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.