The first recovery rally in a major new bear market often convinces investors that all is well, and as the recovery rally continues investors tend to become more bullish than they were at the prior all-time highs. This voyage toward euphoria can be measured with sentiment surveys, put/call ratios, and other ways, which tend to result in blunt and imprecise indicators, until they all enter the extreme parts of their ranges. When these various measures reach historic extremes as they did these past few days, then so does their accuracy in terms of warning that a turn may be at hand. Even, when a recovery rally has relentlessly taken out often accurate Fibonacci targets, or other obvious levels of chart resistance.
Last week’s update documented that the likely Fed inspired recovery rally off the March 23 low had bested four of the five percentage gains clocked by previous major bear market rallies. This past week only one realistic S&P-500 target was left standing at S&P 3238. While I intellectually knew that it is the mission of bear rallies to suck investors back into danger, I must admit to my frustration level rising as the rally was finding a bid during every minor intraday pullback. While trillions of dollars of borrowed liquidity was finding its way into equities, a number of sentiment measures entered the extreme parts of their bullish ranges, where those usually blunt instruments become increasingly accurate. Finally five S&P-500 points shy of an important, and last reasonable target, the rally faltered.
Screenshot-131 above shows that to date the post March 23 rally has completed two legs up interrupted only by a brief ten day decline, which ended on May 14. What followed was a sixteen day rally from 2760 to 3233 shown in Screenshot-126. In this leg of the rally every attempt by the bears to take charge of the market was instantly rejected by buyers rushing in to sustain the bid under the market. As this process continued day after day investors became more and more optimistic, which drove sentiment readings into their extreme zones. Screenshot-126 shows that more than 50% of the gains accumulated over the sixteen day rally were given back in just three days, mostly during Thursday’s 1800 plus point Dow plunge. So the events of this past week will be encouraging to the bears, but being the master of disguise that is the market, the bull/bear conundrum remains an open question. However, now the burden of proof will fall upon the bulls to take charge again, or price levels important to the bear case may quickly come into play, or possibly violated at sequentially lower levels, and at perhaps an accelerating rate of decline.
TATY — A REPRESENTATIVE OF A FAMILY OF STRATEGIC SUPPLY AND DEMAND INDICATORS
TATY is shown above in Snapshot-358 in yellow with the S&P-500 overlaid in red and blue candle chart format. TATY declined this week without ever reaching its normal operating range in spite of the prodigious rally off the March 23 low. TATY finished the week at an oversold 110 level, and the premium/discount indicator in the lower panel declined back below its zero line. TATY’s atypical behavior continues as this statistical outlier of a market event is causing families of both strategic, and tactical, supply and demand indicators to behave atypically and abnormally. This abnormal behavior across families of indicators may be a “tell” that this outlier event has more chapters to complete before its story can go in the history books.
One last observation about the TATY chart. Sharp eyed investors will notice this week’s big red candle down on the S&P portion of the chart “engulfs” the previous week’s bar. According to Steve Nison, the author of the book introducing Japanese candle charting to the Western World, an engulfing candle in this position is a bearish sign. The chart is in weekly format, which makes the signal even more significant.
THE BULL LIVES AND IS JUST TAKING A BREATHER
The late Marty Zweig is credited with coining the phrase: “Don’t fight the Fed, and don’t fight the tape”. The powers of the Fed are awesome, but also finite. The finite limit on the Fed’s powers may come into play, if reasonable officials and the media begin to question the massive amount of debt being hoisted onto the nation’s balance sheet. Or, if Chairman Powell, who said this past week the Fed would keep rates low into 2022, is over-ruled by the credit markets, which may decide to take rates higher. Anyone who has been in this game for any length of time knows the Fed historically follows the rate determined by market action. The Fed can influence short term rates, but longer term rates are the product of markets in action.
The notion that the Fed sets interest rates is one, which the worst lawyer in the poorest rural county in this nation could make an easy case against. How long can the Fed get away with investors not demanding a risk premium for lending their capital for years in increasingly uncertain times? I have friends and colleagues in this business, which can make a potent case that the interest rate cycle, normally decades in duration, has bottomed and rates are likely to rise. Oh yes, the tape has certainly been positive since March 23, but sent a signal this past week that may be about to change.
