Battlestations! S&P in Topping Mode
By Frank Barbera CMT. May 20, 2008
In reviewing the action in various markets over the last few days, it appears as though another juncture is rapidly approaching. Call it the start of "The Great Credit Bubble Phase II." In Phase I, Sub-prime and Alt-A mortgage paper collapsed, Bear Stearns slid beneath the waves, and Gold soared above $1,000 per ounce. The Stock Market tumbled nearly 20% (18.48%) and the Dollar plunged to record lows. For the last few weeks, markets have enjoyed a pleasant hiatus with stock indices recovering and the Dollar strengthening. That is until the last few days, as Gold has revived, stocks have reversed lower as has the US Dollar. While we still believe there is a good chance that equities may not actually break down to new multi-month lows until the fall, there is nevertheless a high risk that prices are at present very close to a major interim peak.
Back on April 22nd in our piece entitled "Oreo Cookies and the Stock Market," we opined,
"Thus, this 1380 to 1400 range becomes a very important zone. If the stock market as measured by the S&P 500 can press above this resistance in the weeks ahead, there is a good chance that prices will continue to extend the bear market rally over the next few weeks into the summer months. Under this outcome, prices could be moving up toward the 1440 level, which represent a .618 Fibonacci retracement of the prior decline."
Since then, the indices have surpassed 1,400 and have managed to stagger their way higher with the S&P hitting a peak of 1440.24 just yesterday. In that same article, we placed a lot of emphasis on one of our favorite indicators, the Medium Term ARMS Index. At the time, the ARMS Index had NOT seen an overbought reading of any material sort, and as a result we concluded that the stock market advance probably had further to run. We stated,
"So where are we right now? With a close of 1.065 last night, the Medium Term ARMS is just slightly above neutral having come down off the deeply oversold values seen a number of weeks back. Of note, we have NOT seen a .80 value, a true overbought value on this gauge since last June, and that is becoming somewhat overdue. Even accounting for the fact that Bear Market rallies might not peak as low as bull market values, what I call a bearish upward "scale shift," one would normally expect at least a reading below .90 BEFORE an intermediate term B-Wave had run its course. So far, that type of low value has not been seen, and thus, in our view, the important ARMS Index is suggesting that the stock market may try to move still higher."
In that same update, we also included a chart of the ARMS Index which is shown below.
Above: "THEN" - a snapshot of the ARMS Index from April 22nd, "Oreo Cookies and the Stock Market"
Importantly, as stock prices have moved sequentially higher, the ARMS Index has "done its thing" and moved sequentially lower. Remember, this indicator is plotted on an inverse scale, where high ARMS Index values reflect great fear, while low Index values reflect a swing toward optimism. Over the last few days, the Medium Term ARMS Index has plunged to values of .864 on Monday the 19th, .8730 on Friday the 16th, .874 on Thursday the 15th and a recent low last Wednesday at .846. We have now not only recorded a value below .90, but we have very closely approached the .85 to .80 window which is usually a very big warning.
Above: "NOW" - the ARMS Index updated to present, with very low values signaling high risk of a market peak.
So what kind of warning could be at hand? In our view, it seems as though there is a good chance that a medium term peak for the S&P could be cemented into place over the course of the next 10 days within the range of 1405 to 1440. At the moment, today's sharp S&P decline has not convincingly violated the rising uptrend of the last few weeks, and to that end, a retest of the highs for the S&P is probably still ahead over the next few days. That said, in the larger scheme of things, we have been leaning toward the idea that a large (a,b,c,d,e) triangle B-Wave is unfolding in the stock market, with the recent advance of the last few weeks comprising Wave C, an upward trending portion of the pattern. We outlined this in general terms back on April 22nd in the "Oreo Cookies and the Stock Market" discussion. In our view, much of that same process remains in place, even though the "C-Wave" has pushed a bit higher toward the 1440 zone. In Elliott parlance, this is known as an irregular "C-Wave" and this is fairly common within triangles.
The bottom line for the stock market as we see it, from a late May high, the S&P could be vulnerable to a trip all the way back down toward the area of the March lows, in the low 1300's. This type of decline may not be a full on resumption of the bear market, as there could still be a final "E-Wave" advance later this year which would ultimately complete the larger five wave triangle pattern and Wave [B]. Thus, thinking "trading range" is probably a wise approach, and to that end, prices right now may be in the act of defining the "high" end of the range.
