There are a number of bear market rules, but the most important rule is to respect the primary trend. In this regard, I ignore bullish patterns, upside breakouts, bullish setups, support levels and bullish retracement zones during a primary downtrend. Frankly speaking, the bullish setups just offer false hopes. The primary trend is down for all the major indexes and this means most bullish setups will fail.
The same extends to stock picking in this environment. Sure, some stocks will buck the bear, but picking them and successfully trading them is another issue. Note that just 37 stocks in the S&P 1500 are up since SPY peaked, which was 29 days ago (February 19th). 37 stocks out of 1500 amounts to 2.47%. Those are not very good odds. The S&P 1500 consists of the S&P 500, S&P MidCap 400 and S&P SmallCap 600.
Programming Notes
Before hitting the charts, a few notes on upcoming commentaries and the bear market projects. Thursday, I will start highlighting some stocks with bullish secular themes going forward. These are stocks to consider at a later date. Friday, I will go over the All-Weather Portfolio from Ray Dalio, which is an amazingly simple concept that works ok (not great). Next week I plan to revisit the Weighted Average Stochastic Score and show this indicator on the ETF charts. I will also release a list of reading material for the coming weeks, perhaps months.
Click here for a detailed article and video explaining the Weighted Average Stochastic Score (WASS).
Contact me if you have any ideas on books or stocks with bullish secular themes.
The Bogus Bullish Engulfing
The chart below shows the S&P 500 SPDR (SPY) with a recap of the bearish events of the past few weeks. SPY broke down with a gap and sharp decline the last week of February. The Index Breadth Model and Sector Breadth Models also turned bearish at the end of February. While I did not predict a market crash, I did highlight the excesses that were brewing in late January and mid February. The tide clearly turned at the end of February. The PPO(1,40,0) dipped deep into negative territory, as in October. The PPO(4,40,0) followed with a move into negative territory in mid March.
A massive bullish engulfing formed last week as the S&P 500 surged some 17.5% in three days. A huge bullish engulfing seems bullish, but it is just a red herring. Why? Because the primary trend is down and the breadth models are bearish. Bullish setups, bullish patterns and bullish banter are just distractions. In fact, a 3-day surge and weekly bullish engulfing would likely be categorized as minor trend fluctuations (noise) in Dow Theory terms.
Bullish candlestick patterns, bullish breakouts, support levels, bullish retracement zones and bullish setups are red herrings in a bear market. Ignore them.
Elevator Down and Stairs UP
Bear markets are often shorter, and sharper, than bull markets. There is an old Wall Street adage that stocks take the elevator down and the stairs up. A bull market will follow this bear market, but I do not know when it will end or how far stocks will fall. Nobody does. Furthermore, it is likely to take a lot longer to recover. As the chart below shows, the S&P 500 fell some 50% over a 15 month period and it took 4 years to get back to the 2007 high.
The chart above was created with Optuma.
Three Distinct Trends and Phases
Writing some 100 years ago, Charles Dow noted that the market has three distinct trends and major trends have three distinct phases. The primary trend is the dominant force at work and Dow compared this to the tide. You cannot stop the tide! The secondary trend represents a move counter to the primary trend. This would be a correction within a primary uptrend and a counter-trend bounce within a primary downtrend. Thirdly, there is the minor trend, which is just daily noise or random price fluctuations, which we seem to have a lot of lately. As you can see with the chart below, there were at least five secondary uptrends during the 2008 bear market.
I do not usually get into sentiment or behavioral analysis because it is too esoteric for my left-heavy brain. Nevertheless, Dow defined the three phases of a bear market using behavioral observations. The first stage is the distribution phase when the smart money sells and there is still hope. Dow notes that there is often a relief bounce that can be sharp and swift. Hmmm…. seems like we just saw one. The bulls become emboldened with this bounce, but it is just a bear market bounce.
The second stage of a bear market often marks the biggest move. This is akin to wave 3 of a 5 wave sequence in Elliott wave terms. According to Dow, this is when business conditions deteriorate, bankruptcies rise, earnings estimates are reduced and revenues fall. This is a time when the trend and business environment are in sync. It seems that this was the September to November period in 2008.
