Market Timing Models – Bearish, Volatile and Lethal

Stocks were extremely oversold last Friday and ripped higher the first three days of the week. The S&P 500 gained some 6% and retraced around 50% of the prior decline. And that was it. The bear market environment, which is the dominant force at work right now, overruled this bounce and stocks moved sharply lower on Thursday. The index looks set to completely wipe out this bounce with a sharply lower open on Friday.

As price action over the last two weeks shows, the seas are extremely treacherous because the broad market environment is bearish and volatility is extremely high. It is a lethal combination. Broad market timers and trend followers would be mostly in cash and on the sidelines. Short-term traders are still active, but must be very nimble and watch prices intraday because of the volatility.

The chart below shows the S&P 500 SPDR, S&P MidCap 400 SPDR and Russell 2000 ETF at different stages of bearishness. SPY is holding up the best because it did not break the October low, but still broke a prior low and exceeded its rising 40-week SMA. MDY and IWM also broke prior lows, and their October lows. These two are perilously close to recording 52-week lows.

IWM looks the most ominous because the recent breakdown signals a continuation of the prior decline. Notice how the ETF fell sharply from August to December 2018 and then formed a large rising wedge.  Moreover, the ETF never exceeded the August high and formed a lower high. This wedge is a big counter-trend bounce and the breakdown signals a continuation of the bigger downtrend. Ouch.

Bearish, Volatile and Ugly

The weekly chart for the S&P 500 SPDR (SPY) is ugly with a harami, gap and long black candlestick that broke the 40-week SMA. SPY attempted to move back above the 40-week SMA this week, but fell sharply on Thursday and finished below this key indicator. The current decline is sharper and deeper than the declines off the January 2018 high and October 2018 high. In fact, this decline is more akin to October 2018 because the breadth models also turned bearish then.

The indicator window shows the PPO(1,40,0) moving into negative territory with a deep cross. Notice how the PPO briefly dipped into negative territory with shallow crosses in March 2018. In contrast, there were deep crosses in October-November 2018. The current cross is deep and compares to the October 2018 cross.

When to Ignore Fibonacci Retracements and Support

Support levels and bullish retracement zones are questionable, at best, in bear market environments. Why? Because support levels are not expected to hold in bear market environments and bullish retracement zones are not expected to work. The odds favor bearish outcomes and bearish resolutions during bear markets.

Even though the S&P 500 is battling its 200-day SMA right now, I am in bear market mode because the breadth models turned bearish for the first time since early September. This means support levels and bullish retracement zones are of little value. This is not only for the major index ETFs (SPY, QQQ, IWM, MDY), but also for most equity-related ETFs. The broad market environment is the single most important factor at work when it comes to stocks.

As the chart below shows, I could mark support based on the August-October lows or even the March-June lows. In addition, I could draw Fibonacci retracements from the December 2018 low to the February 2019 high or from the May low to the February high. As far as I am concerned, these levels simply offer false hope and ignore the shift from bull market to bear market.

Resistance levels and bearish retracement zones are more important in a bear market environment. With a pop and drop this week, SPY reversed in its first bearish retracement zone and established its first resistance zone. The chart below shows SPY closing just above the 50% retracement on Wednesday and then falling back towards the prior lows. It is normal for a counter-trend bounce to retrace around half of the prior decline. Think of it as two steps backward and one step forward. The decline also established a reaction high near 315 and this becomes the first resistance level to watch going forward.  

The EKG for SPY

The chart below shows SPY with a breakaway gap, sharp decline and serious increase in volatility the last two weeks. The breakdown occurred last week and volatility remained extremely high this week. Volatility is like the EKG for the stock market and the stock market is currently in the ER. It takes time to recover from shocks like this.

The indicator window on the chart above shows the 1-day Rate-of-Change exceeding 2% in seven of the last  nine days. This crazy volatility confirms the high level of risk in the stock market right now. The second indicator shows ATR(22) turning up in late January and surging the last five weeks. Notice how ATR(22) moved higher from October to December 2018 when SPY fell.

Index Breadth Model is 100% Bearish

There is no change in the Index Breadth Model as all nine indicators remain on active bearish signals.

