Equity Market & Model Review

Before we begin, a quick review of three things I think are happening:

  1. 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.
  2. 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.
  3. 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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Approaching Tactical Bottom in U.S. Stocks

CORE MODELS

Extreme oversold signals suggest Tactical bottom approaching over the next 1-2 days. Look for reversal to confirm.

This is one of my Core U.S. Equity Risk models. It’s almost fully oversold and very close to a Tactical Buy signal. This suggests an elevated probability of a sharp retracement rally starting soon. This may be the first of two oversold signals similar to the 2016 structure I’ve been expecting (the second one later in October-November).

My Options Gamma Model also very oversold. Positioning may have gotten too negative and is vulnerable to a squeeze.

Several of my U.S. Core Flow models are also extremely oversold. I run several flow models for U.S. markets. Many are scraping the bottom of the barrel here. I haven’t seen a capitulation of this magnitude since February 2018, which is remarkable for a small correction of just 5% so far.

SCENARIO

PRICE

S&P may have residual downside to 200dma and lower band at 2750-2780 area. An undershoot could target 2720 but is less likely. Not shown, NYSE Composite and many key cyclicals are already at respective 200dma and lower band support. Looking for sharp rally possibly to the 2900 area (5-6%).

S&P Daily RSI has reached my minimum target for this initial leg. This is identical to the 2016 period. The market may need 1-2 stabs lower but I’m on high alert for intraday reversals. Stocks have four more days to finish the week. This is a long runway with models so oversold. Any rally later in the week could quickly feed on itself, especially with Gamma this negative. Stocks could still finish the week with a powerful weekly Hammer or bullish reversal.

TIME

S&P E-Mini has a pending Buy Setup that should complete in two days if the market just trades sideways from here. There is also a major Bradley Cycle Date on May 16, the exact day of the potential setup completion.

Adding it all up, this two-day window through Thursday looks like a potential setup for a Tactical turn. Accordingly I am switching my own trading bias to Buy on residual declines over the next 1-2 days. This is my personal trading plan based on my own objectives and risk tolerance, and not an investment recommendation. While I don’t think this is THE bottom, I do think Volatility will remain high and the potential for a sharp squeeze is increasing.

Thanks for reading!

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The Current Stock Market Correction

In late April, nearly four months into a historic Stock rally that began in late December 2018, I tweeted some Summary thoughts and suggested plan for Q2-Q3:

I proposed two core ideas at the time. In this note today, I will focus on the first idea — Stocks. My reasoning is based on some charts that really stood out to me at the time:

First, Stocks were very extended in late April and likely to switch to a volatile mean-reverting regime. On April 29, I tweeted the below chart, showing the S&P Technology sector’s trend strength at one of the highest in history. I added that “a major corrective phase is likely to occur this year, lasting several months. Could be a topping process like 2000. Or (as I believe) a multi-month big volatile consolidation similar to 1991, 1995, 2004, 2012.”

Note the red boxes I drew above. When Stock prices move significantly in one direction for a relatively short period of time, they exhibit very high trend strength. Eventually, this reaches an extreme and the strong trend is vulnerable to exhaustion. The result is a return of two-way volatility, usually a violent sideways consolidation. This is what the red boxes show. And that was my best guess in April for what was coming.

Stocks are now correcting, but I believe we are still in a Bull market. One can never been 100% certain in markets, but I think a Bull market is still the most likely scenario. Note in the prior chart — in 1991, 1995, 2004 and 2012, Stocks rallied strongly and then consolidated bullishly for several months, ultimately moving higher.

I also think this is more likely to be a single digit correction, not another severe decline like last year. To illustrate why I think we’re in a Bull market, and why the correction should be relatively mild, I present the chart below: in late April nearly 80% of S&P stocks were trading above their 200dmas. The key condition to evaluate is: is Stock Breadth ABOVE or BELOW the 50% line?

At the time, I tweeted this chart and wrote it’s “reminiscent of the 2016 rally which reached 78% before two pullbacks that held above 50%. This is very positive longer-term. Market likely to correct through time, maybe 5-10% downside volatility next 3-6M.”

Further, notice above that the most violent declines of the last several years: August 2015, January 2016 and December 2018, all shared the same weak Breadth characteristics under 50%. (In fact this is a recurring feature of virtually every big Stock decline of the last 100 years.) Even late last year, note the red “X” in October-November 2018. That’s where Breadth failed to exceed 50% and soon after, the market collapsed in a second selling wave.

