The problem with the stock market is that breaks in the market come so fast. Before you blink, your portfolio is taking on large losses. Then you go into hope mode and wait to see if it comes back. But what if it doesn’t…Let’s look into the latest Market Timing Update from REED$TRADER.
We got short-term model sell signals in the market on January 13, and a few days later we got an intermediate-term correction warning (This is the methodology we follow and that we teach through VTI, and that we follow in our REED$TRADER Daily Service).
After intermediate-term correction warnings, especially those with multiple months of internal divergences as we had in this one, you want to go over all longs and either exit them or hedge them in some way. The idea is to get your exposure down near 0 because the risk of a substantial correction is especially high.
Short-term sell signal on January 13 and intermediate-term correction warning a few days later to go to fully exit or fully hedged and prepare for major correction. Courtesy StockCharts.com
The other thing about an intermediate-term correction warning, is that you need some major internal divergences to show up at potential corrective lows before getting a correction-over signal.
Divergences were in place at the February 24 corrective low but we didn’t get a valid demand response, and major internals are breaking to new corrective lows, suggesting more downside before the correction ends is likely. Courtesy StockCharts.com
The February 24th corrective lows did come on required $NYHL (NYSE New Highs-New Lows) divergence, but this was not followed by a valid demand response to generate a correction-over signal yet. We could still get a valid demand response off this retest, but with intermediate-term indicators negative and NYSE Advance-Decline line making new corrective lows, a new corrective low below the February 24 lows is more likely.
Multiple month topping formations and divergences of major internals with new highs in the S&P happen ahead of major corrections and bear markets similar to what we witnessed at the January highs. Courtesy StockCharts.com
Major Internals remain negative and suggestive of more potential downside. The NYSE Advance-Decline line (top panel in the chart above), NYSE Cumulative Net Volume Line (second panel from top), Net Points (third panel down from top), and NYSE Common Stock Only Advance-Decline line (bottom panel) have all broken down from nine month+ H&S topping formations and are making patterns of lower lows and lower highs normally exhibited at more major peaks. All are below their long-term Moving Averages in negative conditions. All have made new corrective lows below the February 24 lows, which suggest new corrective lows ahead for S&P most of the time. The NYSE McClellan Ratio-adjusted Summation Index (2nd from bottom panel) is also below -500 and trending lower in a negative fashion.
Supply Index (blue) is trending higher, Demand Index (orange) is flat, and Spread Index (grey) is trending lower in negative condition for the market backdrop. Courtesy Zenophon Trading LLC.
Our proprietary Blue Supply Index (which moves opposite the market direction) remains market-negatively situated above its 40 Daily Moving Average, and its aqua uptrend-line, as well as above its December pivot point. Our orange Demand Index has improved some – it is above its 40 Daily Moving Average and maroon downtrend-line, but remains in a trading range since November. Our grey Net Spread Index (demand minus supply) remains market-negatively situated below its teal downtrend-line, below its 200 Daily Moving Average in dark blue, and below its yellow 40 Daily Moving Average.
For the intermediate-term trend of these internals to improve we would need the net Spread Index to rise above its 200 Daily Moving Average and down-trendline, which it is not currently close to doing.
From an intermediate-term perspective, a plurality of these major internal indicators would need to close back over halfway into their multi-month topping formations to suggest a shift to a more bullish posture might be underway or else, for a valid correction-over signal to occur. Absent a clear and decisive correction-over signal requiring strong demand dominance, the S&P would need to close over 4600 and the internals would need to improve as suggested above before the intermediate-term trend would be improving enough to warrant a significant return to net long posture and net long allocation.
Some Sentiment Gauges are Starting to Get Overdone – perhaps final leg down? Courtesy Goldman Sachs
We are starting to see a plurality of sentiment indicators getting overdone on the downside, which is a sign that it may be getting close to the time for a market bottom to develop. Usually, these start to trigger weeks to a couple of months before a corrective low forms.
The weakest link for the market has been small caps, which have broken down from an 11-month Head & Shoulder topping formation and shown a downtrend of relative strength (top panel) since May of last year. Courtesy StockCharts.com
Small caps, which have been one of the primary impediments to a broader rally, and have been a weak link for internals since March of last year, have broken down from a nine-month Head & Shoulder topping formation, retested the breakdown point from below, and garnered anew some mild volume traction lower, although their relative strength trend is starting to show some signs of life. The bottom line is that both small caps and foreign markets (which made new corrective lows last week) confirm a continued intermediate-term correction (or worse) being underway. That doesn’t mean that a valid demand response to give a correction-over signal is impossible here. It just means that it is less likely than eventual new corrective lows after some consolidation or bounce off the current retest. For now, the correction remains.
