Posted |
By Now You Probably Know... image

Good morning. By now, you are probably already aware that the stock market has gotten off to the worst start of any year in history. So much for the favorable seasonality. So much for the asset allocation work that typically helps equities at this time of year. And so much for all of the fresh money that tends to move into the market at the start of each calendar reset.

By now, you probably already know that traders are completely focused on China at the present time, including the levels of both the mainland and offshore prices of the yuan as well as the on-again, off-again circuit breakers for China's major stock exchanges.

By now, you are undoubtedly aware of the massive decline that has occurred in the energy market as well as the first, second, and third derivative issues that a debacle of this magnitude brings to the commodity itself, stocks of energy companies, bonds of the energy companies, and the junk bond market.

By now, you have likely heard all the arguments from both teams. For example, our heroes in horns remind us that the causes of big, bad bear markets tend to be (1) recessions, (2) bouts of inflation, (3) bubbles, and (4) external events such as wars, crises, etc. Further, we're reminded that none of the above appear to be on the table or even the horizon at this time. In addition, but bulls tell us that the cause of the current market freak-out is not US-centric. Therefore, like most bad news panics, this one will likely be forgotten soon enough.

By now, you are probably able to recite the bear case as well, which includes a fair amount of fretting about current stock market valuations, the "plow horse economy" (hat tip to Brian Wesbury at First Trust for coining that phrase), declining earnings (EPS for the S&P 500 are expected to decline for a third straight quarter), and the pathetic breadth of the market (highlighted by all the talk about the F.A.N.G.'s - Facebook, Amazon.com, Netflix, and Google, err Alphabet).

But what investors may not know is whether or not the current 6% decline in the stock market is (a) going to continue and/or (b) become something more meaningful than the typical emotional panics/V-Bottoms we've seen for the past several years.

To be sure, one needs either a functioning crystal ball or a healthy dose of hindsight to know the answers here. And as I've said a time or twenty over the years, I don't think it is a good idea to try and predict what Ms. Market may or may not do next. As such, the game plan is to try to (a) identify what is actually going on in the market and (b) stay in line with the overall environment.

For me the best way to do this is to "go to the video tape" and run through our market models. To review, the key to this exercise is to try and review the major market indicators as objectively as possible in an effort to ascertain the "message" from the weight of the evidence.

Cutting to the chase, it looks like we've got a case of the good, the bad, and the ugly on our hands.

Let's start with the bad - the price action of the market itself. Below is a chart of the S&P 500 on a weekly basis.

S&P 500 - Daily

View Larger Image

As is fairly plain to see, this chart is not a pretty picture from a technical standpoint. There is downtrend developing. The multi-year uptrend that had been intact for more than four years, has been broken. And the closing price on Friday is darn close to a new low. Therefore, one could not be blamed for being a little nervous about the price action.

But, since chart analysis has become less and less valuable given the emergence of high speed algorithmic trading, we need to look at other indicators to get the full story. So, presented below are the ratings of our key price trend indicators.

In looking at the colored boxes, you might think, "Hmmm... that's not so bad - there are 4 red boxes and 3 green." But let me add a couple caveats. First, the last box is misleading. Yes, the market is in a trending mode at the present time. The problem is that stocks are trending lower, not higher.

Then there is the Long-Term Trend Model, which uses moving average crossovers. The key point here is that these indicators are right on the edge of turning negative. Therefore, things are actually a bit worse than the colored boxes might lead one to believe.

But before I am accused of being a Debbie Downer, there is one bright spot here as the cycle composite shows that stocks have historically moved up during the early part of the year.

Now let's move on to the U-G-L-Y. Below is a summary of key internal momentum indicators.

This, dear readers, is what a sea of red looks like. In short, there is NOTHING good to report here - nothing at all. And history shows that the market has lost ground at a pretty healthy clip when the indicators are in this state.

But before this becomes too depressing, let's move on to the good news. Next up is a summary of I like to call the "early warning" indicators.

Talk about a horse of a different color! The "early warning" indicators are designed to help us identify when a market is "set up" to reverse. Unfortunately, there is never an indication of when a reversal will actually begin. But the bottom line here is that the market is indeed "set up" for a reversal here as one can argue that the action is currently "so bad" that it could be a good thing in the near future.

However, there is a very important caveat on this subject. It is important to remember that an oversold condition (a) can become more oversold and (b) can remain intact for quite some time. So, just because stocks are oversold and sentiment is negative does not necessarily mean that a bounce is imminent.

In addition, we should remember that in truly bearish environments, traders use oversold rallies to sell into. Thus, we will need to watch the action closely when the inevitable rebound begins.

For the record, stocks did attempt to rebound on Friday - but as you are no doubt aware, the attempt failed miserably. But then again, Friday's are historically bad during these "bad news" markets.

Next, the question of whether or not this is merely a correction or the start of a bear market is likely weighing heavy on investors' minds. Therefore, let's also check in on the "external" indicators this morning. In short, these are the indicators designed to tell us the state of the current big-picture market environment.

On the monetary front, we can see that the indicators are torn as the absolute level of rates remains constructive for stocks. However, when the overall picture is taken into account, things are more neutral.

