Calming Your Nerves (SPY)

So, is it a bear market? Is the top in? Are we headed for the long-awaited forlorn furnace of financial ruin?

 

Of course, one can never be 100% certain, but for this observer the answer today is ‘no’.

Art

Now, that’s not to say that we won’t change our minds. It could be that developments today or tomorrow necessitate a change in thinking. But we’ll cross those bridges when we get there.

 

In the meantime, consider the bad news –

 

  1. Dow Theory

 

According to one of the oldest technical means of reading the market, we’re possibly in the beginning stages of a bear market.

 

Dow Theory works on the principle of higher highs and higher lows being indicative of a bull market, while lower highs and lower lows are indicative of a bear. What Dow Theory then does is combine the charts of the Dow Industrials and Transports into a means of corroborating highs and lows, such that new highs on both will be indicative of a bull, while new lows for both will signal a bear. When only one index makes new highs (or lows) without the other confirming, the market is in a state of ‘non- confirmation’, meaning we simply have to wait until the one catches up, or the other breaks down.

 

Let’s look at the Dow and the Transports for the last two years to get a clearer picture of the current Dow Theory read of the market.

DJTA DJIA Technical

The chart shows two distinct phases: the first, when both the Dow and Transports were rising (through the winter of 2014/2015), and the subsequent decline for both indexes through the rest of 2015.

 

During the rise, it’s clear that the Dow confirmed new highs that were posted by the Transports in late November of 2014 (red circle). The problem was that thereafter, the Dow continued to make new highs while the Transports trailed off (in blue), signaling a Dow Theory non-confirmation. That essentially meant the market was in flux, and until the Transports confirmed the last highs on the Dow with new highs of their own, it was unclear which way we were headed.

 

Swan Dive!

 

Then came the action of late August 2015, when both the Dow and Transports fell below previous lows from October 2014, setting off an immediate Dow Theory bear signal (first black and yellow dots).

 

Since that time, the transports have proceeded to set further lows (next black and yellow dot), but the Dow has not yet confirmed. Unless and until it falls below its former lows of 15,370, we are in Dow Theory ‘limbo’, with a non-confirmation in place and little to do but wait.

Hang on a second! This is bearish!

 

That’s right. The last full signal offered was the August Dow Theory bear indication from the summer, and that remains in force, though as you’ll see, we don’t count on it holding for a lot longer.

  1. Consumer Strength

 

Next, consider the relative strength of the consumer discretionary sector vis-à-vis consumer staples. This is a fairly widely watched indicator that speaks directly to the confidence of the average American, as well as his view of risk.

 

The thinking is as follows – when discretionary stocks are faring better than staples, individuals are feeling more confident in their ability to both make and spend, and traders are more confident in taking on additional risk by increasing their purchases of discretionary stocks. But when the strength of the discretionary sector weakens against the staples, we’re likely looking at a period of negative sentiment from the consumer, and traders, too, will minimize risk by preferring purchases of the more stable consumer staples sector.

 

Below is a chart of the two mapped against each other for the last year. We’ve chosen two liquid ETFs to represent each sector, the Consumer Staples Select Sector SPDR ETF (NYSE:XLP) and the Consumer Discretionary Select Sector SPDR ETF (NYSE:XLY).

xly xlp technical

As the chart shows, the discretionaries broke away nicely in the spring and summer of this year, indicating a good measure of health in the market (in red). But with the swoon in Chinese stocks over the summer and the contagion that ensued globally, the gap between the two closed tightly during the late August selloff.

 

Since then, there was a brief rebound, but it appears increasingly that the discretionaries are losing ground (in blue). Whether this is a genuine reflection of consumer spending patterns or rather a ‘risk-off’ trade on the part of fund managers and others, is hard to tell. But there’s no doubt that it’s bearish, and if it continues, could signal something significant.

superman

As to the positive side of the ledger, we have to apologize that we’re repeating ourselves in what’s become something of a mantra here at Normandy, but what can we say, we believe in our story, and it goes like this –

 

  • Sentiment – we’re at rock bottom levels on the AAII Bullish Sentiment gauge. Bear markets never begin from these levels. When we see rampant enthusiasm for stocks, we’ll start to worry.
  • Liquidity – there’s too much money in the system, and it has nowhere to go but the stock market. Eventually, it will arrive.
  • China – the latest bout of nerves stems from China, where market jitters have rocked the Shanghai market since mid-summer. The Chinese will not let the latest apparent instability go unpunished.
  • Nor will the U.S. Government and Federal Reserve, official sponsors of the bull market. If they have to stimulate to help the Chinese or the NYSE, they’ll do it. Count on it.

 

Shut Down Part of an Open Trade

 

We’re closing out one more segment of a trade we initiated back on the 10th of October. The letter was called A Radical Trade, and there we urged you to open both a CALL backspread and a PUT backspread, the majority of which we closed on December 10th.

 

What remains is a short SPY January 199 Straddle, the CALL side of which we’re buying back today.

 

Options Trader Elite recommends you buy your SPY January 199 CALL to close. It currently trades for $1.12.

 

Many happy returns,

 

Matt McAbby

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