reasons listed below.  Note: we are partial to the 82-day cycle because it has had the best fit to the market’s intermediate-term swings over the past few years.

Here are some of the concerns that have stuck in our craw:

Longer-Term Bearish Consolidation

The advance from the March ’09 lows has taken the form of an ascending wedge, which is an upward sloping triangular formation that tapers to a narrow point as it rises.  Ascending wedges are known bearish consolidations.  So, an ascending wedge that had been in force for nearly a year, taken in the context of a longer-term decline from the ’07 highs, has the makings of a bear-market rally. 

Deteriorating Volume

Throughout the bulk of the market’s advance over the past year, the general volume trend has been down.  This longer-term deterioration in volume supports the bearish consolidation theory that we’ve presented in the previous section, since counter-trend consolidations – bullish or bearish – are typically accompanied by deteriorating volume.  The negative volume profile goes beyond the general deterioration over the past year.  Since June ’09, we’ve seen volume increases, on a shorter-term scale, associated with the pullback phases.  This negative volume thrust has become more pronounced over the past few months. Most notably with the deterioration of volume into the January peak, the substantial volume increase into the February lows and the substantial deterioration in volume over the past month as the major stock indices post new recovery highs.  This shorter-term negative price-to-volume relationship is a sign of stock distribution and the mark of a nervous market.

Bad Mood

There is currently a general sense of malaise that runs around the world and paints a very dark backdrop for the equity market.  Bob Prechter has done some great work in this area and points out that form a longer-term perspective, social mood dictates market tendencies and that we cannot expect a sustainable bull market to establish itself if the prevailing social mood is malignant. 

This bad mood is currently manifesting itself in various forms of social unrest.  In January when major financial institutions announced bonuses, there was public outrage that these executives were living high on the hog again not much more than a year after their companies were on the brink of extinction.  This prompted congressional hearings here, with financial reform to come and even prompted new legislation in the UK, taxing bankers’ excessive bonuses.  More recently, we have seen repeated demonstrations in Greece over the past month, protesting the government’s austerity proposals in order to combat a run-away debt problem.  In Thailand, protesters threatened to bring down a corrupt government.  Russian protesters railed against the government’s economic policies and lack of freedom, calling for politicians to resign.  Nigerians protested against a government’s lack of leadership.  French voters threaten to vote out regional government officials over growing unemployment and a rising public debt. 

Closer to home, we’ve seen a few high profile gubernatorial and senate election upsets where Democrat incumbents have been ousted by Republican challengers.  Polls are indicating an overwhelming amount of voter dissatisfaction with their congressional representatives.  A recent Rasmusen poll indicated that “just 25% of US voters now say the country is heading in the right direction”, which is a new 2-year low.  We’ve seen Tea Parties sprout across the country, where conservatives congregate peacefully to protest the liberal spending of government.  We’ve also seen students in a number of universities protesting education cutbacks but most visibly in California, where they blocked off major freeways.  And the legislation that is currently being crafted for financial reform is sure to put the screws to the financial industry, in response to public outrage against excessive compensation, too big to fail, abusive practices and conflicts of interest.  These protestations against a profligate government are only just beginning and are likely to continue into the mid-term elections in November.  The protestations that we’ve seen so far have been mostly in the polls and the few public demonstrations that have taken place up to this point have been very orderly and even civil.  Before this bear market is over, what we are likely to see are more frequent and aggravated protestations, akin to what went on in the 70s, where riots, protest vandalism and a general increase in crime were the rule.

Deterioration in Breadth Momentum

Although popular measures of market breadth like the NYSE A-D Line have posted new recovery highs recently, a reliable measure of longer-term breadth momentum, the McClellan Summation Index, established a peak in September ’09 and has deteriorated since.  Also, the percentage of NYSE stocks above their 200 day moving average posted a peak in September ’09 and has been in a down-trend ever since.  So, the market seems to have established an internal momentum peak already and the move to new recovery highs that we’ve seen recently in the major stock indices is likely to be a negative divergence.

Market’s Overbought Condition

Popular price momentum indicators, like RSI or MACD oscillators, have reached extremely overbought levels – like the levels that preceded the ’07 peak – on both, a daily and a weekly measure, and are starting to show signs of fatigue.  Weekly charts of these oscillators have been showing negative divergences since September / October ’09 and confirm the breadth momentum peak that we’ve seen in the McClellan Summation Index and the percentage of NYSE stocks above their 200 day moving average.

Lack of Retail Participation

Since the market’s aggravated decline in ’08, we have seen a tidal flow of investment funds away from the equity market, toward safer harbors like money market and bond funds.  Over the past year, professional traders have focused on this lack of participation from the general public in the equity market and have held long, waiting for those funds that have been tied up in money market and bond funds to come screaming back into stocks – but it just hasn’t happened.  Many pros continue to hold out, bearing the risks of an overbought market, thoroughly convinced that the retail trade will come back. 

This is not so much arrogance as it is 20 years of conditioning.  Since the early 80s, the trading and investing communities have really had to deal with only one longer-term direction – up.  Cyclical oscillations in the market made for temporary shifts out of the stocks.  Recessions were fairly short, the prospects for finding work were good and credit was readily available.  Traders had tuned into this fairly regular rhythm of cyclical in-flows and out-flows of funds allocated to the stock market and have been hammering out that same rhythm until now.  The only problem is, the song seems to have changed. 

