Stock Market Update October 27, 2016

It has been a while since my last post, but since then I have learned a lot abut technical analysis. With new techniques in mind, lets take a look at where the market is now, and the possible path it will go.

Now, it is important to keep in mind that the election is influencing stock, foreign exchange, and bond prices. In fact, people have been using the USD - MXN (Mexican Peso) exchange rates as a proxy for the election. The Peso would weaken every time Donald Trump seemed to be pulling ahead, but it would strengthen when Hillary Clinton seemed to take the lead. This influence on the capital markets is justified by the uncertainty of the election. Investors are not willing to take big bets until they have a better grasp on the future.

Lets take a look at the S&P 500:

Over the last couple of years, the S&P 500 had been in a range between 1815 and 2125. This range was finally broken, and now the resistance has turned into a support. However, once it broke past 2125, it has not done much. The indicators below the graph are not giving any god signs either. Momentum has fallen, and is becoming more and more bearish. The ADX line (middle indicator), is showing that the trend is strengthening, and it is strengthening downwards.However, the support at 2125 is working rather well. It could be a good sign if the S&P 500 is still above the 2125 support when the election results are realized.

What are the headwinds for the S&P 500? Besides the election, earnings are also holding the index back. High valuations, on an absolute basis, is causing more people to keep there cash, rather than buying stocks. The fear of buying into an expensive market is worrying. However, on a relative basis, the S&P is not that expensive. With interest rates so low, the stock market could have higher valuation. Using regression analysis, the P/E ratio could be somewhere around 22, rather than the 18 it is at currently. The historical average P/E is not as useful in these abnormal market conditions.

Next, we will take a look at the NASDAQ Composite Index:

A similar setup is occurring in the NASDAQ Composite, as the S&P 500. You can see that it has
recently moved past the range, and is testing the support. Also, the momentum readings are similar, in that there is none. Investors are likely waiting for the election, before putting more money to work.

Now, lets look at the transports. This index has been used as a leading indicator for a long time, and can give some insight on the direction of the market.

The transports are a good leading indicator because companies need to transport materials and goods to customers. So, if the transports are making money, it means companies are transporting their goods. What we are seeing in this chart is a correction. The blue dashed line was the uptrend, then it broke down and followed the red dashed line. Now, there is a bullish formation called an ascending triangle. The ascending triangle has a flat top, with an angled bottom support. This is bullish because the support keeps moving up, which means more an more people are willing to buy at higher prices. Now, it may be a bullish formation, however, it is still possible for the index to break downwards.

What makes this chart great, is that it shows, just like the previous two indices, that the market is waiting. This pattern shows, that people are bullish, but they are waiting for a catalyst to really push the index up. Could the catalyst be the election?

Conclusion
For the moment, it seems that investors are waiting for a catalyst before they start moving into the markets. Even though normal valuation metrics put the market in an expensive range, it is important to realize that we are not in a typical market environment. On an absolute basis, the market is expensive, however on a relative basis, stocks have some room to grow. With low and negative interest rates around the world, the stock market could see a big gain as people are looking to put their cash to work.

What is that catalyst? Well, it seems to come down to two options, earnings and the election. Now that oil has stabilized, earnings are on pace to be positive for the first time since the first quarter of 2015. Which, could finally put fears of a recession away, for now. Without the fear of a recession, investors could be willing to put their sidelined money back into the markets.

The other catalyst could be the election. When the election is over, analysts, and investors will finally be able to change their expectations of the future. They will have a better grasp of future fiscal policies, and economic plans. Which of course, means they can implement their plans and strategies accordingly. Really, the catalyst is more likely a combination of the two. A strong quarter of earnings, and a more certain future could be great for the markets going forward.

Technical Damage from the Brexit: Indices

The UK Referendum to leave the EU has large and far reaching implications. Something like this has never really happened before, and it is generating vast amounts of uncertainty in the world financial markets.
It has only been a couple of days, but we can already see some technical damage being created on the charts. In this post, we will be looking at the major US indices. I will be writing about the US sectors later.

First, we will take a look at the S&P 500:

The first thing you will notice is that we are still range bound, and have not made a new high since May 5015. It looks like we were going to try to test those highs again, but the outcome of the vote sent the markets falling. The first support was around 2040, but that has failed to hold. The next price we will look for is 1950, which has never been tested as a support. However, it seems more likely it will fall to a support level in the 1800-1899 range. This is because of the similarities between the three previous crashes: a major event occurred outside of the US, panic, then the realization that the US is fine.

