Assessing the Technical Damage to Markets

 

Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.  The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the time to sell.  -John Templeton

 

Now that the Standard & Poor’s 500 Index has had its first decline of more than 10 percent since 2011, it is time to assess the technical damage.

There is little doubt the past week has bruised the bull market. Since the run began in March 2009, we have had similar or bigger sell-offs. Quite a few pundits and commentators, though, have said that this one “feels different.” That sort of squishy analysis leaves us too dependent on subjective, unquantifiable emotions. Rather than rely on anyone’s gut feel, let’s spend some time today looking at quantifiable data — market internals, trends, supply and valuations.

I am no longer a trader, and don’t look at internals or technicals much. Instead, I rely on the smartest people I know in the trenches to share their insights. The key take away? The past week has done some serious damage, and whatever recovery we see may be a slog.

Let’s start out with the present, oversold conditionsJeffrey Saut, chief strategist at Raymond James, points out how unusual the past few weeks have been:

This downside skein has driven the SPX (S&P 500) to roughly 5 standard deviations below its 50-day moving average, a level of oversoldness not seen since the bottom with the Oct. 19, 1987, crash – which was the crash for my generation, and history shows there is only one crash to a generation. Other extremely oversold metrics show the NYSE McClellan Oscillator more oversold than at the March 2009 lows … and the number of stocks above their respective 10/30/50/200-DMAs (daily moving averages) is very low, which is what is seen at major lows.

For those hunting for a bottom, this might be encouraging. But be aware (as noted on Monday) that what’s oversold can always becomemore oversold.

Next up, let’s look at market internals. For that, we go to Stephan Suttmeier, technical research analyst at Bank of America Merrill Lynch. Suttmeier observes that “Monday was a solid 90% down day with 96.8% of stocks down on 97.0% down volume, which comes after two near 90% down days on Thursday and Friday.” As we have seen in the past, based on work by people such as Paul Desmond of Lowry’s, multiple down 90 percent days are what often occurs before any sort of sustainable bottom is reached.

Monday’s selloff was the highest volume day of the year with more than 6.6 billion shares traded on the New York Stock Exchange. That supports the views of Suttmeier and Saut, that this was a climactic sell-off.

The supply issue is paramount to JC Parets of All Star Charts, who noted that “Technical Analysis 101 is a simple study of supply and demand dynamics.” He observes that markets must now deal with the polarity principle. This is when former support (where demand exceeded supply) breaks down. “Support levels have been broken across the board and that former support is likely to become supply on any rally attempts.” Hence, there is a lot of work that needs to be done to return to the highs of May and June.

Perhaps the greatest concern is the long-term trend break. As I see it, this was the greatest technical damage done this month and it will take a lot of heavy lifting to re-establish an uptrend. It’s worse than merely breaking below a 200-day moving average. That’s a noisy series that can be subject to whipsaws. Rather, look at the 10-month moving average — when August ends on Monday, expect to see markets below that indicator. When that happens typically more declines are to come.

A 10 percent decline isn’t fatal; the S&P 500 fell 19 percent in October 2011 and subsequently recovered. However, as Suttmeier observes, it will mean a “period of base-building before a sustainable advance” can occur.

Let’s end on a positive note: Last week, I had lunch with Nicholas Colas of Convergex Group. His daily missive is a must read. He notes that at the very least, stock valuations have markedly improved:

The typical Dow stock now trades for 15.5x this year’s earnings and 14.0x next year. Not cheap, but no longer the 18x earnings we had with the Dow at +18,000. Dividend yields – and every Dow company has a quarterly payout – are 2.3% on the average versus 2.13% for the 10 Year Treasury. Bottom line: market action tells you the next 1,000 points on the Dow may well be lower, but at that point we’re getting to levels where the fundamentals show compelling value.

That doesn’t mean it isn’t going to be bumpy. But here’s what to keep in mind: Stocks may not yet be cheap, but they are getting closer to being reasonably priced.

 

 

Originally published as: How Badly Was the Stock Market Damaged?

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