Santa Claus rally or the start of something bigger?

Stocks are trying to live up to the expectations for a year-end “Santa Claus” rally.  Most of the market’s improving internal condition is due to the latest strength in the energy sector, with the NYSE Oil Index (XOI) rallying some 6% from its recent lows.

Although recent trading volume has been far lighter than normal, the NYSE advance/decline ratio for Dec. 23 was an exceptional 13:1 in favor of upside volume.  That completely reversed the 1:11 downside volume day on Dec. 11.  It also was the first time since Oct. 5 that the up/down volume ratio has been so high in favor of advancing volume.  While the Dec. 23 big volume ratio may have been a holiday-related aberration, if it’s followed by a 9:1 up/down volume ratio in the next few days it will qualify as a major volume reversal signal which would mean at least a temporary reprieve from the selling pressure of the last few months.

The key to the holiday rally has been short covering in the two biggest problem areas for the stock market: energy stocks and China ADRs.  The 6%+ rally in the XOI mentioned above was mainly the result of a rally in the crude oil price.  As you can see in the following graph, crude oil still hasn’t closed the two days higher above the 15-day moving average required to confirm an immediate-term bottom, but it’s testing this important trend line. 

A reversal of the oil price decline, even temporarily, would undoubtedly give the equity market a relief from the selling pressure that has plagued it for months.  Most of the stocks showing up on the NYSE new 52-week lows list have been energy sector stocks.  An oil price rally would result in spillover strength in oil/gas stocks, which in turn would almost certainly put the new 52-week lows below 40 on a daily basis.  Remember that we need to see a few consecutive days of less than 40 new lows to confirm that internal selling pressure has lifted.  For the last three days there have been fewer than 40 new lows – the lowest 3-day number since the first three days of November, which was the last time there were less than 40 new lows.

Here’s what the reversal of new lows in the last couple of days has done to the important NYSE short-term directional indicator.  As you can see, both the short-term directional (blue line) and momentum bias (red line) indicators are trying to reverse the decline of the past weeks.  A confirmed reversal of both indicators would mean that the stock market’s near-term path of least resistance has turned up in favor of the bulls.

Below is the dominant intermediate-term component of the NYSE Hi-Lo Momentum Index (HILMO).  This particular indicator is important for determining the market’s intermediate-term bias.  Note that after several weeks of declining, this indicator is also trying to reverse. 

While it’s still too early to get excited in light of the historical tendency for the market to rally in late December (the so-called “Santa Claus rally”), if the internal momentum indicators show continued and substantial improvement after January 1, the odds will finally tilt in favor of the bulls eventually regaining control of the intermediate-term trend.

Speaking of intermediate-term trend, our interim trend indicator has turned from bearish to neutral and is on the cusp of potentially reversing.  If at least four of the six major indices (Dow, SPX, NDX, NYA, MID, RUT) finish the week above the 60-day moving average, the trend indicator will tilt bullish.  It wouldn’t mean that the stock market’s troubles are completely over, only that a temporary reprieve has been granted for early 2016.  The next few days will at least tell us what we can probably expect for January.

Below is the SPDR Barclays High Yield Index (JNK) has been a major leading indicator for the stock market for 2015.  The decline to multi-year lows in high-yield bond prices was largely a consequence of the stress in the oil and gas industry, courtesy of plunging oil prices.  Note that JNK is testing its 15-day MA (below). 

The fate of high yield “junk” bonds also ultimately depends on the resolution of the oil/gas stock bear market.  High yield corporate energy bonds have been in a tailspin since the shale oil “fracking” bust began, and this has put dramatic pressure on the debt of oil/gas exploration companies.  This debt-related stress is captured in the downward trajectory of the SPDR Barclays High Yield Bond ETF (JNK) shown above.  As you can see, JNK hasn’t been able to close above its 15-day MA since October and, as such, remains firmly in the grip of the bears.  However, if JNK confirms an immediate-term bottom in the next few days it would provide another indication that near-term selling pressure for the stock market has lifted.  

Returning to the broad market outlook, a New Year’s rally largely depends on continued improvement in the internal condition of the NYSE.  The most important indicator of NYSE broad market health is of course the new 52-week highs and lows.  When traders and fund managers return from the holidays next week, we’ll have a much better idea of what the market’s near-term direction is likely to be since this will tell us whether the recent contraction in new 52-week lows is a holiday-related aberration or the start of internal recovery.  

Reversing the damage of global austerity

A significant undercurrent of internal weakness is plaguing the NYSE broad market.  This weakness is primarily visible in the dangerously high numbers of stocks making new 52-week lows.  Lately that number has exceeded 300 on a daily basis, though it has been above 40 for the last few months in a sign that the market’s health is less than optimal.  The best way of showing this internal weakness is in the following exhibit which graphs the cumulative new 52-week highs and lows on the NYSE. 

As you can see here, the new highs-new lows are in a sustained downward trend which suggests vulnerability to selling pressure in the stock market.  A reversal of this downward trend is required to put the market back on a healthy track.

As potentially dangerous as this internal weakness is for the broad market in the near term, I still don’t think it will prove fatal to the secular (long-term) bull market that began in 2009.  This opinion is based on a qualitative analysis of the new NYSE 52-week lows: most of them are in the energy and natural resource sectors.  The blame for the weakness in this area is mainly due to plunging prices for oil and other commodities.  This in turn has put strain on firms who produce or market these commodities with spillover impact to other areas of the broad market.