10-year Treasury yields ($TNX) are pushing to new recovery highs. Normally they fall sharply as stocks decline to put in a major corrective bottom. Courtesy StockCharts.com
Normally, before an intermediate-term bottom in stocks develops, we get a capitulation down in stocks with multiple 80% down-volume days or a 90%+ down-volume day or period of days where many holdouts to the correction fall sharply and lead on the downside. During this final phase down, it is common for bond rates to fall sharply. While $TNX (10 Year US Treasury Yield) bond rates have fallen some (see chart above), they have not fallen to the extent that normally occurs in a final capitulation phase. While not every major corrective low exhibits this capitulation behavior, about two-thirds of them do. Therefore, we will continue watching for evidence of market internal capitulation accompanied by bond market capitulation ahead to signal that a final phase down is likely underway.
Final capitulation usually leads to rapid price declines and to monetary authorities shifting their projected actions in a more dovish direction. As stock prices fall rapidly, authorities begin to get more concerned about recession risk getting too substantial, and they shift to less projected tightening or even easing of policy that often accompanies key corrective lows. This is similar to what occurred in the Christmas 2018 bottom, and nearly every bear market bottom since WWII.
The Russia-Ukraine negotiations made some progress but remain far from a resolution to the conflict. Russia did not restrict raw materials or energy exports to the West (at least not yet) so the bulk of pain it could cause remains held back for now. Nationalization of Russian domiciled property of foreign companies that have left Russia could be a fairly significant pain to firms that have left Russia. Yet it is the raw materials export limitations (which would be a game-changer and could lead to nearly instant global recession) that were avoided. Despite this, concerns over Russian supply of commodities have sent energy and food prices up 25%+ since the invasion. This will further exacerbate inflationary problems and slow consumption growth.
Inflation hitting 40-year highs and still rising, while the Fed is more behind on raising Fed Funds rates to market levels than it has been since the 1970s. Courtesy JP Morgan, StockCharts.com
Fed Funds rates (black bottom panel in the chart above) are at 0.08% while market-set 2-year Treasury yields are at 1.5% (Gold Line in bottom panel). The Fed is more behind the rise in market rates (difference between the Gold Line and the Black Line) than it has been since the 1970s and inflation is flaring and likely to get worse given Russia’s conflict – the Fed has already made a policy error and caution in raising rates may mean even more rate hikes down the road.
While after a recession it is common for the Fed to get behind the rise in market rates, the extent of the spread is higher than ever, meaning the price of credit is leading to too much credit creation that is fueling inflation further. Normally the Fed plays catch-up to market rates until the black line rises above the gold line and creates too tight credit conditions which eventually lead to recessions (blue vertical lines). The bottom-line for now is that a period of catch-up with the Fed raising rates substantially looms. The market can normally rise slowly during catch-up phases, but 50 bp hikes are usually more market negative. There are risks from the catch-up phase for the market to be aware of as part of the narrative, and with inflation flaring so substantially, there is a risk of stronger rate-hikes that could provide a headwind for stocks to rally against ahead.
Because geopolitical developments are part of the reason for the decline in this correction, we must be alert to a large geopolitical shift in the narrative that leads to a big demand response as well. This usually occurs on new corrective lows historically, but it doesn’t have to. In other words, if we get a classic clear demand response on news of a peace agreement, that may well set at least a tradeable low, if not an intermediate-term bottom to also watch out for – although it is more likely that we’ll get new corrective lows first.
Already the GDPNOW projection for Q1 is flirting with negative numbers. Even in the US we have a potential recession to watch out for that could turn a major correction into something worse. Courtesy Atlanta Fed.
Stagflation appears straight ahead, with Q1 flirting with negative growth, while inflation is still soaring even before the Russia-Ukraine conflict impact. Stagflation, unseen since the 1970s, is not quite as bad for stocks as outright recession, but it is a close second. From a narrative point of view, therefore, further corrective lows seem quite possible.
But there are also some positives to remain aware of. Our COVID-on-the-wane thesis seems to still be materializing. The shift from pandemic to endemic should allow the normalization of economic behavior to speed up. We suspect a new variant is possible, but that because so many caught mild Omicron, that natural antibody resistance would make it less severe than prior strains as the virus begins to decline away. We suspect this faster reopening and economic normalization pace ahead can keep the US out of full recession unless Russia cuts off raw materials exports or the war expands and gets more severe (which we believe is low odds, but possible).
Omicron still looks like the beginning of the end for the coronavirus, and reopening set to accelerate. Courtesy Worldometer.com
The table above, courtesy of Ned Davis Research and LPL Research, shows each of the 33 corrections in the S&P since 1980. The average correction since 1980, including during some bear markets, was -18.6%. But notice the returns after that correction finally ended. While the market has averaged just over 10% annual gains during this period, one year after the corrections ended it averaged +24.8% – nearly 2.4 times the average return and was up 90.3% of the time after a year.
