Before we talk about the trees, we have to talk about the forest to put things in perspective. Over the long-term horizon, I believe we are in a new secular bull market that was confirmed when the S&P 500, the Dow Jones Industrial Average, the Dow Jones Transport Index, and the Russell 2000 all achieved all-time new highs last year. The only one left now is the NASDAQ, which has retraced 75% of the secular bear market that started in 2000. At the price top, the NASDAQ’s PE was 193. Now, at 4100 the PE is 30 – much more reasonable, as companies have had thirteen years to grow earnings. We had a phenomenal run last year, and I believe it is now time to consolidate; however, the long-term secular trend is intact with a lot of support at key levels below current price for the major indices. So, technical damage has been done, and the likelihood of more is high; however, there is a silver lining, in that, not enough damage has been done to call for the end of the secular bull.
Continuing with the forest theme, let’s look at the secular bull market thus far in the S&P 500. A word of caution for the reader: I plan to get fairly technical in my work here, but I will explain it as easily as possible. When it comes to understanding the rhythm of the market, I like using Elliott Wave analysis along with other forms of technical analysis like trendlines. You can gain a good amount of understanding of the market just by knowing these two tools, without getting too advanced.
The basic tenet of Elliott Wave is that the market progresses in the form of 5 waves — three of which progress the market in the general direction of trend (1,3,and 5) while two help to regress back to the mean (2 and 4). This 5-wave sequence is then followed by a 3-wave correction. Because these forms repeat themselves, they can provide guidelines by which the discipline can make predictions.
There were a few charts I drew in my November piece, “What is Your Discipline?” that I’m going to add here to show how the market has developed. In that piece, I discussed the consolidation breakout in October, but noted that we were headed for major resistance in the mid-1800s based on trendline and Elliott Wave analysis. Here is a continuation of those charts as they’ve developed. Note the two resistance lines from the secular trend and the accelerated trend from 2013 intersecting here in January. In technical analysis, when you have more than one area of support or resistance near the same level, its importance increases. Also note how much leeway any correction would have before it violates the secular trend support.
We’d have to trade through 1500, or thereabouts, to break the trend. It would take a real economic disaster to cause that kind of damage, and we don’t see anything on our macro scopes to indicate that’s plausible; much more is right than wrong with the U.S. right now. The main economic problem we’re facing, as a country, is weather, which is temporary by nature. Listen to the CEO conference calls this earnings season, and you’ll hear that business in China is okay, but weather here is hurting businesses; hence the strong economic numbers leading into year-end and the dip we’re seeing in January (unemployment claims, jobs, auto sales, flash PMI, and durable goods). If you don’t think weather can present that great of an influence on the 70% of our economy, come to sunny California to do your shopping – if you can find a parking space. Natural gas prices are rising due to the winter, and retail stocks are getting crushed. But I digress…
Going back to the chart above, unless we get treated to an extension of the current move higher from 1650 that could take us to 2000, it appears that wave III has finished and we’re likely to be treated to a wave IV correction. One of the guidelines in Elliott Wave analysis is the guideline of alternation, which is defined as: a difference in the pattern of a similar wave. When we look at the two corrections that happen in a 5-wave sequence, this typically means wave 4 won’t look like wave 2. Since I attribute the sideways move from the high in 2010 and the low in 2011 as wave II of the secular trend, we’re looking for something “different” for wave IV here. It’s likely to be steep (zig-zag) or a triangle of some kind. If we do extend to 2000, you can bet that wave IV down will likely be quite steep.
Now, as we begin looking at the trees, it appears to me like we have finished a 5-wave cyclical trend that started at the end of 2011; however, there is still a chance that the wave can extend. For now, let’s assume the worst-case scenario. Note that we’ve run from the bottom of the channel all the way up to the top of the channel where we should expect resistance. That might be why we’ve been seeing institutional investors fade the market last year, according to Bank of America’s trade flow data.
This may also be the reason fewer stocks are above their 200-day moving averages at year-end highs (82% compared to the end of May last year at 93%). That kind of divergence in participation (we call breadth), while the heavily-weighted issues are pulling the indexes higher, is typical in the last push higher of a long-term trend. When the percentage of stocks above the 200-day moving average falls below 70%, it’s a long-term sell signal. StockCharts.com shows here, using end of day data, that we’ve held right on it. My TradeStation data shows we actually penetrated that level with a close of 65% on Monday. In a nutshell, “fewer soldiers are following the generals into battle”.
