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Market Timing Models – Trend, Tape and Fed Maintain the Course

The S&P 500 SPDR is up 3% in three weeks (January) and trading near an all time high. Furthermore, the ETF is up 14.5% since August and 9.9% since October. These are big moves in relatively short timeframes, no matter how you slice it.

There are as many “overbought” metrics as you want to find and I could easily name another five. However, note that SPY has been “overbought” in some way, shape or form since mid November. These overbought metrics are just sideshows compared to the immediate trend, which is up. 

Sure, I am cautious because SPY reached the edge of excess in mid January. However, my key trend metrics have yet to signal a short-term reversal that could signal the start of a corrective period. As Charles Dow asserted, the trend is in force until proven otherwise. A correction cannot start without a short-term trend reversal and I continue to watch the short-term trend metrics closely.

On the Edge of Excess

The weekly chart for SPY shows why I think the ETF hit the “edge of excess” in mid January. With last week’s close (17-Jan), the ETF was 9.74% above its 40-week EMA and this was the highest level since January 2018. In addition, the ETF formed two outsized candlesticks in mid January (orange oval). Notice that the move in January 2018 ended after a third outsized candlestick (red shading).  Click here for the original comparison from December 20th [1]

It should be noted that the peak in late January 2018 and sharp decline came without warning. We did not see negative divergences in the Advance-Decline Lines or AD Volume Lines. There was no deterioration in the %Above breadth indicators (%Above 20-day EMA, %Above 50-day EMA or %Above 200-day EMA). We did not see bearish divergences in key momentum oscillators, such as MACD or RSI.. In fact, RSI(14) hit a multi-year high at 86.69 on 26-Jan-2018. There was just excess and then a sudden decline.

Even though the market looks frothy, we need to keep an open mind and stick with the signals. Not all periods of excess end with sudden and sharp declines. SPY could trade sideways in a dull range, it could work its way lower with a falling wedge or it could even continue higher with a slow choppy advance. The best we can do is understand the possibilities and prepare for a correction should we get a signal.

Keys to the Short-term Uptrend

So what is “the signal”. I will first turn to the daily chart with the three indicators we have been following since December 20th. The 1-day Rate-of-Change has not been below -1% since early October, which means SPY has not declined more than 1% in over three months. A decline greater than 1% would signal an “outsized” decline and the most selling pressure in over three months. I would also look for confirmation from at least one of the other two indicators. An ATR(2) move above 30 would signal an uptick in volatility and a move below 50% in S&P 500 %Above 20-day EMA (!GT20SPX) would be bearish for breadth.

At the risk of getting too granular, I will analyze the short-term chart for SPY for clues on the short-term uptrend. The Price Channel (1,1) is shown with the gray shading. The first parameter is the number of days for the SMA and the second is for the percentage distance from that SMA. The upper and lower lines are 1% above and below the 1-day SMA.  

A close below 328 would fill the gap and, depending on the prior close, could also be greater than 1%. A decline greater than 1%, a gap fill and close below 328 would be short-term negative. I also added RSI(5) to the mix because it held above 30 the entire advance. Talk about strong momentum. Normally, a move below 30 would show a short-term oversold condition and this would set up a mean-reversion bounce. However, and this is where the subjective side of technical analysis comes into play, a move below 30 would also show the strongest downside momentum since early October. An uptick in downside momentum could signal the start of a corrective period.

Short-term Checklist

  • 1-day decline greater than 1%
  • ATR(2) move above 30
  • Close below 328 to fill the gap
  • RSI(5) move below 30
  • %Above 20-day EMA below 50%

As long as the short-term uptrend holds in the S&P 500 and SPY, the path of least resistance is still up. Even though this situation could change any day now, the path is up until proven otherwise. This means ETFs with extended uptrends could extend even further, ETFs with fresh breakouts could build on these breakouts and bullish setups are the weapon of choice. For example, the Regional Bank ETF (KRE) and Bank SPDR (KBE) have small falling wedges working and could be poised to breakout.

Index Breadth Model Remains Bullish

Whereas the two daily charts above capture the short-term trend, the Index Breadth Model captures the medium-term environment. Five of the nine breadth indicators have been bullish since early September and all nine indicators are currently bullish. S&P SmallCap 600 High-Low% ($SMLHLP) was the last to turn with a move above +10% in mid January. The chart below the table shows the signals over the last five years. Notice that the model did not signal bearish in January 2018, but did signal bearish in October 2019.

Click here for an article and video [2] explaining the indicators, signals and methodology used in the Index Breadth Model. This article also includes the signals of the last five years.

A Bearish Flip on Sector Breadth Model

The Sector Breadth Model remains bullish overall and supports the bull market thesis. There were two bearish signals this week as the Energy sector broke down. The 10-day EMA of Advance-Decline Percent plunged below -30% for a bearish breadth thrusts, while the Energy %Above 200-day EMA (!GT200XLE) moved below 40% to trigger bearish. All three indicators are back on bearish signals for the Energy sector. Its weight on the broader market is small (4%) so I am not concerned with this sector turning bearish. The six biggest sectors are the ones to watch and all of their indicators remain bullish.

SOMA Increases as Total Assets Dip

It was a mixed week at the Fed as the System Open Market Account (SOMA) [3] expanded at a healthy clip, but Total Assets on the Fed’s balance sheet [4] contracted. As noted before, I am not going to get into the nuances here. Instead, I will simply look at the overall trends. SOMA and Total Assets have been increasing since early September. This is supportive of stocks and it is usually not a good idea to fight the Fed, overbought conditions be damned!

Bottom Line: Bull Market Environment

Charles Dow asserted that the trend is in force until proven otherwise. This can be applied to any length of trend, short or long. We get a signal and adhere to that signal until it is proven wrong. Sometimes we miss a signal, but we must still adhere to that trend until proven otherwise.

The long-term evidence has been bullish since early September and the short-term trend for SPY is clearly up. Even though excesses are building on the weekly chart and I am cautious, the short-term trend has yet to be proven otherwise. At the very least, I need to see a short-term bearish signal before the prospects of a correction become reality.

Thanks for tuning in and Happy Friday!