It would be unfair to say that we haven’t been warned. For a couple of weeks many leading indicators were showing signs of deterioration even though equity markets where reporting new highs (a phenomenon called negative divergence). One of those indicators was MACD, a momentum oscillator which measures the strength of the trend.
A rising MACD indicates a strong bullish momentum while a falling MACD indicates weakness in the trend. This year alone MACD has pretty much warned investors in all three short term corrections.
Apart from momentum, the participation of stocks in a market move is equally important. Since early June the % of stocks above the 20 day moving average has been falling dramatically even though the S&P 500 was rising. Moving averages give investors a simple and reliable way to confirm the direction of the trend and a short term trend is usually measured by the 10 or 20 day moving average. The following chart shows that since early June, one by one stocks have been falling below the 20 day moving average which has finally moved the entire market lower at least for the short term.
So yes, we have been warned but now what? Every investor would like to know how deep the market will fall. Is that a short term correction or the beginning of something worse? Financial media have rushed to spread the fear with the worst case scenarios. After all fear is what sells to people. But they have been wrong at least for the last 18 months.
In the below chart we show how the momentum oscillator RSI was able to provide us with clues over the last 18 months as to the healthiness of the trend and to extend the degree of the corrections. The highlighted red area indicates a bearish momentum while the area above indicates a bullish momentum. Notice that as long as the RSI stays above the red zone then any correction ahead is short leaved and shallow.
Zooming closer into our chart we see that the YTD trend which is considered a medium term trend (less than 12 months) has been violated. Our longer term trends however from 2011 and 2013 are still intact. The red lines below indicate the areas of major support. In other words it is expected that buying pressure will be more than selling pressure at those levels. Markets move in steps so it would be important to see whether the S&P would be able to hold above 1900. In case that is violated then the next support should be at 1800-1825. That would clearly be a deeper correction but still the long term trend since 2011 would be intact.
In addition to the above given that the weakness has started with small caps and that they are close to a medium-term oversold condition, stabilization in the Russell 2000 would likely help arrest the current decline. What will be crucial to assess in the days and weeks ahead is the character of any recovery in the markets. If we see risky assets like small cap stocks only rally marginally from an oversold condition, then we are likely setting up for another leg down. However, if we see strong inflows into the stock market and risky assets rally significantly, then the recent decline will only have helped work off an overbought condition, which is a healthy sign. Time will show.
Costas Pierides CFTe, MSTA
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