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The market started the week off with the bulls in charge pushing the markets up to key short-term resistance levels as shown in the chart below. (Note: as of this writing the markets are failing at resistance. If the market ends this week below resistance, the downtrend will be confirmed.)
With markets back to very overbought levels short term, the question is now whether the “bulls are back in town” or were they “just passing through.” The following chart attempts to prescribe the most likely path for prices in the short-term.
There are quite a few moving pieces here, so let me explain.
The shaded areas represent 2 and 3-standard deviations of price movement from the 125-day moving average. I am using a longer-term moving average here to represent more extreme price extensions in the index. The last 4-times prices were 3-standard deviations below the moving average, the subsequent rallies were very sharp as short-positions were forced to cover. The vertical blue bars show the previous two periods where bulls regained footing and pushed markets from lows towards new highs. The current setup is indeed similar to those previous two attempts. All we are lacking is some serious “jawboning” from a Fed official about accommodative support to push markets higher.
The bottom of the chart shows the overbought/sold conditions of the market. The vertical dashed lines show that oversold conditions lead to fairly sharp rallies. The recent rally, while the “best rally of the year,” has responded as expected from recent oversold conditions. With more than half of the oversold condition now exhausted, the potential for further upside has been reduced.
With the 125-day moving average trading below the 150-dma, and with both averages declining rather than advancing, the easiest path for prices continues to be lower as downward resistance continues to be built. The arching dashed red line shows the change of overall advancing to now declining price trends.
Given the current oversold condition, there is a strong possibility that prices could advance back towards the cluster of resistance now forming at 1990 on the S&P 500. As I have indicated, such an advance would correspond with a rally in the ongoing downtrend and a return of the markets back to extreme overbought conditions. Such would set the markets back up for the next retest of recent lows.
Bear Market Rallies Can Be Sharp
While “bull markets” are much more enjoyable than “bear markets,” being too quick to jump back on the bullish bandwagon can be hazardous to your financial health.
During bear market declines it is not uncommon to see sizable retracements in prices as “short-covering” rallies create fast burning advances that look like a return to a bull market. They usually aren’t and lead to further pain as markets once again fail and head back to previous lows.
As Richard Mojena recently penned:
“Impressive rallies during bear markets are far more common than we might believe, even dramatic. The twin-bears over 2000-2002 (-48%) had 6 weekly gains greater than +4%, the biggest at +7%; the shorter twin bears spanning 2007-2009 (-56%) marked 5 rallies over +4% in one week,the best clocking in at over +10%.
That’s not to say we’re currently in a bear market. We will only know that after the fact. What is a fact that was confirmed on January 15 and reconfirmed on February 11 is that we’re in a primary downtrend since 6 November 2015, until proven otherwise by a weekly close greater than 2014 (8% above the February 12 week-closing low of 1865) on or after April 8 (at least 8 weeks from the February low).”
This is absolutely correct. Most of the biggest daily and weekly gains have occurred during bear market declines. It is unlikely that the recent advance in the market, while it remains within a defined downtrend, is any different.
Numerous Outcomes – Mostly Adverse
Doug Kass recently penned an excellent piece on the current state of the market as well. To wit:
“In the four decades I’ve been investing, I can’t recall a time when there were so many possible market and economic outcomes, many of them adverse. Our markets and economies have never been so monetary-policy dependent, as our fiscal authorities have never been so partisan and inert.
Quantitative Easing and the Zero Interest Rate Policy were successful in trickling up to the S&P 500, although that didn’t trickle down to the average Joe. Our markets responded exuberantly over the past six years, but I’m fearful that a further drop in U.S. stocks could now run that “movie” in reverse — triggering a ‘negative wealth effect’ and bringing on a recession.
The risks and unintended consequences of ever-lower interest rates are rising. For example:
* Many companies have abandoned capital spending in favor of financial engineering.
* The risk of ‘saving ourselves into a recession’ (i.e. the ‘paradox of thrift’) is expanding.
* Low interest rates could cause cash hoarding, lowering personal-consumption expenditures.
* The ‘Ah-Ha Moment,’ in which investors lose faith in central banks, might be at hand.
* Bank net-interest margins and profitability could become challenged, and lending might be curtailed.
Most importantly, I’m fearful that years of artificially low interest rates have pulled forward economic activity and corporate sales/profits. I continue to see a 35% chance of a ‘garden-variety’ recession and a 15% chance of a deeper recession.”
Importantly, if Kass is correct, a normal “garden variety” recession sees stocks declining by an average of 30%. A deeper recession gets substantially worse.
Fundamentals Continue To Worsen
While the technical backdrop continues to deteriorate on many levels (such as momentum, relative strength and price trends,) the bond market continues to recognize the deteriorating fundamental underpinnings of equities.
Despite the recent surge in equities, interest rates continue to trade near the lowest levels we have seen in the last 40 years. Commodity prices continue to remain weak which suggests the global economy is struggling.
“We’re seeing it in the negative real and absolute interest rates around the world and in the widening spreads between investment-grade and high-yield debt. And we’re seeing it in the absence of corporate pricing power and the wobbly global economic growth.”
With profit forecast continually moving lower it is going to be much more difficult for the “bulls” to sustain a broader advance in the markets currently. Furthermore, with the ongoing strength in the dollar, which continues to erode exports, and consumer spending being diverted by surging healthcare costs which is dragging on imports and pricing power, profit margins continue to mean revert.
As Kass concludes:
“The 2009-2015 bull market reflected a recovery from the 2008 crash, as well as stocks’ upward revaluations based on investors’ realization that interest rates would probably remain ‘low for long’ by historic standards. But the market’s recent ‘re-rating’ of stocks downward seems to reflect a recognition that corporate profits will be ‘lower for longer,’ too.
Our recent market weakness might also reflect investors’ loss of confidence in central banks, as well as concerns that U.S. monetary policy has lost its effectiveness and/or simply pulled economic activity and corporate sales and profits forward. Again, I call this the ‘Ah-Ha Moment.’
Lastly, while the odds of a recession appear to be mounting, it’s important to note that a recession isn’t necessarily a precondition for a bear market.
Bear markets can occur even if America fails to fall into a recession, as happened in 1962, 1966, 1987 and 1998.
As legendary technical analyst Wally Deemer (a colleague of mine at Putnam in the 1970s) once put it: ‘You don’t buy GDP futures. You buy S&P 500 futures.'”
The important point is that the recent bullish advance, while heralded as the “second coming” by much of the mainstream media, remains a reflexive bounce within a bear market trend. That will remain the case until the trend is reversed and the fundamental underpinnings begin to improve.
Until then, for investors who continue to ignore the warning signs, the “beatings will continue until morale improves.”
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In