The residual influence of weak energy prices has also spilled over into the bond market.  Below is the chart of the SPDR Barclays High Yield Bond ETF (JNK), which I use as a proxy for junk bond prices.  Most of the weakness reflected in the junk bond market originates in the high-yield debt of energy companies. 

The weakness in the high-yield bond market is also spilling over into higher yielding corporate debt, as the Dow Jones Corporate Bond Index also reflects.  See chart below.

I’m reminded of the 1997-98 experience which witnessed a similar scenario.  In those days the U.S. stock market was in the midst of a powerful bull market, yet there was a negative undercurrent from the so-called “Asian contagion,” i.e. the foreign currency crisis as well as soft commodity prices.  Oil prices had plunged to $10/barrel while gasoline at the pump was just under $1/gallon.  This proved to be a bonanza for U.S. consumers but put tremendous strain on countries that heavily depended on energy exports, such as Russia.  The result was an increasing number of U.S. listed natural resource stocks which put strain on the broad market.  The end result was a quick-but-nasty mini-bear market in the summer of 1998.  

When finally the commodity market weakness was finally resolved in the fall of ’98, the U.S. stock market entered the final year of the glorious 1990s bull market.  In early 2000, the bull was over and a new bear market began.

What I’m suggesting is that we’re probably witnessing something at least remotely similar.  Most key industry groups which comprise the NYSE broad market are still in decent shape.  It’s primarily the commodity-heavy industries which are showing most of the weakness.  If the bear market in commodities can be “washed out” by early 2016, it’s possible the secular bull trend for equities can continue at least one more year. 

The other major reason behind the recent broad market weakness is a case of the chills thanks to the global market weakness.  Europe is one such area of global weakness.  The ECB recently cut its deposit rate by the minimum amount expected, which did little to encourage investors that the central bank is serious about bolstering continent’s economy and financial system.  One is reminded of how the U.S. central bank responded to the growing credit crisis threat in December 2007.  At that juncture investors were on edge and looked for guidance from the Fed.  Instead of aggressively attacking the problem, however, Fed Chairman Bernanke announced a tepid quarter percent rate cut in December ’07 which disappointed investors and which eventually catalyzed a plunge in equity prices.

Investors had hoped based on comments ECB President Draghi made in previous speeches that the ECB would increase its version of QE in order to help stimulate the euro zone financial markets, in turn helping the economy.  Yet the ECB responded in the tepid fashion we’ve all grown accustomed to seeing in recent years.  This is no way to calm the market and it’s not surprising stocks, bonds and commodities have responded the way they have lately.

Looking back at a commentary I wrote on Dec. 8, 2011 I was surprised to find how little things have changed since then.  I wrote, “If Mr. Draghi believes the euro zone won’t eventually be torn apart by the debt crisis he is sadly mistaken and would appear to be severely underestimating the severity of the problem confronting him.  And if he believes that ‘budget discipline’ (read austerity) is the key to successfully dealing with the debt crisis at this stage he is further mistaken.  The time for budget discipline is long since passed; now is the time for aggressive action.  One can only hope that the central bankers of Europe have learned something from our own credit crisis in 2007-2008, namely the importance of preemptive monetary policy action.  Failure to take action right now, when Mr. Draghi still has the option, will result in remorse down the road.”

China didn’t help matters by slamming on the brakes of its real estate market boom.  China’s leaders enacted their own version of tight money by increasing strictures on equity and real estate investors.  Japan’s government meanwhile proverbially shot its economic recovery in the foot by increasing taxes, essentially undermining a successful QE measure. 

When will the world’s central banks get their acts together and re-synchronize monetary policy for maximum global impact?  Your guess is as good as mine, but there are signs that at least the ECB, and possibly the People’s Bank, are slowly waking up to the mistakes of recent years.  How quickly they act upon this realization is a matter of speculation, though.  Hopefully the New Year will witness a renewed resolve on the part of both banks to reverse the damaging austerity and tight money policies which have caused so much grief.

In the meantime, the only safe remedy for global market instability is continued patience and prudence in one’s investing discipline.  The equity market will work through the commodity market and global economic weakness and will, I believe, resume its bullish trend at some point next year.  Until the NYSE new 52-week high-low index tells us that the broad market internal weakness has been completely reversed, however, investors should maintain a healthy skepticism for what may appear, at first glance, to be buying opportunities in the stock market.  Only when the internal condition of the broad market decisively improves will the odds favor embracing risk.

The cycle of debt release

To many investors cycles are the holy grail of the financial market.  Many investors have devoted years to the study of them.  Some have even claimed to have found the ideal cycles for consistently predicting price movements.  What no one can seem to agree upon is exactly which cycles are most accurate for anticipating market moves.  But what all studies of the cycles share in common is an unshakable conviction that cycles hold the answers for what is coming in the future.

If there’s one thing I’ve learned over two decades of studying cycles it’s that there is no holy grail when it comes to historical market rhythms.  Even if there is a “one-size-fits-all” cycle the true believers in cycles tend to forget that in the short term, factors such as trader psychology and news reactions can exert an outsized influence on markets and can temporarily whipsaw a cycle.  The influence of central bank intervention and government policy initiatives can also override, or at least mitigate, the influence of cycles for prolonged periods.

