Time To Refresh Your View of the Markets?

 

(The following is the Introduction to the latest BullBear Market Report for BullBear Traders members)

 

In the last BullBear Market Report, I called for a significant correction to begin and announced that I had closed all long positions and initiated a short position.  My current analysis suggests that that continues to be the correct view of the market, but that the topping process is still in progress and that substantial downside may yet be a few weeks away.  I'm back to 100% cash and awaiting a good shorting opportunity.  I've changed my market stance from Bullish on all time frames to long and intermediate term Neutral and short term Bullish.

It's important for readers to note that I am not a permabear.  In fact just a month ago I was 100% long and firmly bullish in my outlook.  But I think it's crucial for traders to practice non-attachment to views.  Rigid self identification as "Bullish" or "Bearish" is a major hindrance for any market participant.  It's important to be able to let go of an established view when the market reality changes.  Zen master Thich Nhat Hanh says:

"We must not be attached to a view or a doctrine, even a Buddhist one... The Buddha said that if in a certain moment or place you adopt something as the absolute truth and you attach to that…then you will no longer have any chance to reach the truth. Even when the truth comes and knocks on your door, and asks you to open the door, you won't recognize it. So you must not be too attached to dogma - to what you believe, and to what you perceive." Thich Nhat Hanh

 

That doesn't mean we should throw out an established view casually either.  But views should be constantly tested and probed for weaknesses using objective criteria and analysis.  During solid market trends, such probing finds confirmation of the view.  But during the process of a market trend change, eventually probing reveals weaknesses and soft spots which over time develop into a reversal.  It's very possible we are already well into that process now and that a trend change is looming.

Markets are fundamentally driven by the dynamic between buyers and sellers, supply and demand.  That includes the capital markets.  So ultimately it is a game based on liquidity.  Whether liquidity flows into a market depends upon the available pool of capital as well as the psychological willingness of participants to risk that capital in the given market.  When the pool has run low and most participants are already in the pool, the trade is crowded and it will inevitably reverse.  The extent and duration of the reversal depends on depth of the imbalance.  Eventually the pool will become relatively full and will look enticing and market participants will start to dip their toes in the water once again, eventually climbing back in for a swim.

When I analyze a market, my process proceeds from the What and then to the When and lastly the Why of that particular market.  What is the market doing, when is it going to do it and then finally why is it doing what it's doing.  I first concern myself with What a market is doing: is there an identifiable trend or is there a topping or bottoming process?  Then I focus on When: is the market likely to continue its trend for a given time frame or is due to reverse or consolidate sideways?  In the process of doing what it is doing when it does it, the market eventually reveals why it is doing it.  As that process is unfolding I try to identify the motive forces for the move to evaluate its durability and potential extent.

When I turned bullish in March of 2009 and again in September 2010, I put forward a set of criteria that could both explain the apparent bull market and potentially underly its perpetuation.  Evaluating these criteria now I find that they are, at this time, unverified by market action.  This, together with the technical action of the markets at their current state of development, forces a reevaluation of my market position.

My set of criteria for a continued bull market at this stage of the game:

1. Emergence of a leading economic growth sector, most likely Green/Clean Technology and other Tech


2. Leadership from BRIC and Emerging Market sectors


3. Re-initiation of currency carry trades, most likely Yen carry trade


4. Flight of capital from low yielding bonds to risk assets


5. Eventual, gradual broadening of participation in the bull market from professionals and institutions to the general investor population and eventually the general public.


6. Technical condition of the market remains healthy

At this time I am not seeing any of these criteria being met.  Recently, most of the above were approaching or exceeding levels in keeping with a bullish view or were at least showing signs of moving in a bullish direction.  But all have effectively reversed or aborted at this point.  In this report I will detail and evidence this with research and analysis.  Here's a brief synopsis of my findings:

 

1.  NO LEADING GROWTH SECTOR: If stocks are in the third wave of a bull market, at this stage we should expect to see certain effects in the underlying economic fundamentals that confirm that price action.  One of the criteria I was watching for was a Green/Clean Technology investment boom.  Any sustainable economic recovery and concomitant bull market in stocks would require a leading growth sector.  That sector should add value to the economy, increase productivity, produce real job growth and stimulate activity across the rest of the economy while also providing leadership in the general stocks bull market.  The Housing industry and associated stocks served this role in the 2003-2007 bull run.  This time around, we were promised by government and Wall Street that the road to economic renewal would be paved by Green investment.  So far there are no signs of a broad based move by the private and public sectors to invest in such technologies and infrastructure.  The ETFs that track Green investments have recently broken down after repeatedly threatening to break out, indicating that a stock investment boom in Green Tech is not happening at this time.  Absent a leading growth sector, the move off the March 2009 low then becomes a purely liquidity driven rally.