Above: the 20 day Average of Advances less Declines, and Below: the McClellan Oscillator
Other short-term oriented technical gauges also reflect the market swing back toward overbought territory. In the case of the 20 day Advance-Decline Oscillator, with a close of +93.52 last night, we are now back up to the area where each of the last three peak readings, +91.52 on 2/27/08, +82.88 on 12/26/07 and +108.00 on 10.05.07, were highly problematic for the stock market. Likewise, the McClellan Oscillator has also moved back to overbought territory with a close of +297.63 last night. Importantly, the oscillator has essentially continued to trace out a series of sequentially lower highs throughout the rally, indicating that internally this advance is not robust and most likely of the bear market stripe.
Above: Operating Company Only Put to Call Ratio
In addition to the recent set of overbought values on key daily oscillators, we also note that sentiment has swung widely in the last few weeks moving from high levels of fear to a now cautious optimism. 'The Worst is Behind Us' mind set now rules the roost, with the Dollar Weighted Put-Call Ratio for Operating Companies swinging down toward its lower band. Again, this does not mean the market cannot move back up and retest the highs, or even record a token new high in the days just ahead. What it does mean is that traders operating on the long side of the market should be advised that perhaps the lion's share of the rally is now over, and that from a risk-reward point of view, downside risk seems high in the weeks just ahead.
So where are the risks if things get rough? In our view, when we survey the financial world, we still see a dismal road ahead with a lot more problems in front of us rather than behind us. In fact, instead of the "worst being already over," we lean heavily toward the idea that the "worst is still ahead." The price action in stocks like Fannie Mae, Lehman Brothers, and Citicorp is enough to cause us bad indigestion following lunch, if you know what I mean. None of these has any hint that the worst is over, not fundamentally, and certainly not from the positively wretched price action seen on the charts. In each case, huge degrees of financial leverage are in play, and in each case the "light at the end of the tunnel" is most likely a 100-car freight train on a head on collision rolling down the tracks at 100mph. 'Run, don't walk for the exits' would be our best advice.
Above: Fannie Mae - an odds on favorite for leading the parade of Phase Two major problems, way too much balance sheet leverage at work' ultra bearish chart configuration.
Above: very likely still nowhere close to being "out of the woods," no bargain to be had here. Company survivability potentially still in serious doubt.
Above: Long term view of Lehman Brothers (LEH) looks ripe for a renewed major decline; many big questions as to whether LEH will have the financial muscle needed to survive this down cycle potentially another great example of too much leverage in reverse.
Finally, another indication of a trend reversal now rapidly approaching is the Goldman Sachs to Gold Ratio which measures relative confidence. If confidence is high in the financial system, money flows into Goldman Sachs (GS), the bluest of the blue chips, and shuns Gold, and the ratio falls. Alternatively, if confidence is frayed and frightened by the financial system, money flees Goldman and heads for Gold. We note that the ratio has recently undergone a hefty correction as the stock market rallied, but now in recent days, we see the ratio breaking out top side above its declining trend. Gold is regaining the upper footing, and as a barometer of faltering confidence, the rising ratio warns that a more challenging period may be just ahead. For those willing to listen, this breakout is the sounding of an alarm, a call to general quarters, and a warning to review portfolios on the spot. From here forward, odds are high that rallies should be viewed as opportunities to sell and that portfolios should be reverting back to a fully defensive posture.
Above: the Goldman Sachs to Gold Ratio with 9 day RSI. Upside breakout signals "Battle-Stations" to all who will listen.
At the close, stocks ended sharply lower with the DJIA shedding 199.48 index points for a loss of 1.53% to close at 12,828.68. For the S&P, the day's action generated a loss of 13.23 index points or .93% with the S&P ending at a close of 1413.40. The NASDAQ also moved lower, losing 1% to finish with a close of 2491.04, down 25.05 index points. The 10 Year Bond ended at 3.78%, down .06 basis points while nearby Gold was up better than $16 to close above $920 for the first time in many weeks. That's all for now,
© 2008 Frank Barbera