Stock Market Commentary:
Despite recent bouts of trading in or like a bear market, market breadth has somehow managed to avoid closing in oversold conditions. In fact, the last “official” oversold period was 518 trading days ago. Yet, since the NASDAQ topped out in November, market breadth has dropped into and out of oversold on the same day 8 different times. The nearly mechanical rebounds make me wonder just how much longer can the market avoid an extended oversold period? With volatility remaining elevated, the NASDAQ and small caps slipping to new lows, and overly mechanical bounces in the S&P 500, buyer’s exhaustion could finally take an extra toll on the technical health on the market. Indeed, a transition from mechanical bounces to mechanical fades may already be underway.
Last week’s trading action was overlayed by important monetary decisions from three major central banks. (The U.S. also reported important economic news, including a nasty drop in work productivity and another strong jobs report). These banks are marching to the tunes of normalizing monetary policy. Here are just a few bullets to highlight my impressions from each decision. Collectively, these decisions are policy landmarks for inflation-fighting in the face of sinking financial markets.
- The Reserve Bank of Australia (RBA)
- Finally raised rates and went from 0.1% to 0.35%.
- Key quote (emphasis mine): “…inflation has picked up more quickly, and to a higher level, than was expected. There is also evidence that wages growth is picking up…This rise in inflation largely reflects global factors. But domestic capacity constraints are increasingly playing a role and inflation pressures have broadened, with firms more prepared to pass through cost increases to consumer prices.”
- The RBA expects inflationary pressure to moderate in two years assuming interest rates continue higher.
- The Bank of England (BoE)
- Raised rates from 0.75% to 1.0%.
- The BoE directly blamed worsening inflationary pressures on Russia’s invasion of Ukraine and China’s draconian COVID-19 lockdowns (approximately 80% of the inflation overshoot).
- Key quote: “…the very elevated levels of global energy and tradable goods prices, of which the United Kingdom is a net importer, will necessarily weigh further on most UK households’ real incomes and many UK companies’ profit margins. This is something monetary policy is unable to prevent.”
- One of the MPC members pointed out that the major inflation story is the jump in import prices, NOT monetary policy.
- There was a lot of focus on the decline in real (inflation-adjusted) disposable incomes and the economic hardships yet to come.
- The U.S. Federal Reserve (the Fed)
- Raised rates from 0.25% – 0.50% to 0.75% – 1.0%.
- Fed Chair Jerome Powell ruled out a 75 basis points increase in the future (“so 75 basis point increase is not something the committee is actively considering”) which presumably was the prime source of the market’s misguided relief rally.
- Key quote: “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.”
- Second key quote: “Inflation is much too high and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses…It is essential that we bring inflation down if we are to have a sustained period of strong labor market conditions that benefit all.”
The Stock Market Indices
The S&P 500 (SPY) started the week with a picture-perfect bounce of its March, 2021 closing low. I was not fooled. This move was part of what I called the worst kind of oversold bounce. The index rallied two more days, including an impressive 3.0% gain following the Fed’s announcement on monetary policy. The move was classic bear market trading action. The very next day the market changed its mind about the Fed’s decision and sold the S&P 500 down 3.6%. Friday’s 0.6% loss included a fresh test of the May, 2021 closing low. Ironically, the S&P 500 had an overall flat week.
While a follow-through rally from here COULD be bullish, I fully expect support to give way to buyer’s exhaustion. How much longer can the market avoid an extended oversold period? I expect such a period to follow a fresh breakdown for the S&P 500.
The NASDAQ (COMPQX) rallied 3.2% in the post-Fed fake-out. The next day, the index lost a whopping 5.0%. Buyer’s exhaustion came in the form of a fresh 17+ month low. Buyers barely saved the NASDAQ from closing below the critical support level from the September, 2020 high. The NASDAQ’s weakness suggests that the market will be unable to avoid an extended oversold period in the coming days.
