Before we begin, a quick review of three things I think are happening:
- Stocks are in the midst of a 3-6M volatile sideways range. Mean reversion should be the dominant regime over the next few months. Equities are unlikely to sustain any trend.
- Mean-reversion goes both ways. The initial decline has already triggered significant oversold signals in my Core Models, far more than is “normal” for such a small 5% pullback.
- This diminishes the risk of another 2018-style collapse.
Now let’s look at some charts and see why…
My Core Equity Model has fully reset to an oversold condition. This is my most important model. It aggregates all the Equity data I run. Any residual decline could trigger a full Buy.
This is my Core Equity Risk model. It’s extremely oversold and ticking up, which triggers a Buy signal. It’s at one of the lowest points in years, matching some major bottoms in the past. Yet the S&P has only pulled back 5%.
This is my Master Flow Model. It combines all Equity flow data I monitor. It’s still falling as more investors move to the exits. Selling continued even as Stocks chopped sideways last week. Looking for a bottom near the target area (red line).
Some of my individual Core Flow models (which are inputs to the prior chart) remain at a strong Tactical Buy signal since early last week. Starting to move up.
Market on Close (MOC) order volume. Traders are selling aggressively at the close. No desire to hold overnight risk. Getting very “oversold”.
Put/Call Ratios (10d) are almost fully oversold. Still falling, no sign of improvement yet. But most of the adjustment looks complete. Sentiment has fallen significantly. Looking for a bit lower then a turn to confirm.
VIX short positioning has been cut in half. Could be moving to an extreme Long (see ideal target area). If so, the unwind is 50% finished. Or it could just go to the minimum target (similar to 2016). If so, the unwind is 75% finished. Newspaper stories are already showing more fear priced in (snippet below the chart).
Next, my Volatility Seller P&L Model. Profits have been wiped out. This was my base case scenario and it’s now complete. Things could get worse, but I think the damage would be very brief and quickly reverse, like in Brexit in 2016 for instance. I don’t think the odds favor another extreme decline, not like 2018.
AAII Survey Bears increased +16 last week. This was the sixth largest increase in ten years. The wall of worry is quickly being rebuilt, similar to 2012 & 2016 while Stocks traded near their highs. Positive for the eventual breakout and continuation of this advance.
AAII Bull-Bear Spread collapsed -29 last week. This was the third largest decline in ten years. Huge drop for such a small market pullback. The wall of worry is growing.
One reason Sentiment is falling so rapidly: Stocks are gapping down a lot in the last few weeks. It’s creating a lot of discomfort. No one wants to hold overnight exposure. It’s also driving traders to sell aggressively at the close, as I showed earlier.
Below, the negative gaps are so extreme, we’ve only seen them at the capitulation stage of much bigger declines – for instance 2009, 2010, 2011 and 2015. Mr. Market has cleverly made a 5% pullback feel like a major correction. Look for conditions to improve.
S&P short interest has risen sharply, back to the top of the range of recent years, and where Stocks typically found some support. (source: Markit)
Adding it all up, my models exhibit considerable damage for such a small 5% pullback. The correction may not be finished, but the psychological damage is already extensive.
Ultimately this reinforces my mean-reversion thesis, while diminishing the risk of another 2018-style collapse. The longer we’re stuck in this chop, the greater the likelihood that trader sentiment drops even more. Ultimately, this could set the stage for an eventual breakout, perhaps later in the year.
Thanks for reading!
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Macro Charts 