 

2. NO LEADERSHIP FROM EMERGING MARKETS AND BRIC:  If the US domestic market has no leading growth sector to propel the economy and stock market forward, perhaps the engine of forward progress could be found in the BRIC and Emerging Markets.  I'd be willing to accept that hypothesis, but at this point rather than leading the way up, BRIC markets are actually leading the way down with many Emerging Markets following close behind.

3. NO YEN CARRY TRADE:  After the Japanese Yen spiked to an all time high in the wake of the recent earthquake and tsunami and world monetary authorities initiated a coordinated intervention, many speculated that the Yen would then reverse and become the target of the carry trade once again.  The Yen carry trade had been a major funding source for risk trades in prior bull phases.  This hasn't really come to pass yet, and the Yen is not far off its all time highs.

 

4. NO BOND BEAR MARKET:  In a protracted, sustained bull market in risk assets, bonds should suffer as investors leave the perceived safety of the debt markets for riskier plays.  While the 30 Year Treasury and other sectors of the bond market has flirted with significant intermediate and long term levels, the Total Bond Market is back to a new all time high. 

 

5.  NO GENERAL INVESTOR PARTICIPATION:   While professionals are totally committed to the bull, the general investor community remains reticent in spite of some positive stock mutual fund flows in the early 2011 time frame.  The general public is still completely out of the markets.  While this is theoretically bullish since that means there is still a large untapped cache of buying power on the sidelines, it may not work out that way if psychology is so damaged that non-professionals simply will not take on risk at this time and there are insufficient contingent circumstances that will force them to do so.

 

6.  DETERIORATING TECHNICAL CONDITIONS:  SPX is either well into the major 3rd wave of a bull market and in the process of an intermediate term correction or it is approaching a completed C wave top.  The emerging underlying technical conditions suggest that a C wave top of the move off the March 2009 low has either been achieved or will be shortly.  The first warning shot across the bow was the Commodities Crash of early May.  Breadth deterioration began in February and now significant divergences between market price and breadth indicators have emerged.  Sentiment has turned broadly bullish for the first time, generally a contrarian indication.

 

Overall, the circumstances outlined above together with a number of other factors--end of QE2, summer seasonality, waning bullish economic news, bearish news items out of Europe--combine to set the stage for a significant correction or even the resumption of the bear market.  We'll have to see how the market actually performs in the weeks ahead, but I am actually leaning in the direction of calling the March 2009-Februrary 2011 move a three wave ABC bear market rally.  In that context the next probable move would be a three wave  partial retracement of that rally to put in a final bear market bottom.

Traders should keep in mind that topping is a process and SPX may be in the early stages.  False breaks, false starts and sharp counter rallies may be common as shares are gradually distributed.  I'm leaning towards a week or two of mild, grinding upside pressure with a top in the 1340-1380 zone.  Then again, the market is set up such that the wrong news out of Europe could break support and initiate a cascade of selling pressure. 

 

To read the full BullBear Market Report, please join us at BullBear Traders room at TheBullBear.com.

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Need some help staying on the right side of the markets?  Join the BullBear Traders room at TheBullBear.com.  You'll get this kind of timely, incisive, unbiased stock and financial market trading, timing, forecasting and investment technical analysis and commentary daily.  It's free to join, no credit card is required and if you like my work you just make a donation at the end of each month.