The iShares Russell 2000 ETF (IWM) closed the week at a 17-month low which resumes a slide down the slippery slope created by the nearly relentless rally starting in November, 2020. IWM’s post-Fed fake-out consisted of a 2.7% gain followed by a 4.1% loss. IWM ended the week with a 1.7% loss. Like the NASDAQ, IWM’s weakness suggests the market will not avoid an extended oversold period this time around.
Stock Market Volatility
The volatility index (VIX) provided an odd counter-point to my assumption that the market can no longer avoid an extended oversold period. The stock market’s weakness on Friday did not deter the volatility faders. The VIX almost tested the previous intraday surge before fading into a 3.2% loss for the day. The VIX even lost 9.6% for the week.
I was correct that Monday’s fade signaled the VIX’s last surge for the cycle. The VIX faded hard into and through the Fed meeting. I am not sure what to make of Friday’s surprising fade. Meanwhile, I am still holding a small number of shares in ProShares Short VIX Short-Term Futures ETF (SVXY). From here, I would only add to the position on a fresh VIX surge in the middle of oversold trading.
The Short-Term Trading Call When the Market Cannot Avoid Extended Oversold Conditions
- AT50 (MMFI) = 22.8% of stocks are trading above their respective 50-day moving averages
- AT200 (MMTH) = 25.8% of stocks are trading above their respective 200-day moving averages
- Short-term Trading Call: neutral
AT50 (MMFI), the percentage of stocks trading above their respective 50DMAs, gapped down to 19.2% at Friday’s open. In an echo of the worst kind of oversold bounce 4 days earlier, my favorite technical indicator quickly rebounded out of oversold conditions. I am even more wary of this mechanical bounce than I am of Monday’s rebound. This time around, the buyers “saved” the S&P 500 while the NASDAQ and IWM made new multi-month lows marked by late 2020 price levels.
This trading action looks characteristic of a bear market: both the NASDAQ and IWM are in bear markets with 24% losses from their respective all-time highs. Once (if?) the S&P 500 answers the growl of the bear, AT50 should be in the middle of an extended oversold period. The S&P 500 is still just 14% off its all-time high. The index’s bear market point sits in the middle of March, 2021 trading.
Per my plan, I flipped the SPY shares I bought in Monday’s selling. While I wish I caught Wednesday’s massive post-Fed fake-out, I am glad I executed per plan. My next “just in case step” was a purchase of Invesco S&P 500 Low Volatility ETF (SPLV) shares on Friday. SPLV is the last bastion of bullishness in the S&P 500 with the 200DMA uptrend still intact. SPLV even printed a new all-time high last month.
Since I think the stock market can no longer avoid an extended stay in oversold conditions, I held my current bearish positions longer than normal. By rule, I am supposed to close out most, if not all, bearish positions once an oversold period begins. Accordingly, I anticipate taking profits this coming week. I will next mentally prepare for the difficulty of trading extended oversold conditions in a bear market. Ever since I formalized my AT50 trading rules out of the ashes of the financial crisis, the market has suffered just one true bear market. The brief bear market from the pandemic was brutal and truly stretched my convictions!
Be careful out there!
Footnotes
“Above the 50” (AT50) uses the percentage of stocks trading above their respective 50-day moving averages (DMAs) to measure breadth in the stock market. Breadth defines the distribution of participation in a rally or sell-off. As a result, AT50 identifies extremes in market sentiment that are likely to reverse. Above the 50 is my alternative name for “MMFI” which is a symbol TradingView.com and other chart vendors use for this breadth indicator. Learn more about AT50 on my Market Breadth Resource Page. AT200, or MMTH, measures the percentage of stocks trading above their respective 200DMAs.
Active AT50 (MMFI) periods: Day #518 over 20% (overperiod), Day #2 under 30% (underperiod), Day #11 under 40%, Day #22 under 50%, Day #27 under 60%, Day #298 under 70%
Source for charts unless otherwise noted: TradingView.com
Full disclosure: long SPY put calendar spread, long SVXY, long SPLV shares
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*Charting notes: Stock prices are not adjusted for dividends. Candlestick charts use hollow bodies: open candles indicate a close higher than the open, filled candles indicate an open higher than the close.