For reference, here is the same Breadth indicator from 2005-2009. Note the 2008 Bear Market began when the indicator failed under the 50% line. I marked it with a vertical line below. Soon after that, Stocks finished their topping process and began to decline in earnest. When I look back at the chart from April 2019, it’s a long way from any serious weakness and still looks like a Bull market.

I’ll add more charts next, but it’s important not to forget this simple concept illustrated above. In markets, I believe the simplest ideas are the most powerful. What is simple is often misunderstood. When I started in markets, I thought the most complex indicators would give the best results. I searched far and wide looking for answers. In those early years, my quest for more information led to an advancement in my theoretical understanding, but yielded few practical insights. When I decided to refocus on the right things, everything changed. The most important lesson I learned in those early days was: the market had been communicating the message all along, and simplifying my focus allowed me to listen.

Now let’s go one step further.

The next chart is from an idea I tweeted on May 7, where I noted the “Nasdaq Composite with roughly half its Stocks trading >200dma (red series), similar to where the initial rally topped in April 2016. Intermediate breadth weakening, just 56% trading >50dma (blue series). When this breaks below the 50% line, a correction is likely to be underway.”

Unlike S&P Breadth which as we just saw earlier, got very high at almost 80% of Stocks > 200dma, the Nasdaq Composite Breadth was much weaker and still under 50%. Below is an updated version of that chart. Note that 200d Breadth never did get above 50% and now 50d Breadth is moving back under the 50% line. Not surprisingly, we’re starting to see Volatility creep up again.

There are some striking similarities between the current market and some important prior periods. Let’s look at what they are, and what it could mean.

On May 2, Michael Santoli of CNBC noted the following on Trading Nation:

“As S&P 500 sits at a record, nearly a quarter of stocks are still stuck in a bear market […] at least 20% from 52-week highs.”

This weakness is important to study and discuss. I made this chart to illustrate the idea, with some of my own annotations and thoughts added. What we have is a market that rallied back to prior highs, similar to 2012 and 2016, but many Stocks are still more than 20% below their own highs. In other words, the Trend is strong but Breadth participation is weak.

What happened in 2012 and 2016? Stocks spent months basing near the highs, with two separate pullbacks each time. Exactly like the volatile “red box” consolidations from the very first chart, where we talked about the Trend strength being too high and the mean-reversion that ensued. Everything is tied together and related.

Corrections come when uptrends become extended and Breadth can’t keep up. In 2012 and 2016, the result was that Stocks needed time to rest and gather the energy to move higher.

First, let’s look at 2012:

Now let’s look at 2016:

And back to today:

What could this all mean, and what could we see from here? Following the Summary thoughts shared at the top of this note, here are some ideas I’m carefully balancing and considering, while remaining focused on the bigger picture (and keeping it simple):

  • We may be more than halfway through this correction in terms of price. If the 2012 and 2016 interpretations are correct, and we remain in a Bull market as I believe, the S&P index could perhaps bottom in the low 2700s.
  • Historically, Stocks went through mean-reverting phases that lasted 3-6 months and we’re still not even a month into this one. So it seems we could still be in the very early stages of this process, in terms of time.
  • This could provide plenty of opportunity to slowly accumulate good Stocks as weak hands lose patience, get frustrated or shaken out.
  • It seems the market’s goal here is to frustrate Bulls and Bears with a lot of erratic price movement, while ultimately making little net progress either way.
  • Because of the extreme volatility of 2018, some may fear this will become another massive decline. Since Mr. Market never makes things easy, a sideways range could be equally if not more difficult to deal with.
  • Looking back at history, the good news is that once 2012 and 2016 were out of the way, the following years were excellent for Stocks. The S&P advanced 30% in 2013 and 20% in 2017.
  • Those great advances weren’t a coincidence. Stocks had worked off their extended condition through time, while Breadth improved gradually and individual names began to catch up.
  • When Stocks had finally gathered the energy to rally again, the breakout came and they never looked back. Maybe we’ll see something similar later this year, when everyone becomes exhausted of the headlines and volatility.


Thanks for reading.

If you liked this post, feel free to share it with colleagues and subscribe to the blog to receive future updates. I’ll be revisiting this theme and many others over the next months, on my Twitter account and in bigger thematic pieces here.