 

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Significant Market Correction In Progress Now http://www.thebullbear.com/profiles/blogs/significant-market-correction

Significant Market Correction In Progress Now

 

I've been long SPX since the September 2010 bottom and an aggressive buyer on pullbacks.  Today I exited all long trades and went to 100% cash and then even took on a small short position.  My current analysis shows ample reason to conclude that stocks and commodities are in the early stages of a significant correction.  Here's my SPX trading record for 2011:

 

I've just completed a review of recent mainstream and alternative financial media.  Bears are virtually nonexistent.  Almost no one is looking for any kind of a top at this time.  For over two years, even the slightest sign of market weakness and every bit of bearish news has been greeted with a cascade of calls for the end of civilization.  Apparently sentiment has turned fully bullish for the first time, just as the markets are signaling the potential for a deep pullback.  The traders on CNBC Fast Money were completely unfazed by recent market action:

”The market feels vulnerable but it's felt vulnerable a number of times,” says Fast trader Guy Adami. Largely Adami and the other traders aren't terribly concerned by Wednesday's sell-off; they expect a bounce. "On the dip you can buy," says Pete Najarian. "I'm with Pete," echoes Joe Terranova.

And in an environment like this, the Fast Money traders always suggest looking for pockets of strength and putting money to work. 

I had called for a Crude Oil, Silver and Commodities top and a temporary bottom the the Dollar to the very day and expected to see a significant correction over a period of weeks or months.  But I was somewhat surprised by the ferocity of the market action.  I'd been quite bullish on equities, as I said, and the commodities action caused me to reevaluate my analysis of equities.  Experience has shown that a market event like the commodities crash is often a harbinger of further selling, particularly when its significance is universally dismissed as has been the case in this instance.  It seems to me that complacency reigns supreme at just the wrong time and that most market participants are about to be caught on the wrong side of the markets.

My long term view remains bullish on both stocks and commodities, but there is a clear chart setup for a major correction at this time.  The chart setup is supported by negative divergences spanning the February to May time frame between SPX and many breadth and momentum indicators.  

The fact that this condition is almost universally ignored by traders and investors is coupled with very high bullish readings on a number of sentiment indicators and very low cash positions among funds and individual investors creating an excessively bullish intermediate term sentiment environment.  

Earnings season is largely behind us, so the late buying power that enters the market on news has been largely disbursed.  The Fed is winding down QE2, so that font of liquidity is drying up.  Another round of European Sovereign Debt crisis appears to be gearing up.  Next week the US government debt ceiling issue is also on the front burner.

Markets tend to correct this kind of scenario sharply and suddenly and there is good reason to believe that process is under way now.

Here's my current view of SPX on the futures chart:

 

There are quite a few alternate scenarios, and I've presented them all to BullBear Traders members.  But at the moment, this is my preferred scenario.

• What is being corrected?  The Wave 3 of (3) move from the September 2010 bottom.


• What kind of correction is it?  An ABC flat correction for Wave 4 of (3)


• Where are we in the correction?  Apparently starting iii of C of 4 of (3)


• What is the target for the correction?  Strong support should be found in the zone of the lower rail (blue) of the entire move from March 2009, the 200 EMA, the April 2010 high, the November 2010 high, the March 2011 low, and the 38.2% Fibonacci retracement of 3 of (3).


• Is the correction shortable or should a trader stay in cash? That depends on your style of trading.  The magnitude and timing of the likely correction should make it shortable for the intermediate term swing trader.


• Could this be wrong and could the uptrend continue?  Of course!  A wide variety of factors would seem to indicate that a significant correction is imminent. There's no guarantee at all that support will not hold.   Although the risk/reward picture favors the downside for the first time since August 2010, this is still a countertrend trade, which is always a dangerous proposition.  There is significant risk that we will be caught out of position when and if the bull market resumes its upward trajectory.  Cash is largely a countertrend trade (and short certainly is) in this environment.  But this should be as good a setup as we can hope for to either take profit and re-enter at a lower level or even make a little money on the short side. The correction actually began in February with a three wave move down for wave A.  The move off the March low was also a three wave move for wave B.  That wave ended with the "Bin Laden Is Dead" spike (a classic wave ending news event) and wave C began.  We'll get confirmation that C down has begun with a move below the recent low.  That could come as soon as Monday, but most likely by Wednesday.