As with any technical discipline, however, there’s always the temptation to strictly adhere to the cycles in a rigid manner.  Alas, this is where many students of the cycles go astray.  By fixing one’s focus on the cycles to the exclusion of other forms of market analysis and liquidity studies, cycle traders are often disappointed when their cycles fail to produce an expected turning point in the market.  This failure can be explained by the influence of, for instance, Fed intervention which can produce cycle “inversions” or else reduce the impact of the cycle altogether.  Extremes in investor sentiment can also produce temporary countercyclical shocks to the market which frustrate the cycle trader.

A general rule when it comes to cycles is that the longer the period (i.e. time), the more reliable they tend to be.  Probably the most famous of these long-term cycles is the Kondratieff Wave, which tends to average 60 years in length.  The K-Wave as it’s called is the dominant cycle of inflation and deflation in the economy.  While it does influence stock prices, its major impact is on commodity prices which in turn influence the overall state of the economy. 

The 60-year cycle was to have bottomed around the year 2014, although the residual effects of a cycle this long can last beyond that time.  This is the most likely explanation for the continued deflationary undercurrent in the global economy.  Its effects are being felt most acutely in China and to some extent in Europe.  A visual aid which shows the effects of this cycle-driven deflationary trend is the Reuters/Jefferies Commodity Research Bureau Index (CRB), below.  As you can see, commodity prices have fallen to multi-year lows in the face of a drop in global industrial demand.  The effects of the 60-year cycle are clearly manifest in this chart.

Another longer-term cycle which tends to reliably repeat is the 20-year crisis cycle, otherwise known as the “Sheep Shearing Cycle.”  This rhythm manifests itself in the market plunges at roughly 20 year intervals.  (It’s not to be confused with the 20-year Kress cycle.)

The crashes of 2007-08 and 1987 are examples of this rhythm, as are the 1929 crash and the 1907 panic.  Major crashes tend to occur at roughly 20 year intervals, especially if there is widespread market participation among the public.  The explanation for this cycle is that a generation runs approximately 20 years and it takes about that long for the old generation to forget the pain associated with the previous crash.  By that time, of course, a new generation will have come along which doesn’t remember the last crash or depression and are therefore more risk averse.  Thus the entire cycle of boom and bust repeats itself as the next generation repeats the mistakes of its elders. 

Another reliable rhythm which manifests in both the financial market and the economy is the 7-year cycle known as the “Year of Release.”  This cycle was first ordained in the Old Testament book of Deuteronomy as a relief for indebted Israelites.  The law reads: “At the end of every seven years thou shalt make a release.  And this is the manner of the release: Every creditor that lendeth ought [anything] until his neighbor shall release it; he shall not exact it of his neighbor, or of his brother; because it is called the Lord’s release.” [Deut. 15:1-2]

Although the year of release is no longer formally observed, this ancient precept is unconsciously embedded in the financial dealings of Western nations.  The debt release cycle can be seen in the recurring price “corrections” of commodity prices, and to a lesser extent equities, at roughly seven-year intervals.  This cycle can be seen manifesting in the credit crash of 2008, the tech wreck of the 2000-01, the mini-bear market of 1994, the stock market crash of 1987, the inflationary/commodity peak of 1980, and the broad market plunge of 1973-74.

The most recent 7-year debt release cycle was scheduled to make its appearance around 2015; and indeed the cycle’s effects are still being felt.  Depending on how many price imbalances there are within the broader economy, the influence of the 7-year cycle can spill over into the following year, as was the case in 1973-74 and 2000-01.  The primary course of the latest 7-year debt release cycle is in the commodities market, with repercussions in the overall state of the global economy.  It would not be surprising if the residual impact of this cycle is felt in 2016.

The purpose of the 7-year release cycle is to wash away the negative effects of debt and other forms of financial enslavement from the economy.  This would also include artificially high prices, which was clearly a problem in recent years in the energy market.  That oil and gasoline prices have come down so sharply in the last year is indeed a godsend for consumers.  It’s also beginning to have the beneficial effect of increasing oil demand. 

One area in desperate need of correction is retail food prices.  Prices to U.S. consumers at grocery outlets are, in some food categories, at or near all-time highs despite falling diesel and agricultural commodity futures prices.  Before the course of the debt release cycle has completely run its course, it’s necessary that the financially enslaved among us experience a release from the heavy burden of high prices in this area.

A final point to be addressed is the impact of the 7-year debt release cycle on stock prices.  Since the 7-year debt cycle isn’t expressly aimed at equities, its impact on this area isn’t always sharply delineated.  The main effect of this cycle is on commodities, as previously mentioned.  It can be argued, though, that the 7-year cycle’s impact was felt in the stock market this year in the lagging nature of the NYSE Composite Index (NYA), which is arguably the best representation of the broad U.S. stock market.  The cycle’s effect is also reflected in the abnormally large number of new NYSE 52-week lows since earlier this year. 

Much of this broad market weakness is attributable to the weakness of commodity prices, especially in the energy and mining sectors.  Of course it can be argued that this is a spillover effect of the longer-term deflationary cycle previously mentioned.  In any event, the impacts of this cycle are still discernible in the internal condition of the NYSE broad market: new 52-week lows remain abnormally high as of this writing. 

In previous commentaries I’ve suggested that next year would likely witness a bottom in the commodity prices that have lately plagued the global economy.  The standard deviation of the 60-year cycle as well as the 7-year debt release cycle support this notion.  By the time both cycles have completely run their course, the oppressiveness of high prices in the economy should attenuate enough to provide some relief for the debtors who need it most.  Thus the Year of Release will have once again worked its magic.

Has deflation been defeated?

