THE FOUR SCENARIOS
The four market scenarios below, originally referenced on April 8, continue to provide a framework for prudent contingency planning:
ONE: Low is in and stocks continue to rise rapidly.
TWO: The market will remain in a wide trading range.
THREE: A typical retest of the March 23 low is coming soon.
FOUR: An atypical retest with a significantly lower low lies ahead.
Unless you believe you can predict the future with 100% certainty (something we all know is not possible), it is prudent to have a mixed allocation that allows you a migration path to handle all four scenarios.
FAILED BREAKOUT LOOKS
As of the close on Friday, April 17, many charts had a constructive breakout look. In the chart below, notice how price closed above the blue line last week and weekly RSI closed above 50 for the first time since February.
While it is only Tuesday, the same weekly chart is currently sitting in a much more concerning failed breakout state.
There was valuable information in the failed breakouts that occurred after the S&P 500 peaked in February. As long as the failed breakout looks remain in place, they may be providing information about increasing odds related to scenario three (typical retest of prior low) and scenario four (atypical retest with lower low).
BOTTOMS TYPICALLY TAKE TIME TO FORM
In terms of assessing odds related to the four market scenarios, history says major bottoms tend to take time to form. As we have covered via historical examples in the past, more favorable risk/reward entry points following a decline tend to occur when the S&P 500’s 10-week rate of change sits near -5%. The current reading is -18% (chart below), which means even if the market is trying to form a sustainable low, some backtracking/sideways action may be required.
The same concepts apply to volatility expectations. It is not unusual for the 10-week rate of change on the VIX to drop below 10% near a favorable risk/reward entry point. The current 10-week rate of change remains elevated at over 200% (chart below), telling us market participants are still concerned about a retest or lower lows in stocks.
NAILED DOWN PROFITS TO REDUCE RISK EXPOSURE
Given the market’s sharp rally off the March 23 low, even a successful retest could involve a double-digit decline in the S&P 500. Therefore, we reduced exposure to growth investments on Tuesday morning. The buys on March 26, April 6, and April 7 (see tweet below) were based on improvement in data after the March 23 low (see April 6 post for examples).
STALLED NEAR IMPORTANT AREAS
The weekly chart of the NASDAQ is currently stalled near logical areas (see blue arrows below). Last week RSI finished above 50. Thus far this week, weekly RSI has dropped back below 50.
The orange line below has acted as both resistance (2014-2015) and support (2018) on the Global Dow. Until proven otherwise, this area may serve as resistance.
ENERGY WEAKNESS
The S&P GSCI Energy Index tracks natural gas and oil. In the chart below, notice how the index made a stand in 2009 and 2016 (both near major lows in stocks). The intraweek look of the chart checks concerning boxes.
WEAKNESS NEAR RETRACEMENT LEVELS
An April 14 post covered developments near the 50% retracement levels in both the 2000-2002 and 2007-2009 bear markets:
Something very similar happened after the initial drop from the major stock market highs made in March 2000 and October 2007. In each case, the market dropped a long way, had a very sharp rally, and moved back near the 50% retracement. In the 2000-01 case and 2007-08 cases, the S&P 500 reversed soon thereafter and resumed the bear market. The 2000-01 and 2007-08 cases are covered in detail in this thread of tweets. Therefore, it is prudent in 2020 to see how the market acts near a very similar 50% retracement level. Our current allocations reflect the forms of bullish improvement we have in hand and they reflect numerous forms of still-concerning evidence that we have in hand.
All three major indexes rallied back near the 50% retracement of the decline that took place between February 19, 2020 and March 23, 2020. While the Dow, S&P 500, and NASDAQ Composite stalled below the 61.8% retracement, the NASDAQ 100 closed above it in an impressive manner on Friday, April 17. As shown in the chart below, that impressive breakout is now taking on a concerning failed look. The same concerns apply to weakness in the Dow, S&P 500, and NASDAQ near their 50% retracements.
REJECTED AT 50-DAY
The S&P 500 closed above the 50-day moving average Friday. That successful move is now looking more like a failed move.
NYSE WEEKLY
The “now looking like a failed breakout” theme carries over to many markets, including the NYSE. Last Friday’s close was impressively above the orange line shown below. This week price has moved back below the orange line.
RESPECTING ALL SCENARIOS
The S&P 500 is still holding above an upward-sloping 200-week moving average, which helps us remain open to and prepared for a pullback or successful retest of the March 23 low.
As noted last weekend via the tweets below, when the data is mixed, there is no downside to being prepared for a wide range of outcomes.
Bear markets and subsequent bottoms tend to be marked by violent swings, failures, and retests. Thus far, the market has not strayed too far from that script. We will continue to take it day by day respecting and being prepared for all four market scenarios:
ONE: Low is in and stocks continue to rise rapidly.
TWO: The market will remain in a wide trading range.
THREE: A typical retest of the March 23 low is coming soon.
FOUR: An atypical retest with a significantly lower low lies ahead.
This post is written for clients of Ciovacco Capital Management and describes our approach in generic terms. It is provided to assist clients with basic concepts, rather than specific strategies or levels. The same terms of use disclaimers used in our weekly videos apply to all Short Takes posts and tweets on the CCM Twitter Feed, including the text and images above.