Tactical Analysis Part II: The Strong Bear Market Rally Outcome
By Frank Barbera CMT. April 7, 2009
In last week's review, we spent some time looking at the equity market from a dispassionate stance, first dwelling on some of the more potentially negative outcomes. In this week's update, we are going to spend some time looking to set up some parameters for getting a better idea of precisely what a “better than expected” stock market outcome might be. To this end, we have seen some potential progress, with the Financial Accounting Standards Board (FASB) showing a willingness to relax some of the very difficult accounting rules which have hampered the nation's banks. In addition, there are strong rumors that a second large stimulus program could be seen later this year, and that may help to jump start a late 2009 fledgling recovery. Of course, it is too soon to tell, but one thing we can be fairly confident about. If there is a recovery ahead, the US Equity market along with other world markets will likely pick it out in advance. The stock market tends to be quite good at sniffing out recoveries and turning higher in advance. In last week's update, I pointed out what is perhaps one of the strongest positives the stock market has going for it at the current time, namely, the idea that it has been so bad, it might be hard to get any worse.
In the chart below, I show the spread between the 50 and 250 day moving averages, which over the last few weeks has been in record negative territory. This implies that a healthy snap back recovery could well be in order soon, as like a rubber band stretched too far, the stock market tends to snap back from major extremes.
Above: Exactly the same chart, just seen from a 30 to 40 year point of view. We are still in a big outlier.
As can be seen in the chart above, the S&P 50 day average closed today (the lower arrow) at approximately 789.70, with the declining one year moving average (250 days) ending at approximately 1074.90. The 50 day average is just now barely beginning to turn up, while the one year moving average is trending strongly lower. Assuming the usual medium term basing process followed by a second bear market bounce, we can arrive at a sort of ‘middle of the road’ bullish outcome which is shown in the next chart. This outcome allows the market to unwind the recent excesses with a bear market bounce that takes the S&P roughly back up toward the 950 to 1000 area between now and the September to November time period.
As the market steadily recovers in the bear market rally phase, the 50 day average begins to turn up more strongly, and at some point meets the declining 1 year moving average narrowing the spread, and possibly even turning the spread briefly positive. Yet where 2009 is concerned, I would argue strongly that an outcome like this is really about the BEST CASE outcome for the stock market, and for those who might not believe it, it is a very good outcome indeed. Why and how so? Well, this is one time when a little basic ‘Technical Analysis’ can really speak volumes, and where a little knowledge can help investors avoid what could otherwise be painful periods of time. You see, when moving averages get as far apart as they did in 2008 and in the early going of 2009, you can basically count on (a) some regression to the mean but also (b) the idea that the first attempt to cross-over will end in a failure. It is just the way markets change direction. Like ocean liners, the trend tends to change a little bit at a time, and the kind of severe price damage seen in the last 18 months will take real time to repair. That means that the first bear market rally, even if it is very powerful, will almost certainly burn itself out on the upside, and then give way to a second, ideally, much smaller and slower paced bear market decline. This second bear market phase is the 'retest’ phase and in a situation like the one we have today, you can really count on this as a reasonably high probability outcome. Retesting the lows can take months, as retest declines are usually a long and slow process.
In my view, this strongly argues that if a genuine, honest to goodness bull market is going to return to the equity markets, it is a really good bet that such a bull market will not develop until the latter part of 2010 at the earliest. Now some bulls may be reading this and saying, “But Frank, this is the bull case? In the bull case you are setting forth, you are telling us we still have more than a year of going essentially nowhere before the long term trend potentially even begins to reverse steadily higher – some bull case!” My response to that outcome is that in reality, considering the heavy damage to both the banking system and the broader US and global economy, a strong turnaround in the second half of 2010 would actually be quite rapid by almost any post-bubble analog. What’s more, under the outcome described above, the basic lows for the market have already been seen, and while prices bounce off the lows and then end up coming down to revisit them a second time, they do not break the low and/or break down to new multi year lows in this scenario. In that sense, this type of outcome would be a real blessing as it would strongly imply that a Depression type outcome is ‘off the table.’ By default, it would also imply that some of Uncle Sam’s strong medicine was having at least a stabilizing effect.
Mind you, most writers of note today believe that what the government is doing (a) might not or probably will not work, and (b) could actually make things a lot worse. Thus, in this outcome I am giving Uncle Sam at least partial credit for “getting it right” and right now, that is ceding a lot of goodwill. Under the kind of bull case shown above, during the second bear phase, the declining “(C)” wave, the spread between the 50 day and 250 day average would never get as wide as was seen during the first “(A)” wave decline, and the less negative spread would then set up the kind of positive divergence that would herald a larger, more sustained turn. In this outcome, the real trial is the rather substantial amount of TIME that is needed in order to right the ship and turn things around.