The last 15 years have been among the most turbulent on record.  Since the year 2000, America has experienced two recessions (including a near depression), two stock market crashes, numerous selling panics, two terrorist attacks, and one of the slowest economic recoveries on record.

Just when it appears there might be some light at the end of the tunnel and the consumer is getting his confidence back, the threat of global deflation has appeared and has given them reason to remain cautious.    This time around the threat of deflation is coming from overseas, specifically from China.

Thankfully, the near brushes with deflation in the last 15 years have all been averted so far due to the aggressive monetary policy responses of the U.S. central bank.  Every time deflation reared its ugly head, the Fed was right there to ensure prices didn’t stay low for long.  In doing so, however, the Fed has short-circuited the natural process by which the economy is periodically cleansed of economic excess. 

The natural cycle of deflation also brings an important adjustment in the cost of living for everyone, especially the savers among us.  Those who sacrifice spending in the immediate term are typically rewarded for their thrift by the long-term economic cycle.  This time, though, the long-term deflation cycle wasn’t allowed to completely run its course.  The net result was that savers were essentially punished for their thrift while debtors were exonerated.  It means that the natural economic order was turned on its head by central bankers.

This begs a number of important questions: 1.) Does this mean the cycle inflation and deflation known as the K-wave has been defeated by the Fed?  2.) Or will the natural order eventually reassert its primacy over central bank manipulation?  3.) Has the Fed run out of ammunition for mitigating future economic downturns?

Samuel “Bud” Kress, for whom the long-term Kress cycles are named, taught that when it comes to attempts by government to circumvent the long-term cycles, “Mother Nature and Father Time” always prevail in the end.  If Bud were alive today I have no doubt he would maintain the Fed’s impotence in ultimately destroying the long-term economic cycle of inflation/deflation.  The effects of the long-term economic cycle, he always asserted, must win out.

The long-term cycle of inflation/deflation identified by Kress has a period of 60 years and is roughly analogous to the more widely known Kondratieff Wave (K-wave).  According to Kress’ numerical system, the cycle was to have bottomed in late 2014.  The period between 2000 and 2014 encompassed the deflationary portion of his cycle, and it was during this time that the U.S. economy experienced most of the aforementioned turbulence.  During this time frame the closest the U.S. came to the deflationary depression predicted by Kress was in 2007-2008.  The Fed stepped in, however, and unleashed record amounts of liquidity in a furious attempt at reversing the deflationary spiral.  Its efforts proved successful as depression was averted and prices recovered in the years that followed.

Yet the threat of deflation is ever present and remains a constant bugbear of central bankers, especially in Asia and Europe.  The U.S. Fed may have succeeded in forestalling deflation, but the austerity programs pursued by other countries in 2009-2015 are coming back to haunt them.  The interrelated global economy so passionately defended by many has revealed its ugly underside.  Deflation, it turns out, can be spread abroad even to countries that aren’t directly experiencing it at home. 

A classic symptom of the deflationary pressure many countries are experiencing is the steep decline in commodity prices.  The Reuters/Jefferies Commodity Research Bureau Index (CRB) is the benchmark price index for the broad commodities market.  As the following graph illustrates, the CRB is at its lowest level since the 2008 credit crisis.  This depressed level reflects the lack of industrial demand owing to the global economic slowdown.

When monetary policy fails, the classic political response to deflationary pressure of this magnitude is to start a war.  War is inflationary and always succeeds in boosting commodity prices and industrial production to above normal levels.  The military adventures of the U.S. between 2002 and 2011 contributed to an historic boom in commodity prices and likely forestalled the early onset of deflation after the 30-year cycle peaked in late 1999.

There is also a 24-year cycle component of the Kress system which typically harbingers war.  The last few times this cycle bottomed it was followed by a major military conflagration involving the major Western countries.  The most recent 24-year cycle bottomed in late 2014.  It will be interesting to see if any nations pursue this course of action in the years immediately ahead, especially in light of recent developments.  Of interest, the Dow Jones U.S. Defense Index (DJUSDN) suggests that perhaps preparations to that effect are in the making.

In answer to the question of whether the Fed has succeeded in destroying the long-term deflation cycle, the evidence points to the negative.  While there’s no denying the mitigating influence that six years of QE had on U.S. equities, the billions of dollars created by the Fed failed to produce any discernible inflation in the broad economy.  The fact that interest rates and commodity prices remain near historic lows illustrates this failure.

Essentially, there are two possible outcomes to the global economic slowdown: 1.) Either natural market forces will be allowed to run their course, or 2.) Governments will intervene with a vigorous monetary policy and/or military response.  The latter option is the most likely outcome based on history.  Although the central banks of China and Europe have already introduced stimulative monetary policies, these policies have so far failed at reversing the deflationary undercurrents still present in the global economy.  A much more aggressive stimulus effort will be required to achieve the effects desired by central bankers and bureaucrats.  It’s questionable whether they have the political will to do this, however.

By far the quickest route to reversing low commodity prices is the warfare route.  War lifts prices much faster than even the most aggressive QE could ever do.  As undesirable as it is, war unfortunately remains the most likely choice for governments desperate to boost their economies at any cost.

The short answer to the question, “Has deflation been defeated?” is “No,” at least not yet.  It will either be allowed to finish its course, which is a salutary and beneficial outcome for consumers.  Or it will be prematurely circumvented by policy makers, as it was in the U.S., to the detriment of the many and the benefit of the few.  History suggests the latter course will be the one most likely chosen.