Here, I focus on just the last year. While corrections in the past have been slow and measured—within a consolidation pattern, without much fear—last week’s sharp decline smells of something different. I saw more than 2500 declining issues on the NYSE last Friday; something we haven’t seen since Bernanke’s fumble on taper talk last June. I would like to have seen more volume, but I guess we won’t see that unless we break near-term support at 9900 on the NYSE Composite, also a possible neckline in a head & shoulder pattern. 2426 issues are advancing today at the time of this chart, which is a good start to a relief rally; but, unless buyers step in aggressively (seen in the NYSE up volume), it’s likely we have more downside to go.
Looking closer at this correction, there are many things to look at technically: areas of support, areas of resistance, Fibonacci retracements, pattern formation, momentum divergence, oversold conditions, and more. I believe in the weight of all evidence, and so I look towards each indicator and tool to get a clear picture of what’s going on in the markets. In the chart below, I show more Elliott Wave analysis combined with a knowledge of Fibonacci retracements. I believe we’ve finished the first stage of the correction that began on January 1st. The sideways movement before the selloff last week was the beginning of a consolidation. Following the consolidation, the steep selloff over the past week was the final portion of a flat correction. Typically, the steep selloff in a flat correction has a 5-wave sequence, which appears to have been fulfilled.
The second part of a correction is the relief rally. Typically, a steep decline is followed by a 50% to 61.8% retracement. That places near-term resistance between 1809 and 1818 on the hourly chart of the S&P 500. I believe we’re now in the relief rally or wave (B) in this correction as the resistance trendline over the steep correction has been broken.
If the 50-61.8% retracement holds back any relief rally here, I’m anticipating another move down to test the 1738-1746 area. But there is an issue with such a move in the market.
If we fail to break above 1818, and we close below 1774 in a third wave down, we will have formed a head & shoulder top with its own downside target of 1694. That just happens to be near the 200-day moving average (1705 as of today). The important note to make here is that the pattern must complete with a close below 1774. If not, it’s actually a head & shoulder continuation formation, something many can forget. For right now, be concerned if we can’t get above the shoulder resistance area.
My worst-case scenario for this correction is a 100% retracement of the 4th quarter rally, to the end of the 2013 consolidation we saw in October. This just so happens to be a number I’ve heard from several other technicians that anticipated a correction mid-2014. It looks like the timeline might be getting moved up a bit.
One thing I’ve noted is the strength in the NASDAQ and the Russell 2000 relative to the Dow Jones Industrial Average and the S&P 500. Investors continue to find refuge in growth and avoid some of the larger stocks with more emerging market exposure and stronger dollar problems. Even though CEOs haven’t directed much of their concerns towards this area, investors have with the contracting Chinese flash PMI a week ago, and the currency problems outside of developed markets. I noted that there have been 5 central bank moves to support currencies in the past week alone (Turkey, South Africa, India, Nigeria, and Argentina) and Mexico is considering a hike due to inflation shooting up 4.63% in January). As investors are concerned with emerging markets now, it’s important to watch the markets there. An ETF that follows those areas, and is traded widely here, is the iShares MSCI Emerging Markets ETF (EEM). The one thing that could steepen the carnage in our markets is a selloff in emerging market shares. The EEM has been underperforming our market for some time. But if we break major 4-year support, it could spell deleveraging. Something to watch closely!
In conclusion, we’re in the midst of some volatility. It’s imperative that your portfolio be in tune with the market. As of Monday, 35% of stocks in the S&P 500 were trading below their 200-day moving average, which is typically a sign these stocks are in bear markets. Looking at the Dow Industrial Average, Cisco, Chevron, International Business Machines Corp, Coca-Cola, McDonalds, Proctor & Gamble, AT&T, Travelers Companies, Verizon, and Wal-Mart were trading below their 200-day moving average, while Home Depot and Johnson & Johnson have just flirted with that party. So that’s 30% of the Dow trading below the 200-day moving average, which sounds about right when we look at the S&P 500. So, technical damage is being done and you need to make sure you’re in stocks that are either basing or in rising trends.
The silver lining is that this secular bull market isn’t over, and is nowhere close to being questioned at 1794. Likely, once the economy turns around after the winter season’s change and pent-up demand works its way back out on the streets. Rising home prices (Case-Shiller Tuesday said prices up 13.7% yoy in November) should continue to help the consumer, as the market is doing the Fed’s work by easing rates over the past month.
I already started decreasing my exposure to the market before last week’s correction in insurance, retail, and select energy stocks. I’m using this rally to decrease my exposure some more in any stocks that have had technical damage done to them and are breaking down. At the same time, I am beginning to use this opportunity to rotate into stronger areas where companies are beginning to break out of long consolidations. As Stan Weinstein always says, corrections can help you “get religion” to “keep your portfolio in A+ shape”.