In our opinion, investors and traders, in general, don’t pay nearly enough attention to analyzing corrections as they should. When you are in a known correction, hold off on new buying because this is when even the strongest vehicles can play catch-up at the end of the correction, and when we get many stop-outs and false moves. And knowing when the correction is likely over can be a gold mine of information, allowing you to hit the gas pedal on hunting for new longs and to turn up your aggressiveness for allocating to new buying again.
Even with all of our analysis, we will occasionally miss or catch very late a correction-over signal. No analysis is perfect. But catching a correction low well and allowing it to direct your attention to new longs, even in a short-term minor correction, can often be nearly as profitable as catching a bear market bottom, because stocks historically make their strongest moves once corrections end. So it’s worth the effort to pay attention.
What we have found after many decades of real-time trading and researching markets back to the 1920s in regards to correction-related behavior of growth-momentum stocks and top RS sectors, is that being able to figure out when the correction is over and a new up-leg is starting is actually much more valuable information than just locating when the market is oversold and likely to be higher on a 3 month or 6 month view reliably. One reason for that is the final capitulation that occurs often (though not always) in corrections that are larger than average short-term corrections. Final capitulation relates to the behavior of strong RS stocks that have held up well or even continued to make new highs during the first half to 7/8 of a correction. A correction very frequently ends with some kind of climax of capitulation on either new corrective lows or the final retest of them (over 65% of corrective lows are types of retests), and when this happens it often features the strongest holdouts to the correction playing catch-up to the downside in the final day or days of the market correction.
The S&P remains in a downtrend-channel and intermediate-term correction – retesting its lows now, with a (likely) potential further leg down ahead, although volatility in both directions is quite possible as geopolitical developments send prices violently up and down depending on the day. Downside capitulation risk keeps our allocation low and defensive, even in resource holdouts. Think of major corrections as a market’s way of resetting things. Once the correction is clearly over, the market tends to rise at over 2.4 times the normal pace, setting up prime opportunities. In the meantime, we continue patiently letting the cake cook to be sure it is ready.
Avoiding big drawdowns during major corrections and bear markets is one of the keys that has allowed us to make higher than market average (though streaky) returns on less than a third of the drawdown in PSL since 1992. As the Rams proved again this year, defense wins Super Bowls. And for investors, defense to prevent large drawdowns is one of the most important factors to success. That’s why having a proven methodology that highlights corrections can prove so valuable to nearly any investing strategy, and why we believe market timing analysis is a core critical strategy for investors to learn and build into their investing.
Our Portfolio Strategy Letter (PSL) has done well at major trend signals since its first publication in 1992 (top panel) and ReedsTrader Daily Service has done well at intermediate-term timing real-time since 2018. Courtesy StockCharts.com
The chart above shows the real-time signals in our Portfolio Strategy Letter since 1992, and in REED$TRADER Daily Service since late 2018 when it launched. You can learn to locate these signals yourself in our Market Timing Workshop.
This is an equity curve created by a Market Timing Masterclass student showing his application of market timing signals over the course of the 2009-2021 backdrop. Since 2007 his doing this with objective signals shows more than 4.5 times the profit of SPY with a MDD of 9.8% instead of 48.2% in SPY – 4.5 times the profit on 1/5 the risk.
Notice the risk and drawdown reduction – from 48.2% for holding SPY to 9.8%. REED$TRADER Daily Service has had three major corrections since it started in late 2018 and it has signaled intermediate-term correction warnings in each – September-December 2018, February-March 2020, and the current one from January 2022. These are where the bulk of the damage is usually done for investors and trend following strategies. Note that intermediate-term correction signals took you out and warned of these within days or a week of major peaks in each instance, reducing the 38% drawdown of 2020 for example, to an under 6% hit. Since 2007 the 48% drawdown was reduced to 9.8%. Knowing that you have a method of reducing the drawdown of bear markets and major corrections can help you stick with your plan and be able to exploit the upside of bull market periods.
Example: The COVID CRASH of 2020
In the COVID CRASH of 2020, we got a real-time intermediate-term correction warning within a few days of the exact peak, and a correction-over signal the day after the exact low. Courtesy StockCharts.com
The chart above shows the real-time intermediate-term warning signal for the 2020 market crash (red circle) that you will learn in our Market Timing Workshop and Market Timing Masterclass, and can verify yourself, came days after the actual peak, while the correction-over signal (you will learn and can verify yourself) came one day after the bottom.
This method got you out within a week of tops and bottoms real-time since 2018, including the September-December 20% decline of 2018, the February-March 2020 COVID crash of 2020, and the current correction.
For now, we remain in an intermediate-term correction in stocks pending a substantial demand response signal, which we haven’t seen yet. New corrective lows are probable unless that demand response comes soon. You can follow our market timing analysis in REED$TRADER Daily Service and you can learn to do it yourself from our workshop and mastermind courses available through VTI.