The good news is that our economic models remain positive and that the chances of a recession today are fairly slim.

Next is the subject of inflation. Although there is no inflation to speak of at the present time, the indicators looking at what are called "pipeline pressures" have started to wave a few warning flags - especially on the wages front. So, after sporting a bright shade of green for a long stretch, our inflation model is now neutral.

And finally, there is the issue of stock market valuations. As we've discussed previously, this is a subject where one needs to plant a flag, so to speak. The key is to recognize that stock market valuations are either very good or very bad, depending on how one chooses to look at them.

The last word on the subject of valuation is to remember that in the stock market, things don't matter until they do - and then they matter a lot. Thus, the question is if valuations are going to become a focal point in the near term. If so, then stocks could certainly fall further - perhaps a lot further. If not, then the next V-bottom is likely close at hand.

The Message

While the message to be gleaned from this type of indicator review is obviously subject to personal interpretation, my take is as follows. The tape is very weak at the present time and there has been a fair amount of technical damage done since last August. In addition, we need to recognize that this market is clearly focused on China. So, with our "early warning" indicators flashing green, shorter-term traders should be on the lookout for the inevitable oversold bounce in the coming days.

From a big-picture perspective, since the current decline is not US-centric and based largely on the fear of what might happen, I will argue that the current dance to the downside is likely to wind up in the correction camp and be relatively short-lived. However, if fear should become entrenched, there is a possibility of a "mini bear" such as we saw in 2011, 1998, and 2000.

So from my seat, this appears to be a "dip" that long-term investors will want to use as an opportunity to put capital to work. But from a near-term perspective, we all need to buckle up because the ride is most certainly going to be bumpy for a while.

Publishing Schedule For 2016: With my Chief Investment Officer gig at Sowell Management Services (a registered investment advisor responsible for north of $600 million in client assets) comes a myriad of tasks and responsibilities, as well as frequent writing assignments, speaking engagements, video recordings, advisor calls/meetings, and industry presentations. Because of this, the time available to pen a "daily" missive is becoming more elusive (and nearly impossible when I'm on the road). And since my primary duty is to keep our investing strategies up to snuff and on the right path (or "out of the ditch" as William Sowell likes to say), my plan for the upcoming year is to publish my oftentimes meandering morning market missive two to three times a week - or when market circumstances dictate. For most, this will likely be a more appropriate diet of "Daily State" reports! But since there are loyal readers that will check in to make sure everything is okay in my world if I miss a day, I thought it would be best to publish my intentions for the "State of the Market" reports in 2016. Finally, I'd like to say thank you to all those who make this report a part of their morning routine. It is my sincere hope that readers will continue to find these reports helpful in some small way.

Today's Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: closed
    Hong Kong: -2.76%
    Shanghai: -5.32%
    London: +0.04%
    Germany: +0.58%
    France: +0.47%
    Italy: +0.35%
    Spain: +0.32%

Crude Oil Futures: -$0.56 to $32.60

Gold: +$5.70 at $1103.60

Dollar: lower against the yen and pound, higher vs. euro

10-Year Bond Yield: Currently trading at 2.147%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +4.12
    Dow Jones Industrial Average: +24
    NASDAQ Composite: +12.46

Thought For The Day:

Success is not counted by how high you have climbed but by how many people you brought with you. - Wil Rose

Here's wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
Heritage Capital Research

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of China's currency/stock market
      2. The State of Global Growth
      3. The State of Global Central Bank Policy

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 6 months, and long-term as 6 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Negative
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Neutral
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Neutral
(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 1860-80
  • Key Near-Term Resistance Zone(s): 2000(ish)

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Negative
  • Price Thrust Indicator: Negative
  • Volume Thrust Indicator(NASDAQ): Negative
  • Breadth Thrust Indicator (NASDAQ): Negative
  • Short-Term Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Moderately Negative

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:
          - Short-Term: Oversold
          - Intermediate-Term: Oversold
  • Market Sentiment: Our primary sentiment model is Positive

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Neutral

Indicator Explanations

Trend and Breadth Confirmation Indicator (Short-Term) Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates an All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.

Price Thrust Indicator Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.

Volume Thrust Indicator Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.

Breadth Thrust Indicator Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.

Bull/Bear Volume Relationship Explained: This indicator plots both "supply" and "demand" volume lines. When the Demand Volume line is above the Supply Volume line, the indicator is bullish. From 1981, the stock market has gained at an average annual rate of +11.7% per year when in a bullish mode. When the Demand Volume line is below the Supply Volume line, the indicator is bearish. When the indicator has been bearish, the market has lost ground at a rate of -6.1% per year.

Technical Health of 100 Industry Groups Explained: Designed to provide a reading on the technical health of the overall market, this indicator takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.

Weekly State of the Market Model Reading Explained:Different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Market Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.


Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning is an investment adviser representative of Sowell Management Services, a registered investment advisor. For a complete description of investment risks, fees and services, review the firm brochure (ADV Part 2) which is available by contacting Sowell. Sowell is not registered as a broker-dealer.

Employees and affiliates of Sowell may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

Advisory services are offered through Sowell Management Services.