Last week we talked about trend alignment and before moving on, I want to briefly apply that perspective to the broader stock market. We’ll do this by taking a quick look at daily, weekly and monthly charts of the S&P 500.
Starting with the short-term view here is what the S&P 500 looks like on a daily basis. This chart, in my opinion, exhibits more bearish signals than bullish.
Read Bank Tightening Suggests Layoffs Ahead
First, notice that the trend over the last couple of weeks is down (black arrow). We saw the S&P hit 2100 in mid-April before beginning to sell off, ultimately reaching support near 2040.
Focusing on just the last few days of action, we could take it as a positive sign that the index did not drop through 2040, but this line also marks the possible neckline of a developing head and shoulders formation (neckline would be the dashed blue line while the blue curves represent the head and shoulders).
In order for this pattern to come to fruition, we would need to see the S&P make a rally attempt that failed below 2100, followed by a drop below 2040. This may or may not happen. If it does, it will confirm the short-term bearishness that we’ve seen over the last few weeks.
Next, if we zoom out and look at a weekly chart of the S&P, we find this interesting setup below.
Here we can again see the massive rally from the February lows, but we can also see the broader context in which the rally occurred. Even that massive multi-month rally was not enough to break the bearish pattern of lower lows and lower highs that has been in place since the market peaked.
With the market near the upper end of this distorted trading band, it seems fair to conclude that the path of least resistance is down, perhaps back to the low 1900’s or further.
So far we have a short-term chart that is bearish and a medium-term chart that is also more bearish than bullish. What about the long-term?
Hear Tom McClellan: “Sell in May” Doesn’t Work in Election Years – Look for Market Rally Into July
Typically, I would show you a monthly chart of the S&P 500 to highlight the long-term view, but in this case, I want to show you a weekly chart with the time axis stretched to cover a 20-year period.
The reason I’m doing it this way is because I want to highlight one particular development that has been making its way around the web.
In this chart, the blue and red lines represent long-term moving averages; the blue line is the 50-week MA and the red line is the 100-week MA. Technical analysts often adjust the lengths of moving averages to create some type of pretty picture, in which the crossing of the moving averages has little to no false signals and a couple very important accurate signals.
While this can be considered a form of backfitting, it can also make for interesting observations, and that’s what we have with this chart.
Looking at the behavior of these two moving averages, we see three bearish crossovers (shorter-term blue line crossing below the longer-term red line) over the last 20 years. The first two of these preceded massive drops in the stock market (the dot-com collapse and the financial crisis). The third occurred last week.
We can see this latest crossing in more detail in the right panel of the chart above. This smaller chart is a zoomed in snapshot of the end of the main chart.
When you take into account that there were no false signals generated by this method over the last two decades, it makes the current signal seem rather ominous.
Check out Bianco: Gold a ‘High Yield’ Asset in a Negative Rate World
It also makes it appear that we do have some semblance of trend alignment, in that the short, medium and long-term trends of the S&P 500 all appear poised to head lower.
This doesn’t imply that the S&P has to go lower, it only suggests that the path of least resistance is down. Periods of trend alignment improve the probability that a forecast is accurate, but certainly do not guarantee it.
Moving on, I want to highlight two more charts that tell an interesting story about the market. The first is a chart of the NYSE Advance-Decline line, shown here many times over the last few years.
In this chart, we can see the NYSE A-D line breaking out and reaching new highs. Bullish, right? Well, not so fast.
One thing that has bothered me a bit over the past months and years is that this “all inclusive” NYSE A-D line also includes issues such as fixed income and closed-end funds. Some recent estimates suggest there are about 3500 issues traded on the NYSE, but only about 1800 common stock issues.
These non-common stock issues distort the NYSE A-D line to a large extent. During 2016, we’ve seen interest rates decline, which means fixed income prices have been rising. Adding these fixed income issues into the Advance-Decline line over the last few months has distorted the line to the upside.
In this next chart below, we see the NYSE Advance-Decline line computed ONLY from common stock issues. This is more representative of the market breadth for the NYSE.
Notice how different his chart looks. While we do see signs of bullishness, the latest rally did not achieve nearly the same magnitude as in the chart above. Here, the A-D line remains well below previous highs in early to mid-2015.
This NYSE common stock only A-D line seems to be a much better representation of the market action recently and is probably where we should focus our attention from a breadth perspective. No new highs here suggest that our optimism should be tempered and that perhaps we should pay heed to the developing bearish trends in the S&P 500.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
