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There are two really big, really important questions on the minds of investors at the present time. The first would be: Is it over? The key question here is if we've seen the worst of the current decline or if there is more downside action ahead. And the second question looming for most folks is whether August's dance to the downside represents a correction within an ongoing bull market or the beginning of something much grizzlier in nature. This week, we will attempt to address both of these issues.

Today, let's start with the shorter-term question of whether or not we've seen the lows of the current decline. It probably goes without saying, but no one really knows the answer to this question in advance. Thus, the best we can do is to make an objective assessment of the situation based on past experiences.

While the bulls and bears continue to argue about who is in charge at the present time, we should recognize that declines like the one currently playing out have historically tended to follow a similar pattern. Some refer to this as the "crash playbook." However, the use of the word "crash" may a bit of an overstatement here. As such, it is probably better to categorize the current dive as a "waterfall decline."

The good news is that history is replete with instances of such declines and that markets experiencing a breathtaking "whoosh" lower over short periods of time do indeed tend to follow a pattern.

The Playbook

There are many short, swift declines to review from an historical perspective. And what we've learned is that traders tend to implement their "crash playbook" once the event is identified. Thus, it is important to know the way the game is played.

First comes the initial wave of selling, which is generally associated with an identifiable catalyst or "trigger." In response, fear takes hold and stocks trace out a "waterfall decline" pattern, which these days are exacerbated by algorithmic trading and computers chasing their tails. Next comes "the bounce." The inevitable oversold rebound (aka the "dead cat bounce") is usually short and sharp and typically lasts between 3 days and a couple weeks. From there, the reason for the initial decline oftentimes resurfaces and the "retest" phase begins. During this phase, fear resumes and the indices test/revisit the recent lows. Unless the old lows are violated in a meaningful fashion, the "bottoming process" then begins. This period tests the nerves of the bulls and can last anywhere from a few days to a few months. And as long as a new leg down does not begin, the "bottoming process" tends to produce tradeable rallies on an intermediate-term basis.

S&P 500 - Daily

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At the present time, we can argue that stocks appear to be in the "retest phase." Therefore, the low on the S&P of 1867 set on August 25th is a critical level to watch.

However, nothing in this game is ever easy. So if one were to play devil's advocate, they could argue that the entirety of the action seen since August 17th could wind up being viewed as the "initial decline" phase. If this is to be the case, then we should see a resumption of significant selling (was Friday's decline the beginning of this?) and fresh new lows in the coming days.

But, if the indices do NOT take out their recent lows in the very near term, then the odds would appear to suggest that we are currently seeing the "retest phase" and that the "bottoming process" should commence shortly.

Have We Seen THIS Movie Before?

In looking back at the history of all the short, sharp, crash-like, "waterfall" declines - that were also accompanied by extreme volatility - Ned Davis Research reports that the current dance to the downside appears to be remarkably similar to two other events from the past. Especially when volatility is taken into account, NDR notes that the current dive most closely mirrors those seen in 2011 and 1987.

The good news is that while both of these events were vicious in nature, both also wound up being relatively brief in duration. In both instances, the initial decline was extremely short and then the bounce, retest, and bottoming phases wound up lasting only a few months. Thus, investors should watch both the recent lows and the price action in the coming days/weeks for clues as to whether or not this decline has farther to go.

More Forced Selling to Come?

It is said that knowledge is power. And since we now live in an era of "big data," Wall Street firms have the ability to do some pretty impressive analysis of fund managers and their strategies in order to determine if there is likely to be more selling in the near future.

For example, a quant note from JPMorgan was widely discussed on Friday. The report noted that technical selling by quantitative investment funds clearly contributed to last month's losses. More importantly, JPM says the selling is only about halfway completed as there is another $100 billion that needs to be dumped from these quant funds in next 1-3 weeks.

The report explained that these technical sellers are employing trend-following, volatility-based, and risk parity strategies. JPM says the $100B that remains to be sold is actually down from their estimate of as much as $300B a week ago. The report added that while selling by traders who adjust their positions according to pre-set volatility levels is largely out of the way, trend followers and risk-parity managers have more selling to do with as much as $60B for the former and $40B related to latter.

Time To Buy The Dip?

Finally, the JPMorgan report states that the current risk/reward environment for equity investors would seem to favor NOT buying the dip just yet. The report opines that waiting to buy is preferred to being fully invested at this time.

In conclusion, what we are seeing at the present time is clearly a "waterfall decline." As stated above, the good news is that such events tend to follow a recognizable pattern. Therefore investors can watch the action and attempt to discern where we are in the process. Currently, the action seems to suggest that we are either seeing the retest phase, with the bottoming process expected to begin soon - or - the continuation of the first leg down. However, the current situation is complicated by the fact that there is as much as an additional $100 billion of stock positions that must be sold by quant strategies.

While it may sound like I am talking out of both sides of my mouth this morning (stocks have either seen the lows or they haven't), the overall goal is to try and determine where we are in the process and to lay out possible scenarios. It is my sincere hope that this exercise can be of value to readers.

Turning To This Morning

Traders are returning to work in a risk-on mode this morning as foreign markets in China and Europe are sharply higher and U.S. futures are spiking. The catalyst for the buying appears to be a combination of weaker than expected data in China, which is spurring increased hopes for additional monetary easing from the PBoC, and better than expected GDP data in the Eurozone. The question of the day then is whether the algos will chase their tails higher all day or if traders will use the strength to sell into. We shall see...

This Morning's Pre-Game Indicators

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

Major Foreign Markets:
    Japan: -2.43%
    Hong Kong: +3.25%
    Shanghai: +2.91%
    London: +1.42%
    Germany: +2.11%
    France: +1.77%
    Italy: +1.88%
    Spain: +1.74%

Crude Oil Futures: -$1.06 to $45.56

Gold: +$0.10 at $1121.50

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

10-Year Bond Yield: Currently trading at 2.159%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +32.40
    Dow Jones Industrial Average: +277
    NASDAQ Composite: +74.90

Thought For The Day:

"The Gods cannot help those who do not seize opportunities." Confucius

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/Economy
      2. The State of the U.S. Economy
      3. The State of Global Economic Growth
      4. The State of European Banking System

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 3 months, and long-term as 3 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: Negative
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Moderately Positive
(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: 1870
  • Key Near-Term Resistance Zone(s): 1990

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: Negative
  • Breadth Thrust Indicator: Negative
  • Intermediate-Term Bull/Bear Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Moderately Positive

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

Wishing you green screens and all the best for a great day,

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

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.


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 nor any Portfolio 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, an advisor representative of CONCERT Wealth Management Inc. (CONCERT), is founder of Heritage Capital Advisors LLC, a legal business entity doing business as Heritage Capital Research (Heritage). Advisory services are offered through CONCERT Wealth Management, Inc., a registered investment advisor. For a complete description of investment risks, fees and services review the CONCERT firm brochure (ADV Part 2) which is available from your Investment Representative or by contacting Heritage or CONCERT.

Mr. Moenning is also the owner of Heritage Capital Management (HCM) a state-registered investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Neither HCM, Heritage, or CONCERT is registered as a broker-dealer.

Employees and affiliates of Heritage and HCM may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or Heritage/HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

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.