Monday, April 25, 2016

Is It Safe To Bet On The Rebound?

The cyclicality and volatility of the market can be represented by a child playing on a swing in a playground. As the pendulum swings faster and faster in either direction, the rider finds himself invigorated by the prospect of flying higher and higher until the seat flips, chain loosens, and the individual falls to the ground. Often times, like the investors in the stock market, the child will jump back on the device that failed him just a few seconds ago. The oscillation of the market is not just represented by the prices traded on its exchanges, but also in the sentiment of its traders. The year of 2015 replicated these roller coaster-like symptoms to the throbbing hearts of portfolios everywhere. Despite its persistence in correcting equity prices, traders continued to throw wave after wave of bullishness behind falling prices. As a result, we find ourselves knocking on the door of an 18,000 Dow Jones Industrial Average and a 2,100 S&P 500, values prognosticated as speculative just a year before. What should we make of it now?

A review of 2015 doesn't really give hope that this rebound could solidify. The beginning of last year saw a trading range develop where investors constantly shuffled between achieving new highs and falling to new lows. Volume and momentum values hinted at the weakness of the speculative prices peaking around 2,130 (for the S&P 500) before falling to 1,867 in a matter of days. Chinese weakness and questions surrounding the solvency of investments in their stock market inspired a flash shock that shaved a good bit off equities. However, almost half of the losses were gained back in what looked like a contrarian response that drove oil prices and their equities higher after being heavily sold off in the first part of the year. The facade of strength in energy equities caused a phantasmic recovery in a record-setting October which quickly fell into a bearish trading range after hitting the ceiling at about 2,116. At the turn of the year, another bearish crossover of the 50-day moving average and the 200-day average marked the beginning of losses in January and February of the new year. This cycle from bottom to top finished in about four months a quick completion compared to the seven-month cycle that spanned the end of 2014 and the beginning of 2015. We now find ourselves two months in the current trend from the bottom on February 10, 2016. Will we end up falling again?

In the chart above, the RSIs of four of the SPDR Select Sector ETFs are plotted, representing the cyclical movement of the energy, utility, technology, and industrials. The graph and spreadsheet will be available here for a closer look. The orange boundaries follow the lowest and highest points of the plotted lines showing the general RSI of the market as represented by some of its components. There are two periods on the graph that reveal a peculiar result, and they are surrounded by a black box individually. The first shows the cluster of sectors mostly oversold after the sell-off in late August which lead equities into an uptrend into late December where three of the four sectors peaked near 80 or overbought. Around this point, the next downtrend tumbles into late February where another black box marks another period of a cluster of oversold RSI readings. Trace the lines to the green endpoints where we can find them now. Utility and technology stocks are currently meandering near overbought levels but have yet to peak above 80. Conversely, industrial and energy stocks approach 30 and 20 respectively warning of oversold trends. Even though the S&P 500 has approached the ceiling that was established near the red arrow, the momentum indicator reveals some upside potential in industrials and energy despite their weight on the overall markets. An overbought utility sector might also signal more growth or at least sustained girth for the time being as that interest-rate sensitive sector typically leads peaks in the overall market. This phenomenon can be observed in the peak of the blue utility RSI just after the first black box (around October 27th) then weakening as the other three sectors continued to their peak indicated by the red arrow. Could we see the pattern repeat if XLE and XLI recover and push higher?

An important thing to keep track of in an analysis of a bullish trend is if the small-cap equities are justifying the bullishness in large-cap stocks. As stocks are declining, large companies have the ability to counter the poor sentiment shown by their share performance by adjusting their fundamentals in tandem. For example, they can boost their cash position to ensure liquidity or drop costs to encourage revenue growth. Smaller firms, usually with a market capitalization of $1 billion or below, do not have the luxury of an elastic financial position. This especially becomes a problem when the downtrend coincides with quarterly reports. The Russell 2000 is a small-cap index that allows investors to monitor the health of these equities in the current economic environment. The chart above shows that small-cap weakness was very evident before the two sell-offs that occurred in late August and late December. The red arrows show the Russell 2000 entering a trading range with successive lower lows and lower highs signaling bearishness going into the sell-off, shown by the vertical yellow marker. The blue arrows show the further weakness of small-cap shares with each downtrend as the slope of the trendline connecting the lows steepened. After a bottom in February, though, the trend appears to have reversed as early March price broke through a resistance set in late September. The green arrow shows the development of a bullish trend line as prices achieve successive higher highs and higher lows. For now, it looks as though the technicals of the Russell 2000 justifies the market rebound. Look for two important junctions to come up in the future of the Russell chart: the crossover of the 50-day moving average and the test of the ceiling at about 1,200. If these events turn to bullish signals, the recovery could be extended into 2016.

Earlier this week, the Dow Jones Industrial Average reached a local high of 18,167 approaching the 52-week high 18,351 set May 19th, 2015. Similarly, the S&P 500 reached a high of 2,111 also nearing its 52-week high 2,134 set May 20th, 2015. Both indices are trading more than 10% above their prices three months ago reversing the sell-off that stormed into 2016. Since then, investors have picked themselves up and sat back down on the swing to push equities to new heights. These price levels might actually be viable too with a bullish crossover of the 50-day and 200-day moving averages signaling technical strength. Similarly, momentum readings of the major sectors revealing strong utilities which usually lead a stock market peak. The strength of small-cap stocks shown by investors' willingness to purchase these shares justifies the gains of their large-cap pairs. The damage appears to be healing and solidifying into an economic condition that can support the current price trend. Watch earnings for the first quarter as well as some of the technical events that I have mentioned for helpful signals. But as far as swings go, this one may be wanting to go higher.

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