BEAR MARKET SCENARIO

TAKING OUT THE RECENT LOW

We have data in hand, including put-call-ratio readings, that say the October 29 intraday low of 2,603 has similar characteristics to bullish reversal points that held in the past. We also know the October 29 low represents a higher low relative to the February 9 low. The chart below is during Monday’s session with the S&P 500 down 33 points.

MAKING A SERIES OF LOWER LOWS

Concerns would increase if the October 29 low is exceeded, especially for more than a relatively short period of time (a few hours or a few days). Given the market’s renewed weakness during Monday’s session, it is prudent to have a detailed bearish game plan in place.

Our plan is to step out in an incremental fashion based on specific levels. If the market holds above the levels, we will sit tight. If the levels are violated on a closing basis, we will take action. Since markets can bounce back before the end of a week, a weekly close below a predetermined level would be more concerning than a daily close. The size of our incremental steps will be based on the hard data/model readings.

While retests and pullbacks never feel good, price action earlier this year illustrates that bounces can be sharp.

Our predetermined levels respect that many stops are set in the same logical areas, which can cause markets to overshoot those levels and reverse once all the stops have been triggered. We covered the 2011 case in a recent post, which provides an overshoot example during the retest of a prior low.

The chart below is during Monday’s session with the S&P 500 down 45 points. The market still has numerous forms of possible support below.

POSSIBLE OUTCOMES

If all levels in our step-out plan are violated, the model will most likely be moving to 100% cash. If the bond market can catch a strong bid, the math may allow for a cash/bond mix. During Monday’s session, the long-term Treasury ETF (TLT) was oscillating between a small loss and no change. A big bullish spike in bonds would also increase stock market concerns in the coming days and weeks; it may happen soon, but it has not happened yet.

QUICK REMINDERS

Flips between improvement and deterioration are not uncommon during periods of volatility and consolidation (see charts below).

While there is nothing magical about any particular level of possible support or possible resistance, having reference points can help reduce overtrading until the market tips its hand one way or another in a more convincing and decisive manner. The excerpts below from the October 30 Short Takes post still apply:

No one knows how 2018 is going to play out. A fact-based case can be made for both the big-move-up and big-move-down theories. Typically (not always), if we can step back from the day-to-day swings in price and our emotions, we will have time to prudently get allocated in line with the evidence, regardless if the outcome is wildly bearish, as it was in 2007, or wildly bullish, as it was in 2016.

The vast majority of common investing and trading missteps are related to having a very short-term focus and making changes based on short-term fear. The market will eventually tip its hand in the “new downtrend” or “correction followed by a new uptrend” direction. If we can shift our focus to the bigger picture, the odds of success will increase significantly. If we remain focused on daily fluctuations and short-term outcomes, the odds of success will decrease significantly.

NOT TIME TO PANIC, BUT PRUDENT TO BE PREPARED

The market has shown numerous signs of trying to make a bottom, but still has a lot to prove. The short and intermediate-term data remains unquestionably concerning. If we execute in a cool, calm, and collected manner, we can balance the need to protect capital with the risk of overtrading and dying a whipsaw-induced death of 1000 cuts. It is not unusual for the market to be extremely volatile and frustrating while trying to form a lasting bottom.

DAY BY DAY BASED ON FACTS

We are not making any assumptions about whether or not our predetermined levels will hold. We may do nothing in the coming weeks or we may migrate to a 100% cash stance. The market and the data will make the calls. The charts covered on October 30 remind us how helpful it can be to think about day to day swings in the context of the bigger picture.

HOW STRONG IS THE RECESSION/BEAR MARKET CASE?

DETAILED LOOK AT FUNDAMENTALS AND TECHNICALS

WHIPSAWS AND MARKET GUIDEPOSTS

RETESTS ARE COMMON

Fifteen days ago we posted the following charts on Short Takes.

In that October 30 post we noted:

In the 2016 chart above, notice how it is not uncommon for the stock market to push higher and then backtrack to retest the prior low, something that may or may not happen in 2018.

If we fast forward fifteen days, the S&P 500 could be in the process of retesting the October 29 low of 2,603.