Regardless of whether we believe that the recession has ended or that it will continue (double-dip), its duration rivals that of the 70s and so does the rate of unemployment.  Credit is not expanding as it had around other cyclical troughs over the past 20 years.  As a matter of fact, credit continues to contract as households look to pay down debt.  And with Boomers now approaching retirement age, who have been the major economic force over the past 30-40 years, they will be less likely to readily commit funds to risky assets like equities.  Especially after suffering two major stock market declines in 10 years, with funds that were committed to stocks in 2000 are deeply under water right now.

Without the retail investor in the equity market to provide liquidity and to take the other side of the trade, it is likely to be a very messy affair when the pros look to cash out.  There’s a lot of group-think on Wall Street and once the battle cry is sounded to sell stock, we are very likely to see a sharp drop in equity prices as everyone tries to hit the exits at the same time.  Over the past couple of months we’ve started to see overt signs of distribution, so it looks as though some heads have already started to turn toward the exit.

China

Emerging economies were the big story that drove equity markets since the ’02-’03 lows and their poster child was China.  This huge and underdeveloped country was expected to suck up the world’s resources for its build-out and indeed, China and its Asian satellites, along with Brazil, Mexico Canada and Australia who were going to be major commodity suppliers, handily out-performed the more established US and European stock markets.  China’s leadership role in the equity markets became well established.  Momentum on the way up, into the ’07 peak outpaced the West.  Momentum on the way down, after the ’07 peak also outpaced the west in the initial phases of the decline.  The bottoming process was quicker for China and for most of the major Asian indices, as their troughs were made in October / November of ’08, while the US and Europe actually bottomed in March of ’09. 

This leadership continues today only this time, to the downside.  With the US, Germany and the UK poking through their January highs recently, the major Asian indices have not.  Actually, China established its peak in August ’09 and has been in a down-trend ever since.  The interesting development here is that China’s equity market peak coincided (actually led by a bit) the internal momentum peak that we’ve seen for the US, as measured by the McClellan Summation Index and the percentage of NYSE stocks above their 200-day moving average.  Many talking heads are pointing to recent US equity market out-performance as a key leadership change.  We don’t think so.  If history is any guide, real leadership changes typically happen after meaningful and usually painful market declines.  We didn’t see a leadership change after the March ’09 lows, so we would have to go through another painful market decline to get another opportunity at leadership change. 

More importantly however, it looks like the China build-out story is probably done for a good while.  We’ve seen headlines over the past few months reporting the shuttering of factories due to overcapacity.  What was most intriguing though was a recent story about an uninhabited city, brand new with wide boulevards and crisp new developments, just waiting for inhabitants to come rushing in.  That’s the great thing about central planning – you can build entire cities, even if you don’t have the residents to populate them just yet.  China’s apparent over-building is signaling that the heady rate of growth that it has been reporting until recently will have to ratchet down.  That will probably mean pain for the commodity bulls who are expecting China’s real growth rate to climb back up to ’07 levels

Fear in the Currency Markets

Something important shifted for all of the world’s investment markets in the autumn of ’09.  We noted a peak in breadth momentum, as well as a peak in price momentum for the major US stock indices.  We noted price peaks in key Asian stock indices.  We also saw important peaks in key currencies that were associated with the global growth story. 

At the forefront was the euro.  Whether it was the euro/dollar or the euro/yen cross that was used as the market’s barometer of risk tolerance, all was well into the autumn of ’09.  The euro/yen cross which was a benchmark for the risk carry trade, made a series of peaks between June and October of ’09, around the top of a multi-month trading range for the cross.  October was the final peak that made the top of that range, before the cross established a down-trend.  The euro/dollar cross established its peak in December and has dropped sharply over the past few months.  But it was just this past week that this cross broke below a key retracement level, which now argues for a test of the October ’08 lows.

A currency cross that is not followed as widely in the US is the euro/Swiss cross.  The Swiss franc has been a traditional safe haven in the currency markets and its comparison to the euro has been a useful tool for gauging the market’s tolerance for risk among many European traders.  Since the euro’s inception, the euro/Swiss cross has had a remarkably tight correlation with the longer-term swings in the SPX.  It followed the bottoming process in ’02-’03, the topping process in ’07 and made a spike low in October ’08, right alongside most of the world’s major equity markets.  The cross broke down sharply from a multi-month topping formation in December ’09 and is now making new, all-time lows.  This is one international gauge of market fear that we need to pay attention to and if history is any guide, its move to new lows is indicating severe pain in the world’s equity markets.

Conclusions

We’ve made the case that the SPX remains in a longer-term bear market.  That is, the down-trend that began with the “07 peak is likely to remain in force.  At the very least, a test of or a substantial retracement toward the March ’09 lows should give the index a chance to build a longer-term basing process. 

The issue that confronts us now is the shorter-term oscillations in the index.  Since its breakout through the 50% retracement line from the ’07 highs at 1121 and its subsequent move above a “fudge factor” that we had for the index at 1150, the SPX is now mechanically positioned for a test of the 62% retracement line at 1228.  Using our dominant 82-day cycle, which has served us well over the past few years in approximating turning points, we note that the next intermediate-term cycle peak is due on April 5th.  So over the next week, we are inclined to give the up-trend the benefit of the doubt.  We will be using resistance increments at the 1180, 1195 and the key target of 1228.  Should the index break below the 1150 area at any time however, we will be looking to get defensive.  The SPX has become extremely overbought over the past month and the advance has come on steadily deteriorating volume, which means that the party has moved onto very thin ice.  Any sign of new cracks, like a break below 1150, and we’re out of the pond.