SPX Slices Through 200-dma

On Monday, the stock market tried to put together a rally all day long – then it fell completely apart in the final hour of trading. In the process, the S&P 500 index sliced through its 200 day moving average for the first time since late 2012 – without even making a pit stop. The intra-day action can be seen below:

SPX, intra-day: a bad final hour of trading – click to enlarge.

Clearly, the current downturn is different from previous downturns over the past two years. As we have pointed out previously, the market’s internals have deteriorated a great deal, a fact that is also evident if one compares the action in different indexes. More broad-based indexes are much weaker than cap-weighted indexes containing fewer stocks (although the NDX is not included below, it e.g. also clearly outperforms the Nasdaq Composite). Here is an overview:

Four stock market indexes compared: broad-based measures have been weaker than cap-weighted indexes containing fewer stocks, and small caps have been especially weak – click to enlarge.

Obviously, a number of supports have given way – lateral support, trend-line support and support from the most closely watched moving averages. If we were to summarize what is concerning about this, we would say it is this:

Given that a lot of trading activity is driven by systematic black box strategies these days (from HFT to systematic hedge fund and CTA traders), the violation of important technical support levels could easily snowball. This is especially so as margin debt and hedge fund leverage remain close to record highs.

Having said that, routine corrections are difficult to differentiate from kick-offs to something worse. However, the recent action is clearly different from anything we have seen over the past two years. There are also several factors that argue tentatively in favor of a short term rebound beginning soon. These are:

1. on Monday, the perennial underperformer Russell 2000 actually outperformed somewhat, a sign that there is a bit of short covering occurring in this sector.
2. the US dollar looks as though it could soon begin to correct.
3. equity put-call ratios have risen to the vicinity of levels that have previously often been associated with short term lows.
4. treasury bonds look quite overbought (however, see further below why this may matter less than it normally would).

Obviously, if the market demonstrates that none of this matters by declining further, then an especially bearish signal would be given. It should be kept in mind in this context that in recent years, many markets have made quite big moves that were characterized by the markets concerned ignoring various short term overbought or oversold signals. Generally, breaks of support or resistance levels proved to be the more important factor. We will see whether the same holds for equities this time around.

The equity put-call ratio. Under “normal” circumstances, readings near the level of 1 (or slightly above) are associated with short term lows. In extreme circumstances, one day readings of up to 1,35 have been recorded however – click to enlarge.

The US dollar index – while this is undoubtedly a bullish trend, it seems at the very least ripe for a correction. Keep in mind that recently a record high average bullish consensus was recorded (all major sentiment surveys combined) – click to enlarge.

US Treasury Bonds – The Top Performing Asset Class This Year

Readers may recall that we have pointed out on several occasions that speculators have been stubbornly net short 10 year treasury futures since the beginning of the year. This hasn’t just been a garden variety short position, but actually a huge one. You will possibly be surprised how large it still is – as of the last available commitments of traders report, speculators are net short 290,000 contracts in the aggregate.

Given that big speculators are normally trend followers, this is actually quite odd. As noted above, treasuries currently look quite overbought in the short term, as can be seen by looking at a chart of TLT (the long term treasury ETF). However, the still prevailing bearishness of speculators is giving us pause. Should the market continue to exhibit strength, then this group of traders could push it up even further, as growing losses will force some traders to cover.

As the year began, treasuries were universally hated. We know of only very few analysts who allowed for the possibility that yields could fall; the consensus was clearly that stronger economic growth would push yields up.

Treasury bonds: this year’s star performers – click to enlarge.

The commercial hedger position in 10 year notes over the past year (i.e., the inverse of the net speculative position). Hedgers are net long nearly 290,000 contracts, ergo speculators are net short by the same amount – click to enlarge.

Conclusion:

Under “normal” circumstances, the stock market would soon put in a short term low here, based on sentiment data and the fact that inversely correlated markets look quite overbought. There can be no guarantee though that we are witnessing a “normal” correction – in fact, we already know that it is different from previous downturns over the past two years. However, usually the market will also bounce after an initial sell-off even if it is ultimately destined to decline further. In any case, we continue to believe that risk remains very high, regardless of the market’s short term gyrations.

As a final remark, it is noteworthy that a number of favorite big cap momentum names have not yet declined a whole lot. Past experience suggests that downtrends don’t end before the stocks fund managers have picked as their “safe havens” are also taken out back and shot.

Charts by: StockCharts, Sentimentrader