Next we look at the Dow Jones Industrial Average:

The chart looks pretty similar to the S&P 500, however, you will notice there isn't a support level between 17400 and 16400. This helps give credence to an S&P 500 support around 1850. Because the DJIA and S&P 500 follow each other pretty closely, you want to look for common areas on the chart. In this case the common supports are 1825 for the S&P 500, and 15,750 for the DJIA.

Now we look a the NASDAQ Composite:

As with the previous two indexes, you can see the common support is around 4200 for the NASDAQ Composite. It is also the next likely support for the composite, since it has fallen through the 4700 level.

Lastly, we look at the small cap stocks in the Russell 2000:

This index takes a life of its own, so we cannot really compare it to the other three indices. However, we can see that it has tried to leave the 1080 - 1210 range that it was in, in 2014. It fell out of the range at the beginning of the year, but fought back in. Now, we are testing that support once again, so we will soon see where the index goes from here.

To conclude, the Brexit caused a lot of damage to the charts. I believe that we were on the brink of starting a new bull, but it would have required the UK to remain in the EU. Now that we know they are leaving, the uncertainty the future holds is enough to scare investors away from stocks, and force the markets back down. Now the only catalyst that can bring us to a new bull is this quarter's earnings, but those do not seem to be good either.

Stock Market Update, End of May 2016

We will begin this analysis by looking at the most basic Dow Theory component, which is the transports must confirm the industrials. Take a look at the Transportation average below,

You can see that the transports are in a bear market. They did have a great bounce off the February low, with 22% gain. However, the trend is still pointing down.

Now, let’s take a look at the industrial average,

As you can see, there are quite a few differences in these charts. First off, the peak of the transports was near the end of 2014, while the peak in the industrials was around May 2015. Also, after the peak, the transports have had a bearish trend downwards, while the industrials have stayed pretty flat. Since the transports are in a bearish trend, we will wait to see if the industrials follow.

Next, we move on to the S&P 500, and the NASDAQ Composite Index.

A lot like the industrials, the S&P 500 is also moving sideways. There is a support just above 1,800, and resistance around 2,100. Right now, the S&P is testing that resistance, so it will be important to see what happens in the near future. If we can get a significant breakout, we can see the S&P to new highs. However, the breadth of the market does not show such strength.

In this chart, we have three indicators under the price. They are the MACD on top, the S&P High-Low Index in the middle, and the number of stocks above their 50 day simple moving average. All three indicators show bearish divergences.

The vertical blue line shows where the peak of the MACD was, across all indicators. We can see that the MACD has diverged from the price action. This is a bearish sign that the rally should be reversing. The recent peak and subsequent fall, illustrate the predictability of the MACD. Now that the MACD is back to 0 (the middle line), we will need to see where the index goes next. As we can see, the price is starting to move up again. However, this is not showing the breadth we would like to see in a rally, in fact the other two indicators are implying a reversal is on the way.

When an index moves in a bullish or bearish trend, you want to see the underlying stocks moving up as well. That is what the two lower indicators are designed to do. The High-Low Index shows whether or not stocks are making new highs or new lows. When the indicator moves up, it shows there are more stocks making new highs, than making new lows. When it moves down, there are more stocks making new lows, than there are making new highs. The number of stocks above the 50 day moving average is self explanatory.

You want to see these indicators following the market, but because the indicators are moving down it shows underlying weakness in the index. This is true for the other two major indexes. The NASDAQ Composite and the Dow Jones Industrial Average. These charts show weakness in the market, and that the recent rally is not likely to break to new highs.

Lastly, lets leave the US and take a look at the MSCI EAFE, and the MSCI EM charts.

This is a 10 year chart of the MSCI EAFE. Most recently, you can see a nice double top. This is a bearish formation, and implies a reversal. As you can see, the index fell 15% from the highs, and have fallen to the blue support line. I think this support line is just supporting prices for now, but when the US indices break downwards, this index will as well.

This emerging markets index is also on a 10 year chart, and shows a massive symmetrical triangle. This formation doesn’t tell you whether the move should be up, or down. What it does tell you is when price breaks out of the formation, the trend is most likely to go in the same direction. Based off of this chart, we would look to see the index continue to move lower.

