A Laughable Market Moment

8 min readDec 10, 2018

This Wednesday’s rally was a textbook case of ‘the market moves, and a cause is found’. The cause? Two words: “just below”. Fed Chairman Powell stated that interest rates were Just below the neutral level, as opposed to the earlier assessment of “a long way” from neutral. And we are supposed to believe that those two words, concerning rising rates, caused the stock market to rocket higher. It is laughable, really.

The Fed has been raising rates for more than 2-years already and has always maintained that it is gradual and data-dependent, and nothing much changed on Wednesday. If the implication of his words is that the economy is slowing down and, therefore, there is no need to raise rates, then the market should have tanked, not rallied. The truth is, as we know, markets move on internal emotion, not news. The market was technically showing signs that it would likely rally, and Powell’s two words were used as the excuse. We are quite sure that if he had kept the earlier wording, the market would have rallied anyway, and the talking-heads would have justified the rally with something like ‘the market rallied because the Fed said they will continue to proceed at a measured pace’, or something similar.

Fear of losing, and fear of missing-out is what drives the market, and these emotions leave repetitive patterns in the price history of the market. Let’s look at the patterns and see what they say.

Equities

Sentiment

The AAII investor survey shifted toward the bullish side, but as we pointed out on Thursday, both remain outside of their long-term averages. The pattern still fits as a normal correction within a normal bull market (chart below).

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The National Association of Active Investment Managers (NAAIM) exposure index 50-week MA leads market down-turns and lags market up-turns. The average has dipped lower, but this does not change the bottoming process (chart below).

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The chart below shows the put-to-call ratio at the daily-scale with the 8-day MA highlighted. The vertical blue dashed-lines mark the up-spikes in the 8-day MA which also correspond to local bottoms in the S&P 500. Since April, these up-spikes have formed a pattern of lower-highs like 2017 (blue solid trend-lines).

Last week we wrote:

… the average did move slightly lower, but the SPX had a substantial drop instead of continuing to rally. This pushed the correlation in the positive direction and if this continues to increase like it did earlier in the year (pink ovals), then we could see further downside to the SPX as the put to call ratio continues to drop (i.e. positive correlation).

In fact, the correlation turned around as the more normal relationship returned; the ratio kept dropping while the SPX rallied. This coming week, it is reasonable to expect the ratio to continue lower until it bounces off the blue down-sloping trend-line before heading higher, and the SPX continues to rise, then fall in an inverse relationship (chart below).

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The bear-to-bull asset allocation of the Rydex family of funds, has a strong inverse correlation with the SPX; a declining 36-week MA in the Rydex ratio is bullish for the SPX. Down-spikes in the ratio, correspond with tops in the market. In other Weekly Summaries, we have pointed out the similarity in trading patterns of the current bull market, with those of the tech bull market of 2000. During the later-stages of the tech rally, the Rydex ratio (nominal) made a down-spike early in 2000, but the 36-week MA continued to move lower while the SPX moved higher for another six-months before hitting its second (and final) high, and the Rydex ratio made its second (and final) down spike, after which, the 36-week MA started to rise as the S&P 500 corrected itself into a bear market.

What we wrote three weeks ago still holds:

Despite the fact that we have many reasons to think that this is not the start of a bear market, the behavior of the Rydex bear:bull asset allocation ratio is starting to worry us. Each time that the nominal ratio value made a double down-spike and the 36-week MA started rising, the SPX corrected into either a bear market (2000), or into a significant local correction (2011 and 2015). That is the situation we are in now; the nominal ratio has formed a double down-spike, and the 36-month MA is starting to rise.

In 2011, the market corrected -19%, in 2015 it went down -14%, and as of this past Friday, the market is down almost -10%. The market could end up correcting down to meet the long-term trend-line in the 2400–2450 area which would result in a -17% correction. The bull market would not necessarily be over at that point (just like it wasn’t over in 2011 or 2015), but it would be a painful correction.

Last week, we wrote:

The possibility that the market pulls back toward the long-term trend-line is still alive, but we note that the nominal bear:bull ratio has dropped for the second week in a row. This means that bull assets are being added to portfolios. This evidence of “buying the dip” is needed in order for the market to form a bottom (chart below).

This week, the nominal value of the bear:bull asset ratio increased as the market rallied, which means that bear assets were being added and the 36-week MA is pressured higher. This does not have to be fatal, as in 2011 the nominal value spiked, but then came down rapidly (green rectangles on the chart below). This may be a further indication that there is still another pull back to come before the bottoming process completes and the bull market continues.

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The VIX has been following the same downward pattern that it did at the start of the year (green dashed-arrows on the VIX chart below). Here also, we see the likelihood of another, perhaps smallish, pull-back in the SPX before we get back to the bull market.

Technical

The C4 correction pattern from 2000 continues to replicate. Both time-frames have the following similarities:

VIX has made the 3rd up-spike.
Sentiment is increasing.
MACD has made a bull cross-over.
-DI is dropping, and +DI is rising.
Stochastic is rising from over-sold level.
The SPX has moved above the 38% Fib retrace.

The market has bounced higher and breached the 38% Fibonacci retrace level without first testing the 2590 level. The final bounce of the bottom-forming process is likely in progress.

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The emerging markets (MSCI), on average, maintain a positive correlation with the S&P 500. However, on occasion, they diverge into a negative correlation. In the last five years, this has happened five times, and in each case, this has been followed by coordinated rallies for both indices once the correlation returns to positive (red vertical dashed-lines). The latest divergence started in March of this year with the correlation turning positive three weeks ago. Both indices have started to rise.

When the 20-day MA of the ratio of the Russell 2000 to the S&P 500 (RUT:SPX) crosses under the 50-Day MA, the S&P 500 tends to rally (green arrows). The latest cross-over occurred on October 18, and the SPX seems to be on the rise (green arrows).

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Last week we wrote:

The market is likely to test 2600, but chances are good that we get a bounce from there…

We got the bounce, even though 2600 was not tested, and the SPX finished just shy of the first resistance zone of 2760–2770 which corresponds to the 200-day MA and the 50% Fibonacci retrace level, respectively. Our intention is to close half of the SPXL position in this zone and continue to hold the remaining half in anticipation that the SPX will reach up to the 2800–2810 resistance area (62% Fib). We think it likely that the SPX will pull-back from that level before breaking above the 2813 level and resuming the bull market (chart below).

Fundamental

What we wrote last week, still holds:

Even if some of the economic indicators are starting to show marginally-slower growth, we remind you that the economy is accelerating (first derivative) and it is only the rate-of-change (second derivative) of acceleration that is slightly negative.

The table below demonstrates that ‘things are not so bad’. Even though it is sentiment that drives the market, it still is solid fundamentals that provides the scaffolding for the market to climb.

The chart below summarizes how GAAP earnings, industrial production, rising Fed rate, and dropping unemployment all correlate with rising stock markets.