Another positive for the bulls is a study done by Lowry Research, which shows that when a recovery rally results in a new all-time high for the cumulative Advance/Decline line there is a 90% chance that a new bull market is underway. Other analysts point out that the information derived from the Advance/Decline line became challenged, when stocks stopped trading in one-eight of a dollar increments, and switched to penny increments. Lowry Research does excellent work, which I applied very successfully all during my investing career, so their study should not be discounted. However, this outlier of an event started with the Advance/Decline line making an all-time high, only the third time in history that has happened, so one must respect that another leg down in a developing large degree bear may also resume with the A/D line touching new all-time highs during the recovery rally rebound. This is not an easy game even for pros with winning records, because from time to time the market serves up a statistical outlier like the current one.
IT IS A BEAR MARKET AND A TRAP
If the recovery rally is complete, and a large degree bear market is resuming, then the resumption of the decline is likely to gain momentum, and then begin to accelerate lower. The second leg down in a major bear market is the recognition phase, when investors realize the bear has not ended, but is only just getting down to business. As the recognition spreads selling tends to beget selling, and at some point all those Artificial Intelligence algorithms embedded in countless global trading systems will likely be triggered, which may result in more panic selling.
This bear market began with the shortest decline to 30% off an all-time high in the history of the stock market. If that was just the first leg down, then investors can imagine the swift wealth destruction, which may result when global investors recognize the bear for what it is, and then hit the sell button all at the same time. Screenshot-128 shows some Fibonacci support level targets for the renewed weakness, which began this past week. If the bull market still lives, then the renewed decline may likely begin to bottom at one of these levels as the missing to date “test” of the March 23 low. On the contrary, if the bear has awakened from his springtime nap, then these levels may slow the decline, but even so the decline will likely be relentless, and if history is a guide, then the decline will begin to accelerate lower at some point. In short, if the recovery rally is complete, then equity investors will likely be encountering the potential for rapidly escalating risks to their wealth daily, until this new leg lower bottoms.
The extreme bullish sentiment of this past week is a significant sign that the recovery rally may be a trap set by a bear for the overly optimistic. And, the recovery rally now clearly shows two legs up, the second leg being within five points of a Fibonacci .618 of the rise of the first (Screenshot-131 displayed at TOP). This is a typical pattern in bear rallies, although not all paint out such almost perfect Fibonacci relationships. The fact this one did lends credibility to the notion that the rally was a bear rally, and not a kickoff to a new bull leg. There are several important levels at which the bull and bear cases may be tested, but a close below S&P-500 2760, the May 14 low, would be a significant negative for the bull case, which would imply an overlap of the top of the first leg up. If an overlap should occur, then in at least one form of analysis it would grade out with very negative potential consequences. Screenshot-130 below shows Fibonacci support targets for the entire recovery rally to date, and the leg up from the May 14 bottom at 2760 to the top at 3233. The decline may pause, or stop at any of these, but if all the upper targets are breached by the budding decline, then the odds will increase in favor of the bears.
Lastly, ever since this decline began in February it has generated outlier type metrics, and atypical and abnormal behavior in my families of both tactical and strategic supply and demand indicators. The failure of these indicators to lead the rally higher like a gravitational pull has never happened before. When an indicator like TATY fails to return to its normal operating range after such a huge rally in the price, then one must treat that aberrant behavior as a warning that something historically significant may be afoot with this bear market.
THE BOTTOM LINE
The stock market remains a master at disguising its intentions. However, the events of this past week have given an edge for the time being to the bears. I do not like the current potential risks to reward for owning equities, because the penalty for owning equities in the recognition phase of a major bear market is potentially very severe, and that penalty tends to be applied swiftly. If our risk/reward assessment changes in favor of reward, then we will dollar cost average into a reasonable asset allocation core holding of equities. However, uncertainties abound due to the looming election, a virus Pandemic for which there is no vaccine, nor efficacious remedy, depression level economic metrics due to unemployment, racial unrest, a swift and parabolic increase in the national debt during a potentially rising interest rate cycle, and the list goes on — and the stock market most definitely does not like uncertainty! If the bull market still lives, then it will have to climb the proverbial “wall of worry”, which is currently constituted with a multitude of worries.
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