We can see confirmation of the ABC corrective pattern by observing other markets and ratio charts which are showing similar ABC setups in even clearer terms since February:

• Dow Jones World Index


• New York World Leaders Index


• Euro Stoxx 50 Index


• SPX : Total Treasury Market Index


• SPX : US 30 Year Treasury (Daily)


• SPX : VIX (Volatility Index)


• Corporate Junk : 30 Year Treasury


• Grains Index

Technical charts also show bearish divergences with underlying price that go back to January or February, confirming that the markets have been correcting in a sideways ABC pattern for the last few months.  Here are just a few examples; there are many more:

• Nasdaq 100 : Dow Industrials


• Russell 2000 : Dow Industrials


• Wilshire 5000 : Dow Industrials


• Apple : QQQ


• SPX : Total Put Call Ratio (50, 200 EMAs)


• Advance-Decline Volume, 50 Day EMA


• Bullish Percent Index


• Stocks Above 50 Day Moving Average

These indicators are now showing signs of being ready to roll over into bearish territory as the market corrects.  Eventually they should reset into a buy position (if the bull market is to continue) and we will look for bullish divergences to help us identify the bottom of the correction.

The correction should be fast and scary and should bring out the bears in droves.  No doubt figures like Bob Prechter will be making the mainstream financial media rounds next week.  The function of the correction, in the context of a larger bull market, will be to force cash positions higher and reset sentiment to bearish levels again, setting the stage for a renewed bull move.

We're seeing some interesting divergences between market professionals and the general investing population.  The data is showing that professionals are excessively bullish and heavily invested in stocks and are holding very low cash levels, while non-professionals are uninterested in stocks and invested heavily in bonds.

The following charts are from Sentimentrader.com.  First, let's look at market liquidity as measured by cash levels:

Rydex funds are used by market professionals.  Rydex fund cash positions moved sharply lower recently even as the market hovered near its highs:

Rydex Bull/Bear asset allocation is stretched far to the upside:

The use of leverage is running very high as well:

Mutual Funds are apparently totally committed:

Money Market fund levels are at levels previously associated with tops:

This survey indicates that professionals are heavily allocated to stocks and are holding very low cash levels:

The use of margin is quite high on the NYSE:
Short interest ratio is very low, so latent buying power from short covering is weak:

The following four charts show that sentiment surveys of market professionals indicate a very high level of bullishness:

The AAII survey of the general investor population shows a low level of interest in stocks, however.

While investors are allocated to stocks, the levels are much lower than the professional segment and bond allocation is much higher, while cash levels are also very low.

Mutual Funds just saw the first big outflow in quite a while.  I wouldn't view that as a contrarian indication at this time.

While professionals are heavily committed to stocks, they are also active in puts to a degree not seen since the 2007 top.  They may be literally hedging their bets against a big decline.
Overall the picture I am seeing is a setup for a surprise intermediate term decline that scares professionals out of their apparently overconfident complacency and forces cash levels up to a more sustainable level.  If the general investor base joins in the next rally off the bottom with the professionals, that may mark the end of the long lateral bear market and the onset of a new long term bull phase.

If support does hold here the next leg up will likely be a 5th wave in a diagonal pattern that will set up a correction. Here's one potential bullish interpretation of the short term picture on a 4 hour chart.

The most bullish view places the market at the cusp of launching into (iii) of 3 of 5 after a sideways triangle abcde correction:

Both of the above scenarios are viable and represent risks to the current short position.  A break above the upper boundary of the proposed triangle correction would have to trigger a stop loss on the position.  We can also see that the market is perched precariously upon key support and the potential for a gap down below support on Monday morning is high.  That could trigger a series of stop loss levels and initiate a cascading decline.  Given that just about no one is looking for that kind of scenario, it becomes much more likely.  And given the very heavy bullish sentiment and commitment of professionals to the market, there may be no one left to stop the decline once it has begun.

There is long term bearish potential in the current setup as well, but it would be jumping the gun to even speculate about a long term bear turn without first seeing a good size correction and a break of some key support levels.  Then we would have to revisit the indicators and see what they are telling us.

To read the full BullBear Market Report, please join us at BullBear Traders room at TheBullBear.com.

---

 

Need some help staying on the right side of the markets?  Join the BullBear Traders room at TheBullBear.com.  You'll get this kind of timely, incisive, unbiased stock and financial market trading, timing, forecasting and investment technical analysis and commentary daily.  It's free to join, no credit card is required and if you like my work you just make a donation at the end of each month.

 

Keeping You on the Right Side of the Markets