A retest of a low can take place by moving above previous low, to the previous low, or as noted earlier this week below the recent low. Retests can pass and retests can fail. We will learn something either way.

ANY SIMILARITIES TO 2016 LOW?

A logical question after five days dominated by selling conviction is:

Does the present day look anything like the days leading up to or the day of a low?

To help answer that question, we compared the S&P 500’s daily chart on the day of the major 2016 low to today’s chart. If we compare the strength of the move off the first low (compare A to B), you can make a case that numerous indicators looked stronger at point B then they did at point A. For example, in 2016 CCI never approached 100; in 2018 CCI recently cleared 100.

IMPORTANT: All we are looking for is similar here; we are not calling a low or forecasting a low in any shape, form, or fashion. Like any other chart, indicator, or data point, if the look of the 2018 chart varies in a bearish manner in the coming days, then we will learn something. We are simply looking at the data in front of us today. Tomorrow will bring new data and we will review it with an open mind. In the simplest terms, the charts above help us answer the question is there any reason at this time to remain open to a bullish reversal? We must also remain open to much lower lows.

PATIENCE CAN HELP AVOID A DEATH OF 1000 CUTS

When markets are indecisive, they can rally sharply for five days and then drop like a stone for five days. If we continually try to allocate to data that is flipping like a flapjack, we would most likely destroy value rather than add value. Thus, we must seek a prudent balance between managing risk and managing the risk of overtrading, a concept that applies to mid-November 2018.

GUIDEPOSTS CAN HELP

In the 2018 whipsaw chart above, using the February low of 2,532 as a “try to leave it alone” guidepost proved to be very helpful. There was nothing magical about 2,532, nor is there anything magical about any level, retracement, indicator, moving average, or form of possible support; they simply give us logical reference points to manage against.

If a 2000-02 or 2007-08 event is still in front of us in 2018 (which may be the case), we know with 100% certainty all four of the levels shown below will be taken out and taken out in a convincing, decisive, and lasting manner. Conversely, if stocks can make a stand soon (TBD), then all four levels will hold. It is quite possible the real world falls somewhere in between, and as the 2011 low demonstrates, all four levels could be violated and the market could sharply reverse in a bullish manner - helping us emphasize there is nothing magical about any level or guidepost. Maximum flexibility 100% of the time even after levels are violated.

There is no question the four 2018 levels shown above acted as support. Thus, going forward they fall into the “areas of POSSIBLE support”. In each case, sharp and strong rallies occurred after the lows (see chart below). If we retest these areas, the retest may pass or it may fail. We learn something either way. If the chart above was a 60-minute chart, we would not hesitate to consider the four levels as being possibly meaningful in the short run; fractals tell us the same concepts apply to a chart spanning an entire year. The percentages below show each A to B move after a low.

In all four cases prior to the bullish A to B move (green lines below), stocks dropped sharply (red lines below), it felt really bad, and it was stressful. In all four cases, sharp rallies (whipsaws) followed. Not a prediction about how things will turn out with the orange line; simply stating some facts about 2018 YTD.

BULLISH TRENDS AND BEARISH TRENDS

When the data is mixed, it can be helpful to look at things in the simplest terms possible. Bullish trends make a series of higher highs and higher lows. Bearish trends make a series of lower highs and lower lows. The last major event in the S&P 500 was a new all-time high that was made 54 calendar days ago. Thus far, the low in the current decline represents a higher low relative to the February 2018 low. If a devastating bear market lies ahead (which may be the case), we know with 100% certainty the S&P 500 will make a significant lower low below the February 2018 low (requires a drop of more than 169 points from 11/14/2018 close). That may indeed happen in short order, but it has not happened yet.

BEARISH OUTCOMES AND MUCH LOWER LOWS

Are there reasons to be concerned and could much lower lows be in the cards? Yes on both counts. What happens if we take out all four 2018 lows? Obviously, that would most likely prompt some defensive shifts (add to cash and/or add defensive assets); it depends on how the data looks at that time. The shifts could be relatively minor or they could be significant. Our approach is built on taking it day by day based on the facts in hand. If action needs to be taken based on the facts, action will be taken.