Clif Droke in Trader's World Magazine

Traders World, the leading magazine on Gann, Elliott Wave and technical analysis, has published an article by yours truly on the topic of moving averages.  In it I explain the basics of some of my trading techniques involving harmonic moving averages based on Kress cycle time frames. Traders World issue #61 is now in circulation and you can view the article (on page 113) free by visiting the following link:

http://www.tradersworld.com/issue61/#/0

The bear indicator never lies

In the September 10 column entitled, “The bear makes a welcome return”, we discussed the return of the infamous bear image on the front cover of several news magazines and newspapers.  The most conspicuous example of the bear could be seen on the front cover of Businessweek magazine, shown below.

From a contrarian’s perspective, this was a most welcome return for it strongly suggested that the bottom would soon be in for the stock market after the August decline.  As I observed, “From a contrarian standpoint it doesn’t get any more emphatic than this.”  Since then the major indices have rallied off their lows with some even making token new highs (e.g. the NASDAQ 100).  I’ve never heard of a manifestation of the bear cover indicator failing to mark a decisive market bottom, and this time proved no exception.

Now that the Dow Industrials and the S&P 500 index have rallied back to the February-July resistance zones, should we expect a resumption of the selling pressure that plagued the market this summer?  Or should we rather expect a period of consolidation (i.e. backing and filling) and eventually a breakout to new highs?  As always, the answer to that question will be answered by the market itself but the current weight of evidence does provide us a meaningful clue as to the most likely outcome.

Before we look at the evidence, it’s worth making an observation about the previous sell-off.  What happened to the stock market over the three days between August 20-24 qualified as a classic selling panic, as opposed to a fundamentally-driven crash or credit episode.  This distinction is important, for if true it will make the difference between entering a bear market in 2016 and continuing with the bull market that began over six years ago. 

A market panic is catalyzed by an adverse and extreme reaction to a news event.  In the August sell-off it was the currency devaluation in China that panicked investors into selling.  One thing that history consistently has shown is that true selling panics are usually retraced in short order once the fear subsides, i.e. usually within a couple of months.  The less time it takes for the major indices to recover their losses, the less likely the selling was fundamentally driven.  Hence, a true selling panic isn’t typically the precursor of an imminent bear market.

It’s also worth noting that the market’s present internal condition is virtually in complete contrast to what it was earlier this summer heading into the August panic.  Prior to the summer swoon, the market’s extremely weak breadth could be seen on a daily basis for weeks on end.  From June onward the number of NYSE stocks making new 52-week lows each day was extremely elevated and showed that the market wasn’t internally healthy.  Moreover, this showed up in the NYSE internal momentum indicators (which are based on the new 52-week highs and lows).  Most of those indicators were in decline as I mentioned earlier this summer.

Since the August bottom, the situation has reversed.  The number of new 52-week lows has been drying up since September and have numbered less than 40 for most days since Oct. 5.  The NYSE internal momentum indicators are now mostly in a rising pattern as opposed to the declining pattern before the August crash.  Below is a chart showing the six major component of the Hi-Lo Momentum (HILMO) index.  Only the longer-term component (orange line) is still in decline; the others are either rising or bottoming, in the case of the dominant interim indicator (blue line at bottom). 

These indicators are very important because they show the stock market’s near-term path of least resistance.  There is at least one fly still in the ointment, namely the longer-term internal momentum indicator which is still declining, as already mentioned.  But all the other indicators – short-term and intermediate-term – are rising.  This implies that the bulls currently have the advantage and that the heavy internal selling pressure which characterized the stock market this spring and summer is not an issue right now.  This doesn’t preclude another (potentially sharp) pullback between now and year’s end, but the market’s main uptrend should remain intact.

Also worth mentioning is that the New Economy Index (NEI), our in-house measure of how strong or weak U.S. retail spending is, hit a new all-time high last Friday, Oct. 30.  Although business owners remain worried over growth prospects, mainly because of overseas woes, consumers don’t seem the least bit concerned.  They just keep spending as the NEI chart suggests (below).  What’s more, we’re about to enter the critical holiday season when retail sales typically hit their highest levels. 

After a major decline in the stock market it always pays to monitor the sectors and industry groups for signs of relative strength.  When, for example, the Dow Jones Industrial Average makes a series of lower lows during the final stage of a decline and certain individual stocks make higher lows, that’s a tip-off that informed buying is likely taking place.  When the market turns up again and these individual stocks continue leading the market, that confirms it.  At the bottom of the August panic, the industry groups which showed the greatest resilience to the decline were water, defense, and broadline retail stocks along with toy companies. 

Among Dow Jones industries currently showing exceptional relative strength are: Broadline Retailers (DJUSRB), Business Training and Employment (DJUSBE), Consumer Finance (DJUSSF), Defense (DJUSDN), Leisure Goods (DJUSLE), Restaurants and Bars (DJUSRU), Software (DJUSSW), Toys (DJUSTY), and Water (DJUSWU).  This group of industry leaders is very much in keeping with the bullish consumer spending patterns we’ve seen reflected in the New Economy Index lately.

There are, however, some industries that are conspicuous laggards which are close to their yearly lows.  If these industry groups don’t improve soon it could pose a problem at some point in 2016.  Not surprisingly, most of them are commodity and industry related and were heavily impacted by this year’s global economic slowdown.  They aren’t likely to a pose a problem for the balance of 2015, however, especially if they remain within their 2-month holding patterns.  They include: Aluminum (DJUSAL), Coal (DJUSCL), Healthcare Providers (DJUSHP), Mortgage Finance (DJUSMF), Pipelines (DJUSPL), Steel (DJUSST), Railroads (DJUSRR), and Recreational Products (DJUSRP).