Click here for an article and video explaining the indicators, signals and methodology used in the Index Breadth Model. This article also includes the signals of the last five years.

Serious Weakness in Breadth Indicators

The table below shows the percentage of stocks above the 200-day EMA for the major indexes and sectors. Only 20.33% of small-caps and only 24% of mid-caps are above their 200-day EMAs. Among the sectors, only four have more than 50% of their components above the 200-day EMA (Technology, Consumer Staples, Utilities and REITs). XLK %Above 200-day EMA (!GT200XLK) is at 50.70% and will probably move below 50% soon. Thus, only the defensive sectors are holding up internally and they too could be vulnerable.

The next table shows the High-Low Percent indicators and only three are positive (Consumer Staples, Healthcare and Utilities). Again, only the defensive sectors are holding up internally. Assuming no new highs on Thursday, some 20% of stocks in the S&P SmallCap 600 recorded 52-week lows. Also note that High-Low Percent is below -15% for four of the big six sectors (Consumer Discretionary, Communication Services, Finance and Industrials). There are a lot of new lows out there and this affirms the bear market environment.

More Red in the Sector Breadth Model

There were some new signals and some signal flips in the Sector Breadth Model. The face-ripping bear market bounce the first three days of the week pushed the %Above 200-day EMA indicators above 60% for Utilities, Consumer Staples and REITs. However, these three also triggered bearish signals for High-Low Percent last Friday and all three sectors are net bearish. XLK %Above 200-day EMA (!GT200XLK) did not dip below 40% last week and did not trigger bearish (yet). Nevertheless, all eleven sectors are net bearish and 30 of 33 indicators are net bearish. There really are very few places to hide.

Correlations tend to Rise in Bear Markets

The table below shows a correlation grid for the 11 sector SPDRs. Relatively high correlations are in green, relatively low correlations are red and the shades represent the varying degrees. The highest 20-day correlation is .99 and the lowest is .82, both of which are high numbers. Even the SPDRs with “relatively” low correlations still have high absolute correlations. XLU and XLRE have correlations above .80 against the other sectors. This is high and means we can expect XLU and XLRE to move in the same direction as the other sectors the vast majority of the time. The lowest correlation for XLP is .89, which means it has an even stronger correlation with the other sectors.

The second correlation grid shows the 65-day correlation for each sector pair. The numbers drop with XLU and XLRE showing the lowest positive correlation with the other sectors. The average 65-day correlation is .405 for XLU and .466 for XLRE. Correlation is less positive on the three month timeframe, but still positive as these two are still affected by the broader market. XLU and XLRE are the most independent of the 11 sectors, but they are not entirely immune to broad market movements. These grids were created using Optuma software (

Fed Expands Balance Sheet

The Fed is coming to the rescue with a serious rate cut and a sharp expansion in its balance sheet. After flat line growth in the balance sheet for two months, total assets surged this past week and exceeded $4.2 trillion. The System Open Market Account (SOMA) also expanded this week and hit its highest level since December 2018. While Fed action is technically positive for stocks, it is not going to change the way businesses are dealing with the Coronavirus. The world is not in an economic slump because of high interest rates and tight monetary policy. The world is moving towards an economic slump because people are self-isolating and businesses are being affected by a big unknown. Nobody knows how long the Coronavirus will last or how bad it will get, but this too shall pass at some point.  Links: Fed Balance Sheet and  System Open Market Account (SOMA).

Bottom Line: Bear Market Environment

The shift from bull market to bear market was swift and the bulk of the evidence is clearly bearish. The bull signal from September 5th was replaced with a bear signal on February 26th. Cash is king in bear markets because the winner is the one who loses the least. That paraphrase comes from the late Richard Russell of Dow Theory Letters.

According to Dow Theory, neither the length nor the duration of a trend can be forecast. The same applies to bull and bear markets. They simply last as long as they last. There will be consolidations and probably even sharp counter-trend bounces, but the path of least resistance is down until proven otherwise.

Whew - T.G.I.F.

-Arthur Hill, CMT
Choose a Strategy, Develop a Plan and Follow a Process

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