The third phase of a bear market is when all hope is lost and the last holdouts throw in the towel. This would be January-February 2009. The news is bad, the economic outlook is bleak and buyers are scarce. Notice how the bear market phases go from disbelief and hope (phase 1) to deteriorating conditions (phase 2) to despair (phase 3).
The indexers, those how simply buy and index fund and ride it out, are using this decline as a chance to rebalance and average down (hope). We have yet to see business conditions seriously deteriorate, but they will and this could be phase two. The death of the indexing craze would mark the despair needed for the end of a bear market. Look for this headline: Indexing is Dead.
Keep in mind that the market has a mind of its own and does not always follow the blue print. Thus, we must follow things on a weekly basis and keep an open mind. The news cycle is as fast as ever, QE is off the charts and more fiscal stimulus is on the horizon. For us chartists, the primary trend is down and market volatility is out of control. The two alone are reason enough to remain on the sidelines.
The chart below shows the 2008 bear market with the 10% Zigzag indicator. The green lines show when there was an upswing of 10% or greater, while the red lines show a downswing of 10% or greater. I count 15 swings greater than 10% from October 2007 until March 2009. The blue shading in October-November 2008 shows 9 swings greater than 10%. The S&P 500 has currently had just two swings that were ten percent or greater, which means we may have a few more to go.
SPY Forms Harami at First Retracement
The next chart show SPY with a 30+ percent decline from February 19th to March 23rd and a 15+ percent bounce over the last six days. These are the two 10+ percent swings. This bounce retraced 38.2% of the prior decline and this is normal for a bear market retracement. SPY then stalled in the danger zone. RSI(10) hit 49.62 and technically did not cross into the danger zone. Not every counter-trend bounce ends at the exact same retracement or RSI level, but clearly SPY was in a dangerous spot when trading above 260. A harami formed on Monday and Tuesday, and a big gap down is expected on today’s open.
As noted last week, trading in this environment involves intraday decisions and a close watch. In addition, traders must prepare to sell/short when price action looks the strongest, buy/cover when price action looks the weakest and often make trades near the close of the day. Yep, this is not a market for retired gunslingers. As Ed Seykota famously stated:
"There are old traders, there are bold traders, but there are no old, bold traders"
Correlations Continue to Rise
As noted several times over the last few weeks, correlations rise in bear markets and there are few, if any, hiding places. The images below show the Correlation Grid (created in Optuma). These numbers are based on the 30-day correlation between the two symbols. SPY and RSP are perfectly positively correlated (1.00) and the rest of the stock-related ETFs are at .90 or above, which is a strong positive correlation.
The second image shows the bottom half of the list. The 20+ Yr Treasury Bond ETF (TLT) has a strong negative correlation to SPY (-.85) and this means it moves opposite of SPY. The Aggregate Bond ETF (AGG), Gold SPDR (GLD) and US Dollar Index (DXY) are also negatively correlated to SPY, but this negative correlation is not as strong. Even though these ETFs seem like natural alternatives to stocks, they are also experiencing high levels of volatility. Risk is high all around.
All Stock-Related ETFs Below 200-day SMAs
The next image shows a scatter plot with the 60 ETFs in the core list. The y-axis shows the percent above the 200-day SMA and the x-axis shows RSI(14) values. ETFs in the top third are above their 200-day SMAs. Even with a 17% surge in the S&P 500, only four ETFs are above their 200-day SMAs: GLD, DXY (UUP), AGG and TLT. The energy-related ETFs and the Mortgage Real Estate ETF (REM) are the furthest below their 200-day SMAs (lower left).
Of the stock-related ETFs, the Biotech ETF (IBB) is the closest to its 200-day SMA (upper right). The tech-related ETFs are also holding up better than the rest (QQQ, XLK, IGV, SKYY, SOXX). The Healthcare SPDR (XLV) and Healthcare Providers ETF (IHF) are also in the mix here. Despite relative strength, which just means less weakness, they are not in long-term uptrends and still in the avoid category.