Some notes on Stock sentiment

Last week produced a list of “Bullish” news so extensive, I don’t recall seeing anything quite like it in many years. I’m writing a list to organize my thoughts with the goal of revisiting everything later on. Perhaps there is something to be learned here. Only time will tell.

To me, it looks like sentiment is completely euphoric and speculation is rampant. While this kind of excess can sometimes keep going and get even more extreme, one thing is clear: we’ve come a long way from the dark days of December.

  • Major Wall Street banks are “telling clients to be ready for a sudden rip higher in the market.” The banks “highlighted the possibility of a rapid, surprise jump in the stock market known as a ‘melt-up,’ driven by investors looking to get in on a positive momentum shift.” (CNBC, May 1). The banks recommend playing the melt-up with call options, “the best risk-adjusted way to add beta”.
  • Several Wall Street strategists increased their S&P target prices simultaneously this week. The most stunning move was a strategist who had the second lowest target, jumped overnight to having the second highest target.
  • Tech “Unicorns” are flooding the market with a huge number of IPOs. The unicorns have incinerated billions of Dollars of private equity money over the last decade, operating in low barrier-to-entry markets with little chance of ever making money. Many unicorns even say this in their prospectus, telling investors they may never turn a profit.
  • Beyond Meat, a company that makes plant-based meat substitutes started trading this week, its stock rose +163% on the first day of trading, making it the best-performing IPO since the financial crisis.
  • The SoftBank Vision Fund, perhaps the biggest private equity fee-generating bagholder scheme of all time, is “considering audacious fundraising plans, including a public offering of its $100 billion investment fund and the launch of a second fund of at least that size, as it looks to seize on an exploding startup scene”. Audacious may not be the best word to describe this plot.
  • Louis Dreyfus, a family-controlled company that has been private for 168 years, is suddenly holding talks with potential investors to sell equity stakes.
  • Almost every major financial media source/website published a “DON’T Sell in May” article this week.
  • Berkshire Hathaway revealed it has finally bought stock in Amazon. Warren Buffett himself regretted publicly years ago that he “missed” the opportunity to buy shares early in the company’s history. All of a sudden the most traditional, disciplined value investor in history has capitulated and bought into the most consensus growth story of this investment era. The decision was likely influenced by his lieutenants, who have been moving towards tech investing in recent years.
  • On May 6 (today) the CME will launch Micro E-Mini futures for the S&P, Nasdaq, Dow and Russell indexes, offering a product for small retail traders to access index futures. Historically, the launch of new futures products have coincided with some major turning points in markets. The most recent case was Bitcoin futures, which started trading December 2017 just five days before the cryptocurrency topped and fell -84%. Other examples include Uranium futures in May 2007, almost the exact day of the top, after which prices fell -88%. Gold futures debuted December 1974 less than 0.80% from the final top, after which Gold fell -44% over the next 2 years.
  • Businessweek magazine just put Microsoft’s CEO on the cover, displayed as a heavenly figure surrounded by clouds, captioned “The Miracle of Microsoft” and proclaiming “The greatest tech company of the 1990s is back!”. Previously, the last stock featured on the cover of BW was Boeing on February 19 2018 (“Up. Way Up. How Boeing seized the sky”), after which the stock spent ten months plunging five different times.

Welcome to Macro Charts!

Look for regular content here soon! Feel free to subscribe if you’d like to receive future posts.

Here is an initial outline with some topics & ideas I might write about more regularly:

  • Single-topic posts such as comparisons between historic market environments, a chart run of a topic I’m exploring, scenarios/probability analysis and risk management.
  • Data analysis & Model discussion using unique and practical datasets I’ve created over the years.
  • Some educational resources. For instance, how I learned to use market indicators more effectively, common myths & misconceptions about markets, and links to relevant academic research.
  • Weekly Summary of my Tweets in a convenient single archive.
  • Short Commentary on a recent market development that could be important (most aren’t).
  • Bigger thematic reviews tying major markets together.
  • Suggestions and ideas received from readers.
  • Stories and experiences from trading global markets over 25 years.

Why am I doing this?

  • It’s a small world and I’m always looking to meet smart people with diverse interests.
  • Keeping a blog diary and reviewing it later on helps improve my process and my thinking.
  • Paying it forward: maybe some of what I’ve learned can help or inspire someone on their own path to success.

Look forward to this new and exciting journey.