However, for those who enjoy trading, this kind of climate can be an excellent environment for ‘hit and run’ trading strategies where the name of the game is “Make the Money-Take the Money.” In my view, TIME could be a crucial element all the way around. For example, if the S&P can move back above 900 and stay there for three to four months, residing for a reasonable amount of time above 900, that should go and likely will go a long way to setting up an ultimate bottom and eventually the kind of stability that can lead to a new secular bull. Alternatively, if the S&P moves up to 900 and gets blown out of the water after a period of a few days or as little as a week or two, that kind of outcome would be more in keeping with a downside continuation pattern, where values could fall to new multi-year lows, and this could continue to unwind in a major way.
At the moment, we still see may reasons to be very careful, both technically and fundamentally. On the fundamental side, the steady rise in 10 Year Bond yields should be bothering all bulls. If this is not keeping you up at least a little bit at night, then something is very wrong. I mean look at it, the stock market went straight to hell from January to March, the economy hit the deck with unemployment numbers unseen in most people's lifetime and yet, throughout that entire period of time bond yields did not move lower. WOW!
Flash-forward to the time period of the last two weeks, we have Uncle Ben telling us that he will be buying bonds and yet, instead of going down (and staying down) yields plunged and then reversed out all of the gains. WOW Again! In my view, this hints broadly that something is very wrong in Bond-land. Perhaps the market is now focusing primarily on a huge channel of forthcoming supply, or perhaps, the market is concerned that foreign creditors will withdraw their buying support. Some combination of these fears seems to be at work and for the stock market, rising bond yields could be a toxic brew. The action these last two weeks has me remembering the late 1970’s when higher bond yields depressed the stock market.
Elsewhere, on the technical side, the stock market rally of the last month now is starting to look tired and very overbought.
Above: the Medium Term ARMS Index
As can be seen in the prior chart, over the last three weeks the Medium Term ARMS Index has moved from some of the highest, most oversold values of the last 10 years to now, some of the lowest, most overbought values of the last 10 years. While the ARMS Index can be ‘early’ in calling meaningful highs, it is usually a good idea to become more cautious when markets start to show very low values on the ARMS Index. That is the case right now, and it suggests a period of downside counter-trend action dead ahead over the next few weeks.
Above: the S&P 500 with the 20 day Average of Advances less Declines.
In addition to the ARMS Index, other gauges like the 20 day average of Advances-minus-Declines are also now residing in ultra-overbought territory. This suggests that a period of downside correction is in order, and that the market will be choppy over the next few weeks. Notice also that in the prior paragraph I characterized this period of downside action in the next few weeks as ‘counter-trend.’ I say that because I now believe that the medium term trend, defined as the 3 to 6 month view, is UP and is likely to remain up for a few months. To that end, set-backs in the major averages are counter-trend moves. At the same time with any number of long term moving averages still moving strongly down, there is virtually no way that the Primary (long term trend of the market) is not still pointing DOWN. While there have been a few instances in past history where bear markets bottomed without a retest phase, I am not aware of any that developed where the bear market had packed this kind of downside wallop, with so much accumulated downside “mo.” For this reason I would argue that if equities are able to stage a multi-month rally, it will be a good sign indeed as what investors need most right now is a period of relative calm, where confidence can gradually be restored and convictions allowed to steadily build.
A final thought on ‘strong trending markets” and the marked tendency for markets like this to ‘retest’ former lows. Perhaps no market has trended more powerfully on the downside than the Financials during the last 18 months. Over that time, we saw non-bounded momentum indicators like MACD move down to historic extremes with huge downside momentum registered at the November lows (Point X) and the January lows (Point Y). In instances such as this, it has been my experience that MACD tends to initially move back up and above zero, (Point Z - where we are now) and then roll over a second time. Usually, prices end up retesting the lows even as MACD manages to make a higher, less negative set of lows (Point A?). In my view, the Bank stocks are probably the most important sector to watch. If the BKX can move strongly above 31.00 it would probably send a powerfully bullish message. Conversely, any breakdown below 26 in the near term would likely suggest the beginning of another declining phase in Bank shares, and that could put a lot of pressure on the equity market. As I see it, the next few weeks are likely to be trying times for investors, but if all goes well, once oversold indications appear, another good buying opportunity may not be far away. That’s all for now,
© 2009 Frank Barbera