Short Takes

If you were in commodities in 2008, you remember the July waterfall declines, which offered little in the way of countertrend rallies. The collapse in commodities was a bad omen for risk. The S&P 500 dropped from 1,250 to 666 over the next eight months. That is an extreme example, but the concepts still apply to the present day.

It is also hard to forget the crash of silver in May 2011. The S&P 500 peaked simultaneously before dropping 20% over the next six months.

We have no idea what will follow today’s high volume sell-offs in gold and silver, but we do know recent history tells us to pay attention and be very careful with risk assets. The gold ETF (GLD) had a four-minute span to remember today. Today’s drop was void of any real countertrend rallies and it occurred with almost a three-fold increase in volume relative to a typical day. GLD normally trades 12.1M shares per day; today’s session saw 34.9M shares change hands.

The silver ETF experienced a mini crash today losing 9.7% in about an hour and a half. SLV’s average daily volume is 18.3M shares. Today an eye-popping 91.1M shares traded.

Both gold and silver experienced high volume and sharp sell-offs in spring 2011. As shown below, the stock market also experienced rough seas in the following six months.

We have no idea what tomorrow will bring, but we do know it is prudent to respect high-volume, waterfall declines in any market. A close this week below 1,354 would add another check to the list of correction concerns. The bulls are still in control, but they may be losing their grip a little.

Some short-term S&P 500 levels we are watching that would increase the odds of a meaningful turn: 1366, 1364, 1360. Possibly the most meaningful indication of a turn would be to have a daily close below the current weekly low of 1354. While we have numerous bearish set-ups, the bulls remain in control until we see some evidence of a turn. Short-term up side includes 1376, and 1384.

From a DeMark perspective, we have a valid daily S&P 500 exhaustion signal in place. With a close above 1363, we will pick up another S&P 500 sell setup. A close below 1363, would “confirm” the valid exhaustion signal. Therefore, either way (<1363 or >1363) another sign of a tired market will appear at today’s close.

The ECB printed a little more money than the market’s expectations, but well within the expected range. As shown below, the DAX has given back about 60% of this morning’s early gains. Most markets are either up a little or down a little - nothing dramatic either way.

The market has given little in the way of new information in the last two sessions. Breadth has weakened relative to what we saw in the last few weeks. As of 2:56 p.m. the advance/decline line is slightly negative on both the NYSE and NASDAQ.

Yesterday, we noted some bad news would probably be needed to tip the scales in this market. This morning’s economic data fits the “bad news” bill. From Reuters:

New orders for long-lasting manufactured goods fell in January by the most in three years as demand slumped across the board, suggesting the economy started the year on weaker footing than expected. Durable goods orders dropped 4.0 percent, the biggest decline since January 2009 when the country was still mired in a deep recession, according to Commerce Department data on Tuesday.

We often use the Summation Index as a way to monitor the markets “internals”. The Summation Index is a market breadth indicator that is derived from the number of advancing and declining stocks in a given market. The concept of breadth is easy to understand; healthy markets have broad participation during rallies (a stable or rising Summation Index).

The charts below are busy, but the concepts are simple. In the present day (shown below), the Summation Index climbed above 1,300 and has now started to decline (see orange box and blue arrow top right). The blue arrows to the left show the previous times the Summation Index turned down after a rally in stocks; the S&P 500 corrected soon thereafter (see purple boxes at bottom). Corrections in stocks (purple boxes) also occurred after RSI turned down from high levels (red boxes top); the far right red box shows the similar setup we have in RSI today, which leans bearish.

The concepts presented in the chart above apply to the 2003-2004 chart below as well. The Summation Index turned down from above/near 1,300 and stock market weakness/consolidation followed. RSI (red boxes below) also dropped below 70, just as it has today (red box above far right).

The chart below takes a closer look at the 2003 case. After the Summation Index rolled over from a level near 1,300, the S&P 500 dropped 5% over the next two weeks.

The setup in 2009 was similar. Stocks dropped 5.5% in three weeks (point A), rallied 8.7% over the next three weeks (B), and then dropped 9.1% over the next four weeks (C).

The takeaways for us today are (a) the odds favor some type of pullback beginning in the next week or so, (b) markets may be volatile for a time while making little progress, and (c) we have to be open to higher highs in the coming months. As noted in yesterday’s post/video, two items carry a bullish bias in the short-run: (1) the take up of ECB’s second round of three-year loans is announced Wednesday, and (2) Wall Street likes to “mark up” stocks at month end.

The bulls have been firmly in control since the Europen Central Bank (ECB) induced rally off the December 19 low in stocks. However, last week’s capitulation selling in the VIX and current divergences between the S&P 500 and Transports have opened a crack in the bearish door. We believe a news item, such as the lack of progress made at this weekend’s G20 summit, is needed to give the bears some traction.