If commodities can establish a bottom in the next couple of months, particularly crude oil, then the global economic woes of 2015 are far less likely to be of concern to the U.S. in 2016.  Moreover, if the stimulus measures of the ECB and China continue the global economic slide will likely be halted next year.  

Thoughts on profligate spending

Question: I once remember you stating a paradox of human behavior that can exist, and forgive me if I don't word it correctly, but I believe it was around the time of when oil first starting going over $60 a barrel [in 2005].  You mentioned that people's habits of buying SUVs hadn't changed, and paradoxically had increased, that during poor economic times, people sometime buy even more expensive items or waste their money in a more egregious way - does this ring a bell?

Answer: It sounds like an observation I made many years ago, and yes, I still believe it still holds true.  An example of that would be the nationwide mini gambling mania during the Great Recession of 2009-2010.  You may recall that there were a lot of “Internet cafes” creeping up everywhere in just about every city.  These were actually casinos where people could gamble at video terminals 24 hours a day, 7 days a week.  Many of them were jobless and really couldn't afford to gamble, but they did it anyway.  

I think it was Bob Prechter of Elliott Wave fame who first noted that gambling crazes are actually most common in the early stages of bear markets/recessions.  He explained that while stock speculation is all the rage in bull markets, people also like to gamble away their money in bear markets since the primary purpose of the bear is to destroy capital.  Plus, people still have the speculative impulse in the early stages of a bear market, a carry-over from the previous bull market phase.  Eventually, though, if a bear lasts long enough it will destroy even the gambling and reckless spending impulse until people are afraid of spending money for any reason.

What could reverse the global market decline?

Falling stock and commodity prices around the world are underscoring a change of fortunes for the global economy.  As the shockwaves from Europe, China and the developing markets spreads, there is a growing sense among investors that the U.S. might be the next casualty of the global slowdown. 

Economists have already begun questioning what, if anything, the Federal Reserve might be able to do to stem the financial market selling pressure.  Weakness has been broad-based and is visible in stocks, commodities as well as high-yield corporate bonds.  Since the first bear market of the new millennium, the Fed has played an outsized role as a stimulator of equity markets and the economy. 

Congress has long since surrendered its sovereignty to the Fed in the way of introducing stimulus measures (e.g. lower taxes and lifting regulatory burdens), and has simply looked to the central bank in times of trouble.  That dynamic will likely change in the years ahead as it becomes increasingly apparent that the Fed’s stimulus game since 2002 has likely played itself out.

With interest rates near zero and quantitative easing (QE) on the shelf, economists wonder what the Fed could possibly due to reverse a major bear market if it develops.  The latest crisis which threatens the U.S. financial system originated from abroad with problems China and the emerging markets.  Economists are debating what impact a global economic slowdown might have on the mighty U.S. economy and whether or not the U.S. could shrug off global weakness. 

The most reliable leading indicators of domestic economic strength, including the Conference Board’s Leading Economic Index (LEI), show no sign of weakness in the U.S. economy yet.  In view of how much momentum as the economy currently has, it will likely take several months before current financial market and global economic problems show up in U.S. economic statistics.  It wouldn’t be surprising to see consumer spending levels remain elevated in the coming months even if the global economy continues deteriorating. 

It seems to be a mantra among classical economists that “recessions cause bear markets.”  Anyone who has spent a number of years in the world of finance knows the falsity of this statement.  There have been numerous instances of bear markets preceding recessions, including the 2000-2002 bear market.  So if the current equity market weakness develops into a longer-term bear market it wouldn’t be the first time equities turned sharply lower while the economy was still strong. 

The question economists should be asking is, “What happens to the economy if a bear market in stocks and commodities persists for several months?”  Is the U.S. economy strong enough to withstand a major bear market?  I don’t think there’s any question that a major bear market would eventually have a residual impact on economic performance.  As heavily reliant as today’s economy is on the financial market, any prolonged downturn of stock prices is bound to have a negative spillover effect at some point.  The additional negative impact of a weakening global economy would make it even more difficult for the U.S. economy to remain the lone bastion of strength in a troubled world.

All of this leads to the ultimate question as to what it will take to reverse the broad market decline and revive the bull?  Since it started with the global market decline, I submit that the answer will have to come from aboard.  As previously mentioned, the U.S. central bank appears to have played its hand.  Fed members, moreover, seem resolutely clueless as to how to approach the developing crisis.  One week the leading Fed members suggest an interest rate increase is inevitable by year’s end, while the next week they reverse their position.  This indecisiveness and lack of leadership is causing investors to lose confidence, and that’s not helping the stock market. 

As an aside, I would point out that every incoming Fed president of the last 40 years has had to deal with a crisis of varying magnitude within the first couple of years of their tenure.  Volcker had the inflation crisis, Greenspan had the 1987 stock market crash, Bernanke had the credit crisis, and Yellen will most likely have the global market/economic crisis to deal with.  How the crisis was addressed determined the efficacy of the Fed president’s subsequent tenure.  While it’s too early to tell, it’s beginning to look like Yellen may not be up to the task of handling the crisis with the firm resolution it requires.

