Weekly Market Brief

On Knife’s Edge

Last week’s inside week produced a massive rally off of heavily oversold conditions, but then gave a large part of the gains back, closing just above the weekly 50MA, but below the 2016 support trend line leaving markets on a knife’s edge. My suggestion to both bulls and bears here: Pay really close attention and keep a very open mind. Make no mistake here: This is a critical phase for these markets.

Let me walk you through some considerations.

As mentioned in previous updates from a technical perspective the underlying weakness in the internals leading up to the September/October peaks amidst tightening technical patterns and negative divergences (Lying Highs) was not a surprise.

And if you view this recent correction through the lens of simply supply & demand, this correction also makes perfect sense. After all insiders cashed out aggressively in September and then 2018’s biggest artificial liquidity infusion, buybacks, temporarily ceased into the earnings window.

From a bullish perspective this correction will be simply another temporary dip before buybacks return and then stocks can embark on another major rally into the positive mid term seasonality window:

This may well happen and that is clearly the script many expect.

However, for counter balance, I’d like to offer a couple of other considerations.

Firstly, in regards to the mid term seasonality window, let’s be clear, 2018 so far has not followed the mid term seasonality script very well. It would have called for a market peak in April, then a low in to late September/early October. None of that has happened in 2018. We saw a first peak in January and a low in February and then another peak in September. So if one is relying on a mid term seasonality script they are relying on a pattern that hasn’t really applied all year.

But as you see in the chart above typical market seasonality is also strong into year end, between the end of October and late December specifically. Think FOMO and mark-ups as lagging funds need to play catch-up. Add returning buybacks into the mix and you have a solid argument as to why markets can back on program.

So bulls have a historically strong case for a major rally to emerge into year end.

And frankly they need one. Badly.

Because if you can’t rally on supposed 4% GDP growth, a $1.5 trillion tax cut, record buybacks and record earnings what can you rally on?

$SPX is barely up 3% on the year and while $DJIA and $NDX are still up on the year many indices and sectors are either flat or down on the year:

Transports, semis, the banking index, I could list others, but you get the point: Where’s the bull market in these?

However let’s be clear there is precedence for markets not to rally into end of year.

Look to 2007 and you get the perspective:

Back then markets corrected in late February/March, proceeded to make several new highs and finally peaked in October. A bull market that suddenly saw several corrections creep in and make a new all time high on a negative monthly divergence.

Similar to what we are currently seeing:

The stakes couldn’t be higher as a repeat of this setup would invite the end of the bull market inviting a complete technical retrace of the rally since 2016 at least:

And when I say on a knife’s edge I really mean it:

Last week’s intra-week bounce not only came on massively oversold conditions, but also a retreat in yields again validating the pivotal relationship between stocks and bonds.

Why the sell off late in the week? Well one could argue the rally in bonds has not exactly been impressive so far:

The message remains: Both bonds and stock markets are at critical trend support.

Next week earnings will be in full swing and many of the big hitters will be reporting. Earnings continue to be expected to be solid on tax cuts, buybacks, and a still strong economy riding the tax cut sugar high. However, the reaction to earnings is more important than earnings themselves and hence need to be closely watched.

Some banks started reporting last week and so far the reaction has not exactly been convincing as seen in the banking index:

So bulls need to see a stronger and more convincing reaction to the upside.

And be clear, the potential firepower for a massive bounce is there. After all some long term oversold readings moved to even steeper levels.

I could show you a number of examples, but I’ll just use the highs/lows chart to illustrate the point:

This is near an area that has produced sizable bounces and even meaningful bottoms before. Some of these produced rallies that led to a double bottom retest for a major low, and some have produced rallies in context of an emerging bear market. As I said: Stay open minded.

Let’s run through some charts:

While equal weight also experienced a bounce last week it too gave much back of the bounce:

The risk for bulls here is that $SPX may be forming a bear flag suggesting a retest of lows or even new lows before this current correction can act on these oversold signals.

Note, at the point of this writing we do not have new lows yet, but I’m outlining the potential based on the pattern risk.

New lows from here would actually not necessarily be bad for bulls as they could produce positive divergences. And the potential for these are very notable in a number of charts.

Firstly note $NYMO printed such a positive divergence on a new $SPX low earlier in the year:

$RUT would also print a positive divergence on new lows:

It’s underlying volatility index also leaves room for a potential bull flag suggesting potentially more volatility yet to come.

And we can see such a potential for a positive divergence on $SPX:

The problem with this scenario of course is that new lows would break the 2016 trend line and markets would fall below the weekly 50MA which in turn would open the road the larger fib retraces:

But it’s a weekly chart an hence it leaves room to repair any new low damage into week’s end and of course month’s end on the monthly charts.

What’s potential support on a break to new lows?

I’ve outlined the .618 fib at 2684/85 as potential support on any new lows. The recent low was at 2710 and this 2684/85 area may well serve as a new low on a positive divergence. It’s also just below the weekly Bollinger band.

Should this area break then further support can be found near 2645:

Hence, if lows break in conjunction of oversold signals one should not be surprised if either see a sizable rally or major bottom could potentially emerge from the 2645-2685 area.

But there are problems with the major bottom in the making theory and I want to highlight just a couple of them.

Check Rydex bullish/bearish positioning. Where’s the fear?

In major corrections past investors showed signs of fear and capitulation. Even 2016 produced a shift in positioning. Since then? Nada. Zilch. Zip. Flat lined. Full bullish positioning no matter what.

Even the 2018 February correction didn’t manage to even produce a blip in positioning. So while money flows have produced a negative divergence along with the market itself investors simply do not appear to care or worry. Permanent complacency? ETFs for the win? Stocks always come back?

I can’t say what the sentiment driver is here, but historically this chart suggests we are miles away from a capitulation bottom.

And as much as we’ve seen many individual stocks get clobbered in the big picture the biggest and baddest market cap monsters have barely even begun to correct.

Take $AAPL and $AMZN as examples:

So the reaction to earnings will be key. Cause if these baddies break lower then $NDX is unlikely to hold onto its trend line it just defended:

And if it breaks below that next trend line is much lower still.

To summarize: Markets are in a critical phase here that threatens the long term bull market trend. Many signal charts are heavily oversold which make a larger rally to come very probable. If a retest or new lows emerge they would produce positive divergences leaving room for trend line breaks to be repaired before month end.

Any such a rally then has to produce new highs or this bull market is likely to have seen its end (see also New Highs or Bust).

If new lows are made and key trends and moving averages cannot be recaptured by month end then much further downside could emerge rapidly into November.

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Authored by: Sven Henrich

Categories: Weekly Market Brief

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