In conclusion, it looks like the recently rallies are not sustainable. The weakness in market breadth is the major concern with these rallies. The underlying stocks are not showing the same strength that the index is showing, which is a problem. It means the indexes are relying on fewer and fewer stocks to push the index higher, and the recent rallies are not sustainable. Weakness in the EAFE and emerging markets indices also show that there is weakness around the world.

Predicting 2016, From a Behavioral Standpoint

The S&P 500 has had the worst start to a year in its history. Investors are worried about China, and the strength of the dollar. The first day of trading, in China, showed the first use of their circuit breaker system. This led to a global sell off of risky assets. Two days later, there circuit breaker system was used again! The market was only open about a half hour, before shutting down for the day again. On Friday the US had a exceptionally strong jobs report, but the trading day still ended up down around 1%. So, what is going on? Why are US investors selling their stock?

To understand why the market is selling, we need to look at the market behavior. We need to take a look at the market participants, and evaluate their reasons for selling.

The first thing you learn in your fundamental economics class is that in order for any theory to work, market participants are assumed to be rational. However, when you look at the stock market, you quickly realize that this assumption is about 50% false. Let us take a look at the rational side of things first.

The market has been on a tear since the Great Recession. It has been uncharacteristically good. If you bought in 2009, 2010, 2011, 2012, 2012, or even at the beginning of 2014, you likely saw some nice gains. So, you have some strong gains, in an uncharacteristically risk-less market. Now comes along 2015. The market does not move. There is the first correction in 3 years. First there was the Grexit, where everybody was uncertain about what would happen in Greece. Then there was the Chinese slowdown, where everybody was scared that a slowdown in China meant a slowdown in the global economy. On top of that, the bond market went into its first bear market in over 25 years. Commodities have plummeted, and oil just kept on falling. Earnings have been weaker and weaker. To top it all off, we had the first rise in interest rates in eight years. Even though all of this was thrown at investors the S&P held its ground. That is pretty remarkable. Now let's look at December 2015. Everybody is expecting this "Santa Clause Rally." Analysts everywhere, on every channel are predicting this rally to come, late into the year, but it never comes. Where does this leave investors?

With the memories of the Great Recession in the backs of their minds, they decide to take what they have gained. They are scattered, and jittery. They want to protect their gains, and make sure that they do not lose everything in a recession, or a big sell-off. With the recession in everybody's minds, they realize the risks of losses, and they remember that the stock market has its risks. The market will always go back down, so protect your gains and sell.

On the irrational side of things, people are actually wanting to buy stocks. They ignore evaluations, and believe the market is going to keep going up. This is entirely possible, but why would you want to risk it? The risk reward ratio has gone up significantly since 2015. You do not take the same risks for 3% growth, that you would with 14% growth. The stock market was not as risky in the previous years, not because the risk was not there. It was just less likely to occur. The Fed basically wanted to improve the economy by pushing up stock prices. With all the economic fundamentals going against the market, coupled with a negative year, it makes the likelihood of a downturn much more reasonable. At the very lease, investors should be rebalancing their portfolios to at least lower some risk.

That is right, it is irrational to believe the market will continue with its previous years strength. In prior years, the confidence of the stock market was strong. Interest rates were as close to zero as possible. The Fed was doing its best to propel the market up. All this has changed though. Interest rates have been raised, and the market is concerned that earnings are starting to slow. Sure you can miss a few percentage points of growth in your portfolio, but at what risk? Especially when you look at a typical portfolio. Even an average 60/40 portfolio, a 3 percent gain in the stock market only translates to a less than 1.5% increase in the portfolio. So instead of 60/40 portfolio, you would expect rational investors to lower stock exposure, and move to less risky assets.

With all of this, you would want to see a gradual step lower in the overall stock market. You should not see a huge drop, or panic selling (until maybe the end). There will be a gradual decrease in stock prices, and we have a well mannered bear market for a little while. At least until valuations decrease, and stocks become cheap again. When earnings show strength again, and global uncertainties start to go away again, people will gain their lost confidence back in the market, and move back into the more risky assets.

Disclaimer: At the time of publication the author is long RWM, DOG, SPH, PSQ. Inverse ETFs of the major US indexes.