If few admit surprise that the S&P corrected in January, most will confess that the sharpness of the sell-off so far was totally unexpected. But one-sided sentiment on either side should always be cause to expect the unexpected. At this juncture, it makes sense to expect a test of S&P support near 1775, followed by a rebound. Why? A) The market is short-term oversold, and will be more so at 1775. B) The intersection of support at 1775 – a retracement level, a neckline and the 100-day moving average close by – is substantial. And C), an FOMC meeting is scheduled this week. The primary question is, will the Fed taper, as most believe, and risk further currency fallout in the reserves-withered Emerging Markets? And will taper-no taper matter, if Japanese PM Abe can’t slow the global carry-trade un-wind?
Unlike the S&P or the Dow Transports, the Dow Industrials have not posted a new high in 2014. The significance of that divergence increases with each broken support suffered in this decline. Should next support near 15,700 give way, it might not doom the Dow to bear market inevitability, but it will reduce the probability that the Dow Theory violation can be corrected.
Speaking of the Transports, Friday’s 4% decline seems significant beyond its point loss. Coming 24 hours after Thursday’s new all-time high, the largest percentage decline in 3½ years almost has to signal an important trend reversal.
Still, the bell cow this cycle remains the Nasdaq Composite. As long as the COMP’s bullish trend channel points higher and to the right, investors will view pullbacks only as dip-buying opportunities. Expect that theory to be tested this week, but odds are that it will pass with flying colors. Its current pullback already looks extended, yet its next serious test of support remains comfortably distant.
But two developed warning patterns that have begun to signal are lurking in the longer-term background. The first, below, is the VIX. Importantly, however, it’s not the trading VIX, which surged 32% Friday, nor the primary trend VIX, which also recently turned up. Both of those have been known this cycle to spike impressively higher one period, only to fizzle and return harmlessly lower the next. What this chart shows is the monthly VIX. When the monthly changes direction, it almost always brings important consequences. As evidenced in the chart, VIX “crossovers” in either direction occurred only six times in 13 years. Each turn led to a major reversal in the S&P. The current upturn looks like number seven.
The other warning pattern is the primary trend yen chart below. The upturn anticipated last month is fast becoming this month’s pox on stocks (and everything else risk-on), even if it ultimately traces out only an a-b-c counter-trend upturn. As discussed many times the past thirty days, a rising yen undermines the hugely leveraged carry-trade, no matter which risk-on asset is carried. And given the yen’s overwhelmingly bearish sentiment at year-end, investors were unprepared for any upturn, let alone a primary trend upturn, hence last week’s aggressive un-wind. Additional pain seems likely. For that reason, bearish pattern read aside, investors should be on the alert this week for a response from Mr. Abe, one probably involving his QE fire hose. We’ll see.
But carry-trade un-wind isn’t the only factor responsible for the U.S. correction. Earnings misses, declining share buybacks, GDP forecast revisions and continued deterioration in jobs and income trends all helped push confidence and prices down. Possibly the clearest reflection of eroding economic confidence can be seen in the rotation out of retail stocks. And it’s never a good sign when the sector responsible for 70% of GDP ranks among the worst performers in the stock market.
Perceptions in the bond market have also changed for the worse. And the complete about-face in bond prices in the past five weeks signals borderline dramatic change. Nothing less could convert 95% bearishness bond traders to a trend line breakout in Treasury bonds, with a further neckline breakout pending.
In the face of nearly unanimous expectations that the 10-year Treasury yield would continue to push past its 3.04% high, yields actually reversed early in January, and now have retraced 62% of Q4’s fifth wave upturn. While a short-term rebound should follow, either from Friday’s close at 2.73% or a possible test of 2.69%, the trend direction in rates for the moment remains down. Ultimately I expect new correction lows. It’s even possible, with the economy faltering and earnings falling short of expectations, the TNX could re-test its October’s low at 2.49%. That said, once rates complete this correction, their long-term upturn should resume. The curious thing is that the rise will have little to do with a strengthening economy.
My review shows the vast majority of global markets in downside synch. And in the U.S., even the most stalwart, bellwether industry sectors show primary up-trend cracks. Bottom line, the technical damage these past few weeks, whether the result of correction, recession or carry-trade un-wind, might be more significant than the lost market value. That is, from its look and feel, if this really is just a correction, the inevitable rebound will warrant close attention. While it could presage additional highs, it also could segue into another correction, possibly a deeper correction.
Which makes the following chart of the Shanghai Stock Exchange Index all the more curious. Belying all the bad financial news in China, the SSEC is building a nice bottom and could turn up soon, if it hasn’t already. But in reaction to what? Growth estimates are falling, as demand-challenged trading partners continue to starve China’s export machine; production facilities are shuttering, as weakened demand adds to the problem of idle capacity; and the country’s financial crisis is only deepening. Shadow banking is a tinderbox, depositors have been denied access to their funds, and overnight repo rates stabilize only when the PBOC pours liquidity into the system. Bottom line, the backdrop in China is not good. Yet that chart below shows real promise. That alerts me to approaching government intervention.
Others must sense the same thing, given the early upturn in the pattern. And that previously was signaled by the SSEC’s oversold low and its divergent histogram. But the pattern needs further incubation, first, to build a better trading base and, second, to provide the developing bottom in the weekly SSEC chart time to catch up. That raises the possibility of a trading re-test. Still, the question remains, what intervention haven’t Chinese officials already tried to quell concern in shadow banking, let alone kick-start more than two quarters worth of “growth?”
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