A reversal of the global market decline would likely require a decisive and coordinated response among the world’s major central banks to truly do “whatever it takes” to revive global growth.  Unlike the famous platitude of ECB president Draghi, the leading central banks will have to aggressively loosen monetary policy without ceasing.  They must avoid Japan’s recent mistake of stimulating monetary policy, which proved effective, then undermining that policy by raising taxes. 

The mistakes of Europe in recent years in the way of pursuing austerity policies will also have to be steadfastly avoided.  Brazil has seemingly gone down this road after its socialist government proposed a package of drastic austerity measures.  Brazil is in deep recession due to the global collapse in commodities prices and is desperately trying to revive its economy.  Unfortunately, the country’s leadership is repeating a critical blunder made by many European nations in recent years.  It’s unlikely the outcome will be any different.

The alternative to a coordinately global monetary and fiscal policy response would be a laissez faire approach.  Simply letting events take their course and allowing prices to seek their natural levels, while resisting the temptation to raise taxes or impose austerity, would probably be best for the long-term health of the economy.  It would probably take several years before the economy’s imbalances were completely rectified, however, and it’s unlikely that policymakers have the foresight or patience to follow this approach.  It would also be an admission that the policies of the past decade were ineffective, and failure isn’t something bureaucrats and politicians like to admit. 

In the final analysis, the most likely policy response will involve a heavy commitment of liquidity and lower interest rates among the world’s major central bankers.  The sooner a coordinated loose money policy is initiated, the less damage the global economy will suffer in the near term.  And while it’s true that a global QE would be tantamount to kicking the proverbial debt can down the road, can kicking as an economic policy has served the U.S. well for many decades.  It’s not the most preferred policy, but it has proven effective as long as there’s enough road to kick it down. 

Are we in a bear market?

A client writes: “Thanks as always for being our jury, Clif, and weighing the evidence.  As prosecuting attorney for the Bears, I wish to point out some prima facie evidence of past bear markets and past vicious corrections.  Bad news revealed was causal identification for a bottom (LTCM/Russia), while the lack of bad news identified a bear market.  Unless the attorney for the Bulls can produce some very bad news very fast, this prosecution will rest.”

My answer: I agree that major bottoms should ideally be accompanied by bad news, or by some catastrophic event.   One thing that bothered me about the late August low was that at no time this summer did the percentage of AAII bears exceed 41%, and that was way back in July. A major low should see somewhere in the neighborhood of at least 50% bears or more (preferably more).   It’s almost as if individual investors are still too complacent.  

And yes, I agree that the news could, and probably should, be a lot worse (China notwithstanding).  At the very least we can say that the market’s intermediate-term trend is bearish.  This is confirmed by the interim trend indicator as well as by the NYSE intermediate-term internal momentum indicators.  

One could even make a preliminary case that the long-term trend has turned bearish, if you look at the 200-day MA and some other indicators.  I believe in giving a secular bull market every last benefit of the doubt, however, so I haven't officially pulled in my horns on the longer-term trend.  I may be forced to do so, though, if things don’t improve in October.

Halloween came early this year on Wall Street

The Federal Reserve guessing game ended Thursday after the FOMC made its decision on interest rate policy.  The Fed left rates unchanged in a tip of the hat to investors who felt the economy was vulnerable to overseas weakness.  This was what most on Wall Street wanted, although there was a sharp intraday reversal after the announcement (apparently a case of buy the rumor, sell the news).

In last week’s commentary I emphasized that there was a built-in Wall of Worry for stocks to climb based on the recent spike in bearish investor sentiment.  There’s still a lot of short interest in the market which could be used to fuel a short covering rally, especially now that Fed interest rates are unchanged.  There’s no denying that equities love low interest rates, and the longer the Fed leaves the benchmark rate unchanged the better it bodes for investors.  Whether or not it actually helps the economy is a different story, however.

There seems to be some contention among pundits as to whether the Fed should raise interest rates before the year is over.  The hawks maintain that keeping rates near zero would only encourage another equity market bubble and eventually lead to another credit crisis down the road.  The doves insist that the longer the Fed funds rate remains at or near zero, the more stimulative it will prove for the financial market and the banking system.  My view is that bubbles occur when the Fed funds interest rate fails to keep pace with Treasury yields.  Considering that government bond yields aren’t much higher now than they were at the depths of the 2008 credit crash, I see no problem with keeping the Fed funds rate low for a while longer.  At the end of the day, though, it’s up to investors to decide whether or not they like the Fed’s policy. 

Assuming the market is ready to kick off a recovery rally, there are a couple of areas in need of improvement.  I’d like to see some continued improvement in the market’s internal condition first and foremost.  The minimum requirement for internal repair is a diminution of the NYSE new 52-week lows.  On a positive note, the number of stocks making new lows has diminished each day since Sept. 11.  Moreover, we finally saw the first day since Sept. 3 in which there were fewer than 40 new lows on Thursday, Sept. 17.  If the new 52-week lows remain below 40 for the next few sessions it will confirm that the market has returned to a normal, healthier internal state. 

The NYSE Hi-Lo Momentum indicator series known as HILMO is based on the new 52-week highs and lows and shows the stock market’s path of least resistance on a short-, intermediate-, and longer-term basis.  The short-term directional components for HILMO are looking better than they have in a long while but still need more improvement.  You can see here that they’re trying to turn up in sustained fashion, though.  If it continues from here it will support the bulls’ attempts at rallying the major indices back to the pre-panic levels from early August.

Meanwhile, the intermediate-term HILMO components are in even greater need of reversal.  Note the continued downward trend reflected in the sub-dominant interim (blue line) and dominant interim (red line) indicators shown below.