The VIX measures implied volatility for the S&P 500 over the next 30 days. When the VIX is at low levels, it tells us the market is not concerned about a volatile pullback or negative headlines. Therefore, the VIX is another way to monitor market sentiment. Sentiment can be a powerful contrary indicator when the level of bullishness reaches extremes (or when the VIX reaches extremes).

The VXX ETN has a strong correlation to the VIX. VXX dropped 8.32% on February 23 telling us we may be nearing the level of maximum complacency in terms of bullishness. A strong reversal this week in VXX would add to our concerns relative to a possible pullback in stocks.

The video below mainly focuses on the current oversold nature of the VIX and the possible ramifications for stocks. Recent DeMark trend exhaustion signals for the VIX are discussed within the context of historical signals. Other video topics include a bearish divergence in the Transportation Average and the next round of money printing in Europe.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

The aforementioned bearish divergence between the Dow Jones Transportation Average and the S&P 500 is shown below. Note how peaks in the S&P 500 (top) and Transports (bottom) have tended to occur in unison in recent months (see blue-dotted vertical lines). The current market breaks the pattern with the Transports already experiencing a 5.5% pullback since early February (see red box right side).

The video above covers the always-important calendar of events in Europe. The most important and potentially market moving event is Wednesday morning’s announcement of the European Central Bank’s (ECB) second round of unlimited three-year loans for banks. While the bias for money-printing exercises is always bullish, a smaller than expected tapping of the ECB’s generous facility could disappoint markets addicted to central bank liquidity.

As we outlined in a December video, the debt levels in Europe will most likely remain problematic for investors for years to come. However, the strong market trends we cited last week are often associated with brief corrections followed by more upside.

The market’s bias near month-end also tends to be bullish, which means any pullback could be muted early in the week. Our base case looks for an S&P 500 pullback in the range of 5.5% to 11.0%, with a more shallow correction being the higher probability outcome. Should a pullback occur, we will be looking at leading markets and sectors as possible buy candidates, including technology (QQQ), homebuilders (XHB), consumer discretionary (XLY), small caps (IJR), and mid-caps (IJK). During any pullback, a spike in VXX is also worth keeping an eye on.

While evidence of a probable 5% to 11% stock market correction keeps piling up, the bulls remain in control until we see tangible signs of a bearish turn. The video below mainly focuses on the current oversold nature of the VIX and the possible ramifications for stocks. Other video topics include a bearish divergence in the Transportation Average and the next round of money printing in Europe.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Today’s video may be posted a little later than expected - let’s say between noon and 5 p.m. EST.

The Economic Cycle Research Institute (ECRI) is not backing off their controversial call for a U.S. recession.

We are working on a video to update the ongoing case for a correction in stocks. The video will touch on the VIX, transports, and possible pullback buy candidates (opportunities/ETFs/sectors/regions of globe). The video should be posted sometime late Saturday or before noon on Sunday.

Europe - The Problem That Won’t Go Away - From Reuters:

The head of the Eurogroup of euro zone finance ministers, Jean-Claude Juncker, said on Friday he could not rule out that Greece may need a third bailout.

In case you lost count, we are now working on the second bailout. Debt levels are unsustainable in the long-run; not just in Greece.

We believe the highest odds favor a pullback between 2.5% to 5.5% on the S&P 500 relatively soon, with the second most likely range being 5.5% to 11.1%. One reason for the relatively tame correction expectations has to do with the strength of current trends.

On February 20, we noted the black ADX line for the NASDAQ was above both the green and red lines (directional lines), and presented the text below from Trading For A Living:

When ADX (black line) rallies above both directional lines (red & green), it identifies an overheated market. When ADX turns down from above both directional lines (red & green), it shows the major trend has stumbled. It is a good time to take profits or partial profits.

There are numerous markets and ETFs with extended ADX profiles, including the S&P 500 Growth Shares ETF (symbol IVW). The ADX reading we have today (see point A1) is similar to the ADX reading from early 2004 (point A). The high level of ADX reflects a strong trend. The lesson from 2004 is we may see a very brief and shallow pullback, followed by some relatively tame gains. Due to the strength of the current trend, a period of consolidation (a few weeks) may be required before any significant correction takes place (see 2003-2004 scenario below).

It is possible the market does very little in terms of gains and losses over the coming weeks. However, we need to see what happens next. The main takeaway is the odds are relatively low we are nearing a major top and/or sharp reversal. A sharp correction is most likely in the cards over the coming weeks, but it may take time to develop (see right side of 2003-2004 chart).