We still have two full trading days before this week goes into the history books. A typical retest of a low says even under the successful retest scenario, the S&P 500 may still need to drop another 60 to 120 points. If we look at multiple timeframes (5 min to weekly), three additional S&P 500 levels are worth noting: 2,691, 2,687, and 2,646. Those levels range between 10 and 55 points below Wednesday’s close.

ADDITIONAL FORMS OF POSSIBLE SUPPORT

The chart below was originally presented to assist with “what happens if all three A to B retracements are taken out?” Many of the levels shown are based on longer-term retracements dating back to the February 2016 major low. The chart below is as of the close on November 14, 2018.

DATA ON DECK - ADDITIONAL COMMENTS

Retail sales are due to be released Thursday and the latest industrial production numbers come Friday before the markets open. Additional charts and comments can be found here.

WHY IT IS PRUDENT TO TAKE A BIG STEP BACK

LONGER-TERM OBJECTIVE

In these inflection point situations, our objective is not to find data to support the bullish case, nor to find data to support the bearish case, but rather to prudently develop a plan to increase our odds of being properly positioned for the next sustained move (up or down).

BEGIN WITH THE FACTS IN HAND

After Monday’s sharp selloff in stocks, the S&P 500 was still up 1.97% YTD, which means the longer-term setups on annual charts have not been negated. From a simplified perspective, the last major event in the S&P 500 was a new all-time high. As of this writing, the market has made a higher low above the February low. While the look of the chart below may change, it has not changed yet.

TRYING TO FORM A BOTTOM SCENARIO

It is not unusual for the market to be extremely volatile and frustrating while trying to form a lasting bottom. Think about the November 12, 2018 session in the context of the volatility and frustration near the 2011 low.

Notice in the chart above, even in the context of big swings up and down, the market for the most part is making very little progress either up or down. We can draw horizontal lines and hit price spanning several months, which is a form of consolidation. The 2018 chart below shows sideways action over the past month. In these situations, overtrading can lead to whipsaws and frustration.

A recent Short Takes post noted:

“It is not uncommon for the stock market to push higher and then backtrack to retest the prior low, something that may or may not happen in 2018. “

If a retest of the October 29, 2018 low of 2,603 is in the cards, it is prudent to keep in mind that short-term violations of a prior low can be followed by sharp reversals. For example, the first low in 2011 was made in August at 1,101 (see chart below). The August low was violated by a small margin on a closing basis in early October. The following day the market dropped well below the August low intraday, but reversed sharply before the close, finished green, and well above the August low. After everyone’s stop-loss orders execute, markets can rally sharply.

Notice in the chart above how many whipsaws occurred between the August 2011 low and the October intraday low of 1,074. The “what happened next” chart below puts the correction and period of wild volatility into a longer-term perspective.

ALTERNATING BETWEEN IMPROVEMENT AND DETERIORATION

Last week, the S&P 500 gained 58 points and we could have shown numerous examples of improvement in the data and on the charts. Monday, the S&P 500 dropped 55 points and we could show numerous examples of deterioration in the data and on charts. Flips between improvement and deterioration are not uncommon during periods of volatility and consolidation (see charts below).

GUIDEPOSTS CAN REDUCE WHIPSAWS

While there is nothing magical about any particular level of possible support or possible resistance, having reference points can help reduce overtrading until the market tips its hand one way or another in a more convincing and decisive manner.

OPEN-MINDED AND DATA DEPENDENT

Given the S&P 500 closed Monday 123 points above the October 29 low and 194 points above the February 9 low, we still have logical guideposts to manage against. The excerpts below from the October 30 Short Takes post still apply:

No one knows how 2018 is going to play out. A fact-based case can be made for both the big-move-up and big-move-down theories. Typically (not always), if we can step back from the day-to-day swings in price and our emotions, we will have time to prudently get allocated in line with the evidence, regardless if the outcome is wildly bearish, as it was in 2007, or wildly bullish, as it was in 2016.

The vast majority of common investing and trading missteps are related to having a very short-term focus and making changes based on short-term fear. The market will eventually tip its hand in the “new downtrend” or “correction followed by a new uptrend” direction. If we can shift our focus to the bigger picture, the odds of success will increase significantly. If we remain focused on daily fluctuations and short-term outcomes, the odds of success will decrease significantly.