The decline in the intermediate-term HILMO components shown above is consistent with the fact that our intermediate-term trend indicator is still technically bearish.  To get a renewed intermediate-term buy signal we need to see a majority of the six major indices back above their 30-day and 60-day moving averages on a weekly closing basis.

Our immediate-term (1-3 week) trend indicator has confirmed a bottom, however.  All six of the major indices – the Dow, SPX, NDX, NYA, MID and RUT – have all closed at least two days higher above their 15-day moving averages to confirm the bottom.  This technically paves the way for a relief rally.  It’s worth mentioning that panic declines are usually reversed within a couple of months once the fear that catalyzed the sell-off has completely dissipated. 

It’s also worth mentioning that the Dow Jones Transportation Average (DJTA) has erased most of its losses which it sustained during the “flash crash.”  This has positive implications for the Dow Industrials, shown above.  Keep in mind that the DJTA led the way lower for the Industrials heading into August.  It’s constructive, from a Dow Theory perspective, that the Transports are showing relative strength at this time.

The NYSE Composite Index (NYA), which I consider to be the most comprehensive measure of the U.S. stock market, has barely budged higher recently and hasn’t yet broke out of its 3-week consolidation pattern.  By contrast, the NYSE advance-decline (A-D) line is finally starting to show relative strength.  One of the things I like to see at a market bottom is for the A-D line to show leadership versus the NYA.  This has started to happen, and if it continues should bode well for the prospects of the NYSE Composite Index. 

The bear makes a welcome return

The S&P 500 Index had its worst August since 2001, while the Dow’s 6.6 percent drop was its biggest since declining 15 percent in August 1998.  Most investors consider the September-October period to be the witching months for equities, but the past month was a painful reminder to many of them just how bad August can sometimes be. 

Along those lines, Bloomberg has observed that while August ranks in the middle among months based on share performance, it has produced some of the worst returns of the year since 2009.  During the week ended August 12, 2011, the S&P 500 alternated between gains and losses of at least 4 percent for four days, something never seen in 88 years of data compiled by Bloomberg.  In 2013, the S&P 500 fell 3.1 percent in August, one of only two months of negative returns in a year when the index surged 30 percent.

Since the late August sell-off, there has been a constructive development underway in terms of investor psychology.  The market’s sentiment profile has shown vast improvement since the last month before the sell-off.  The following magazine headline from a recent issue of Bloomberg Businessweek is a classic example of the magazine cover indicator at work.

That’s right, a cover full of bears!  From a contrarian standpoint it doesn’t get any more emphatic than this. 

Below is another manifestation of the bear on a recent news magazine cover.  The headline questions whether a bear market is imminent, which has definite contrarian implications.

The bear analogy can also be seen in the Sept. 7 issue of The New Yorker.  Even The Economist got in on the act with a Sept. 4 reference to China’s market decline (the alleged cause of Wall Street’s plunge) on its front cover.

These are the type of magazine cover that appears at, or very near, important interim lows.  While the magazine cover indicator can’t always be used to time the exact location of the bottom, it does provide an important “heads up” that the bottoming process has most likely begun with a confirmed interim bottom to follow in the weeks immediately ahead. 

The bigger question confronting investors is whether the August correction was simply a one-off event or the prelude to something much bigger?  This is a question that will undoubtedly be given much attention by analysts in the weeks ahead. To proclaim the termination of the 2009-2015 bull market right now would be premature in my opinion.  I believe an established long-term uptrend should be given every last benefit of the doubt to prove itself before proclaiming its death.  If the bull market is to persist beyond 2015, however, it’s imperative that the internal condition of the stock market relative to the new 52-week highs and lows substantially improve.  Otherwise the situation we witnessed in August will only repeat at a later date. 

Market episodes like the late August sell-off rarely occur out of a clear blue sky.  The market usually provides a preliminary warning to give wary participants a “heads up” that something bigger could be on the horizon.  For instance, in the lead-up to the 2008 credit crash there were several early warning signals in the stock market beginning with the February 2007 correction and again in August that year.  The preliminary warning to the recent correction was the NYSE electronic outage in early July.  NYSE trading screeched to a halt for nearly four hours on July 8, which officials blamed on a “technical glitch.” The event spooked investors, which was a further sign that market psychology was vulnerable to another surprise event.

Investor fear seems to have reached a crescendo since early September, however, and any further erosion in fear from this point could serve as a catalyst to short covering rallies, near term.  The latest Bullish Consensus indicator (below) has reached its lowest reading of bullish sentiment since 2013.  This is also a sign of a healthier market from a contrarian perspective. 

By far the most important ingredient needed for a major bottom and re-entry signal is a significant contraction of the number of stocks making new 52-week lows on the NYSE.  The number one problem that has plagued the stock market since the beginning of summer has been the persistence of internal weakness.  It’s also what made the market vulnerable to the correction that occurred last month.  This can be seen in the fact that on most days the number of stocks making new 52-week lows has exceeded 40, which is the historical dividing line between a healthy and an unhealthy market environment. 

Only once this month to date has there been fewer than 40 new lows (Sept. 3).  Each day this week (Sept. 7-11) has witnessed an expansion in the new 52-week lows, culminating with 131 new lows as of this writing on Sept. 10.  This is unacceptably high and tells us that there is still some internal weakness within the broad market.  Moreover, this weakness must be resolved before the market launches its next sustained rally.